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CGRP26 - Ten Myths of "Say on Pay"

CGRP26 - Ten Myths of "Say on Pay"

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Say on pay is the practice of granting shareholders the right to vote on a company’s executive compensation program at the annual shareholder meeting. Under the Dodd-Frank Act of 2010, publicly traded companies in the U.S. are required to adopt say on pay. Advocates of this approach believe that say on pay will increase the accountability of corporate directors and lead to improved compensation practices.

In recent years, several myths have come to be accepted by the media and governance experts. These myths include the beliefs that:

1. There is only one approach to “say on pay”
2. All shareholders want the right to vote on executive compensation
3. Say on pay reduces executive compensation levels
4. Pay plans are a failure if they do not receive high shareholder support
5. Say on pay improves “pay for performance”
6. Plain-vanilla equity awards are not performance-based
7. Discretionary bonuses should not be allowed
8. Shareholders should reject nonstandard benefits
9. Boards should adjust pay plans to satisfy dissatisfied shareholders
10. Proxy advisory firm recommendations for say on pay are correct

We examine each of these myths in the context of the research evidence and explain why they are incorrect. We ask:

* Should the U.S. rescind the requirement for mandatory say on pay and return to a voluntary regime?

Read the attached Closer Look and let us know what you think!
Say on pay is the practice of granting shareholders the right to vote on a company’s executive compensation program at the annual shareholder meeting. Under the Dodd-Frank Act of 2010, publicly traded companies in the U.S. are required to adopt say on pay. Advocates of this approach believe that say on pay will increase the accountability of corporate directors and lead to improved compensation practices.

In recent years, several myths have come to be accepted by the media and governance experts. These myths include the beliefs that:

1. There is only one approach to “say on pay”
2. All shareholders want the right to vote on executive compensation
3. Say on pay reduces executive compensation levels
4. Pay plans are a failure if they do not receive high shareholder support
5. Say on pay improves “pay for performance”
6. Plain-vanilla equity awards are not performance-based
7. Discretionary bonuses should not be allowed
8. Shareholders should reject nonstandard benefits
9. Boards should adjust pay plans to satisfy dissatisfied shareholders
10. Proxy advisory firm recommendations for say on pay are correct

We examine each of these myths in the context of the research evidence and explain why they are incorrect. We ask:

* Should the U.S. rescind the requirement for mandatory say on pay and return to a voluntary regime?

Read the attached Closer Look and let us know what you think!

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07/26/2015

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Tpics, Issus,  Ctvsis i Cpt Gvc  Lsip
STANFORD CLOSER LOOK SERIES
stanord closer look series 1
T Mts f “S  P”
IntroductIon
“Say on pay” is the practice o granting sharehold-ers the right to vote on a company’s executive com-pensation program at the annual shareholder meet-ing. Say on pay is a relatively recent phenomenon,having been rst required by the United Kingdomin 2003 and subsequently adopted in countries in-cluding the Netherlands, Australia, Sweden, andNorway. Te U.S. adopted say on pay in 2010 aspart o the Dodd-Frank Wall Street Reorm andConsumer Protection Act. Under Dodd-Frank,companies are required to hold an advisory (non-binding) vote on compensation at least once every three years. At least once every six years, companiesare required to ask shareholders to determine therequency o uture say-on-pay votes (with the op-tions being every one, two, or three years, but noless requently). Advocates o say on pay contendthat the practice o submitting executive compensa-tion or shareholder approval increases the account-ability o corporate directors to shareholders andleads to more ecient contracting, with rewardsmore closely aligned with corporate objectives andperormance.
Myth #1: there Is only one ApproAch to“sAy on pAy”
Despite what many believe, there is no single policy or implementing “say on pay” that is uniormly adopted across countries. Instead, models or say on pay vary considerably. In some countries, share-holders are asked to vote on the compensation o executive ocers, while in others they are asked tovote on the compensation o the board o direc-tors (which typically includes the CEO). In someinstances, shareholders are asked to approve the
By dv . l, a l. Mc,Gz omzb  B tyJu 28, 2012
compensation policy (its overall objectives and ap-proach), while in others they are asked to approvethe compensation structure (the specic size and el-ements granted the previous year as well as currentpolicy). Say-on-pay votes might be binding, mean-ing that the board o directors must take action toaddress shareholder dissatisaction i the pay planis rejected. Alternatively, say-on-pay votes mightbe advisory (precatory), whereby the board o di-rectors has discretion whether to make changes orleave the plan unchanged. In some countries say onpay votes are legally mandated, while in others they are voluntarily adopted due to market pressures. Forexample, prior to the enactment o Dodd-Frank,companies such as Aac and Verizon voluntarily ofered shareholders a vote on executive compen-sation contracts even though they were not legally required to do so. Countries such as Switzerland,Germany and Canada continue to allow voluntary adoption o say on pay, without making it a legalrequirement—although Switzerland is moving to- ward a compulsory system (see Exhibit 1).Currently nobody knows which, i any, o theseapproaches is the best or rectiying compensa-tion problems. It might very well be that diferentmechanisms are efective at mitigating diferentproblems (e.g., excessive pay levels vs. lack o pay-perormance alignment) or that market pressuresare sucient, without say on pay being required atall.
Myth #2: All shAreholders WAnt therIght to Vote on executIVe coMpensAtIon
 A related myth is that markets respond avorably to a regulatory requirement or say on pay. Tat is,many governance experts and lawmakers believe
 
stanord closer look series 2
Ten MyThs of “say on Pay”
that shareholders as a whole want the right to voteon executive compensation and that making say onpay a legal requirement leads to improved gover-nance quality and shareholder value at rms with“excessive” compensation.Research evidence, however, does not supportthis. Prior to Dodd-Frank, shareholder supportor proxy proposals requiring say on pay routinely ailed to garner majority support. Among the 38companies where shareholders were asked to vote whether they wanted the right to vote on executivecompensation in 2007, only two received major-ity approval (see Exhibit 2). Furthermore, the stock market tends to react negatively to a legal require-ment or say on pay. Larcker, Ormazabal, and ay-lor (2011) nd that companies with high executivecompensation exhibited negative excess returns ondays when it looked like say on pay was going tobe included in Dodd-Frank. I the market believesthat say on pay would be efective in reducing ex-cessive pay levels, the results should have been theopposite. Te authors posit that “the market per-ceives that the regulation o executive compensa-tion ultimately results in less desirable contractsand potentially decreases the supply o high-quality executives to public rms.” Tey conclude that a regulatory requirement or say on pay is likely toharm shareholders o afected rms.
1
Myth #3: “sAy on pAy” reduces executIVecoMpensAtIon leVels
Prior to the enactment o Dodd-Frank, advocateso say on pay also expected that shareholders wouldtake advantage o a right to vote on executive com-pensation to register their widespread dissatisac-tion and that this in turn would create pressure onboards o directors to reduce pay. Neither o theseoutcomes has occurred. Among approximately 2,700 public companies that put their executivecompensation plans beore shareholders or a votein 2011, only 41 (or 1.5 percent) ailed to receivemajority approval. Support levels across all compa-nies averaged 90.1 percent.
2
During 2012, resultshave been similar. o-date, ewer than 2 percent o companies have ailed to receive majority approval,and average support levels remain at 90 percent.
3
Tese trends have held steady despite the actthat average compensation levels continue to rise. According to a recent study, total median compen-sation among large U.S. corporations rose 2.5 per-cent in 2011, ollowing an 11 percent increase theprevious year.
4
Te ailure o say on pay to reducecompensation levels was to some extent anticipat-ed by researchers. Ferri and Maber (orthcoming)studied compensation trends in the United King-dom and concluded that say on pay did not reduceoverall pay levels in that country.
5
Myth #4: pAy plAns Are A FAIlure IF theydo not receIVe Very hIgh support
Given the general approval rates o say on pay, at-tention has shited to the pay packages o compa-nies that receive passing, but not overwhelming,support. For example, the proxy advisory rm Insti-tutional Shareholder Services (ISS) gives additionalscrutiny to companies whose plans received lessthan 70 percent support the previous year. ISS willrecommend against these companies’ plans i theboard does not “adequately respond” to the voting outcome in the ollowing year’s proxy statement.
6
 Similarly, the Australian government recently ad-opted a “two strikes” test that grants shareholdersthe right to orce directors to stand or reelection i the company’s compensation plan receives less than75 percent support in two consecutive years.Viewpoints such as these treat relatively modestlevels o opposition as equivalent to a ailed vote.Implicitly, they raise the threshold or approvalrom a simple majority to a supermajority. How-ever, there is no evidence that these low levels o opposition to a company’s compensation programindicate that the plan requires change nor does itmean that the plan is economically awed. Calls orsupermajority approval might reect the desire o dissidents to increase their inuence over corporatedirectors and executives rather than a true econom-ic need. Moreover, these same dissidents commonly complain that supermajority voting is an outragein other settings (such as mergers and acquisitions)but seem perectly ne adopting a supermajority voting standard or say on pay.
Myth #5: “sAy on pAy” IMproVes pAy ForperForMAnce
 
stanord closer look series 3
Ten MyThs of “say on Pay”
Critics o executive compensation contend thatCEO pay is not suciently tied to perormance.Tey point to a requent disconnect between com-pensation levels reported in the proxy statementand total shareholder returns. o remedy this, they recommend voting against any increase in executivecompensation i a company’s total shareholder re-turn (or other nancial metrics) trails the industry average over a given period.While it is true that executive compensationlevels are not always justied at all companies, thegeneral relation between compensation and per-ormance is stronger than critics contend. Over75 percent o the value o compensation oferedto executives takes the orm o bonuses, stock op-tions, restricted shares, and multi-year perormanceplans whose ultimate values vary directly with cur-rent- and long-term results (see Exhibit 3). For thisreason, the amount ultimately earned by an execu-tive very oten difers materially rom the originalamount expected (i.e. what is reported in the proxy statement) in the year the compensation awards were granted. For example, in 2011, the medianexpected value o CEO compensation among largeU.S. corporations difered rom the median earnedvalue by $2 million, or 18 percent (see Exhibit 4).Tis act is almost never clearly disclosed in thesummary compensation table or the annual proxy, which takes a mostly prospective view o compen-sation. A more reasonable assessment o pay orperormance would compare the amount earnedby an executive (determined as the value vested orreceived in a given period) relative to the operating and stock price perormance during the same peri-od. Te results o this analysis are oten very difer-ent rom those that rely on compensation amountsdisclosed in the summary compensation table.
7
Myth #6: plAIn-VAnIllA equIty AWArdsAre not perForMAnce-BAsed
 A similar myth in executive compensation is thatrestricted stock grants and stock options shouldnot be considered “perormance-based” incentivesunless they contain perormance hurdles in addi-tion to time-based vesting criteria. For example, theproxy advisory rm Glass Lewis argues that “long-term incentive plans that rely solely on time-vesting awards do not ully track the perormance o a company and do not suciently align the long-term interests o management with those o share-holders.”
8
However, researchers have long observedthat stock options are an efective tool or encour-aging risk-averse executives to invest in promising but uncertain investments that can improve thelong-term value o a rm. For example, Rajgopaland Shevlin (2002) nd that executives understandthat the expected value o a stock option increases with the volatility o the stock price and that they tend to respond to stock option awards by invest-ing in risky projects to create this volatility. Te au-thors conclude that stock options are an efectivetool or overcoming risk-related incentive problemsand encourage long-term investment.
9
Tat is, theresearch evidence does not support the notion thatplain-vanilla equity awards are insucient as per-ormance incentives or that they ail to align theinterests o shareholders and managers.
Myth #7: dIscretIonAry Bonuses shouldneVer Be AlloWed
Many governance experts also believe that the boardo directors should not be allowed to use discretionin determining the size o an executive’s bonus andthat bonus calculations should be based strictly on whether the executive has achieved predeterminedperormance targets. Tey contend that sharehold-ers should vote against any compensation plan thatallows discretion because it signals excessive CEOpower and the ability o executives to extract eco-nomic rents. However, this is not always the case.Tere are clearly settings where discretionary ac-tors can produce positive incentive benets, partic-ularly when the economic environment or industry setting is highly uncertain, making it dicult orthe board to assign meaningul perormance goalsat the beginning o the year. In these cases, relying on a year-end review o results can be appropriateor rewarding executives rather than potentially re-lying on actors outside o the executive’s control.For example, in 2009, Bassett Furniture, Danaher,and Starbucks all awarded discretionary bonusesto reward executives whose results were impactedby the recession.
10
Te economic importance o discretionary bonuses is also documented in the

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