How much do shareholders--or the public--really care about executive pay? A new proposal from the U.S. Securities and Exchange Commission may be aimed at finding out.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, (“Dodd-Frank”) requires publicly traded companies to hold non-binding (advisory) “say-on-pay” proxy votes at least once every three years on executive compensation policies.

In the short history of say-on-pay, these votes have at times attracted considerable publicity. In 2011, shareholders of Stanley Black & Decker, a tools and hardware company based in New Britain, Conn., issued a “no” vote, and the company's board lowered the CEO's pay by 63%, raised minimum officer stock-holding requirements and altered its severance pay agreements to be less CEO-friendly.

In 2012, Vikram Pandit was forced out as CEO of Citigroup six months after shareholders rejected an increase in his compensation.

Although say-on-pay votes are non-binding, their effects can be significant, and have the potential to reshape the way companies create, disclose and communicate their executive compensation policies.

This year, a proposed rule under Dodd-Frank, recently approved by the SEC, would require companies to disclose the ratio between the pay of CEOs and the median pay for all other employees. Democratic Sen. Robert Menendez (N.J.), who wrote the provision on pay-ratio disclosure, said that the proposed rule will help investors monitor how a company treats its average workers and whether its executive pay is reasonable.

Critics of the proposed rule say that it is mostly intended to create public outrage against companies that are perceived to be awarding overly high salaries to CEOs. The reality is that executive pay continues to rise - about 875% between 1978 and 2011, according to a 2012 study by the Economic Policy Institute - despite regulatory and shareholder efforts to restrain it.

Upward Spiral
The proposed rule is part of a continued emphasis on disclosure under Dodd-Frank, although the focus on transparency could actually contribute to steadily rising executive salaries. For one thing, the publicity surrounding CEO pay gives executives a good idea of how much they can ask their own companies to pay them. But there may be a more important reason for the continuing increases.

Corporate governance experts Charles M. Elson and Craig K. Ferrere, faculty members at the John L. Weinberg Center for Corporate Governance at the University of Delaware, point to a more important reason: the way boards of directors set salaries. Their recently published analysis, “Executive Superstars, Peer Groups and Over Compensation – Cause, Effect and Solution,” showed that most company boards use a statistical technique called peer benchmarking to set CEO salaries.

It usually works like this: a board's first step is to gather a “peer group,” made up of companies that are in the same line of business, similar in size and have a variety of similar characteristics. Next, the board gathers data that specifies the level of CEO compensation at each company. To complete the process the board decides at what percentile they want to target their own CEO's total compensation. Most boards set their chief executive's pay no lower than the median (50th percentile) of the group, while boards at other companies could decide to place CEO salaries at the 75th or even the 90th percentile. And with other peer group companies using the same benchmarking process, it all but guarantees that CEO salaries will continue to rise.

The proposed rule sharply divided the SEC commissioners, but won approval by a 3-2 margin.

Commissioner Luis A. Aguilar said: “If comparing CEO compensation solely to the compensation of other CEOs can lead to an … upward spiral, then comparing CEO compensation to the compensation of an average worker may help offset that trend.”

Another member expressed strong dissent. Commissioner Daniel M. Gallagher said: “There are no – count them, zero – benefits that our staff have been able to discern. As the proposal explains, '[T]he lack of a specific market failure identified as motivating the enactment of this provision poses significant challenges in quantifying potential economic benefits, if any, from the pay ratio disclosure.'”, a news and information website for retirement industry professionals, published the results of a poll by the consulting firm Towers Watson. That firm polled 375 corporate executives and compensation professionals regarding the ruling. The poll revealed that 56% of poll respondents said they are most concerned about the process of complying with the new disclosure requirement, especially collecting pay data, deciding how to approach data-sampling and determining the median employee. Only one-third of respondents (34%) said they are confident they will have the information necessary to comply by 2015.

What Shareholders Want
The benchmarking process itself raises important questions about executive compensation. For example, when do shareholders care about CEO pay, and what matters most when they vote, yes or no, on CEO compensation?

The impetus for passage of Dodd-Frank's say-on-pay requirement in 2011 focused on remedying “excessive” CEO pay. Shareholders generally expressed outrage that CEOs of companies considered to be “underperforming” were receiving large salaries and other compensation (e.g., stock options and other equity-based compensation). Few if any shareholders ever complained about CEOs who were underpaid relative to above-average company performance. This largely explains why say-on-pay votes are usually discussed in terms of reducing overall CEO pay, rather than strengthening links between pay and performance.

A group of researchers conducted experiments to discover whether shareholders care equally about both of the outcomes described above, or whether they considered CEO pay, company performance, or lack of alignment between pay and performance, differentially. The researchers conducted two experiments, rather than use existing data on say-on-pay votes, because it allowed them to focus on different combinations of pay and performance conditions and determine whether causal relationships exist.

Somewhat surprisingly, the results showed that “shareholders” in the experiment were no more likely to reject high CEO pay than low CEO pay. Adding company performance, however, added some necessary context. Participants in the study were much more likely to reject high CEO pay only if the company showed poor performance relative to its peer group. Otherwise, study participants expressed no preference for high or low CEO pay, or for a CEO pay increase or decrease, when company performance was strong. Shareholders were concerned only with CEOs whom they considered to be overpaid when their company performed poorly.

The study's results are confirmed by real-world performance data. Equilar, an independent consulting firm that provides information about executive compensation, analyzed key financial metrics of companies that have held say-on-pay votes in 2013, to investigate a possible correlation between the company’s financial performance and its say-on-pay passing rates. Equilar's analysis considered such key metrics as change in earnings and one-year total shareholder return (TSR, assuming all capital gains distributions and dividends are reinvested), as well as revenue and market capitalization (the total value of shares a company has issued) at the end of the fiscal year.

The companies that passed their say-on-pay votes had an increase in year-over-year earnings of 4.5% and a one-year TSR of 17.1%. These companies had $1 billion in revenue and $1.6 billion in market capitalization. Conversely, the companies that failed their say-on-pay votes had a decrease in year-over-year earnings of 14.4% and a one-year TSR of 11%. In addition, they had $0.8 billion in revenue and $1.3 billion in market capitalization.

Those that passed performed better in all of the key metrics observed compared with those that failed. These results suggest that financial performance does, in fact, have a positive correlation with shareholders voting in favor of executive pay packages.

It should be noted that the number of companies that failed (31) is significantly smaller than the number of companies that passed (1,567). Equilar's analysis found that “pay for performance disconnect” – a high level of executive compensation coupled with poor relative company performance – was the most common reason that shareholders voted against a company's say-on-pay proposal.

Global Say-on-Pay Policies
The most important difference between the U.S. approach to say-on-pay and evolving regulations in Europe is that U.S. companies are not legally required to address negative shareholder votes, as European corporations may soon be required to do.

Earlier this year, Switzerland became the latest European country to require binding shareholder say-on-pay votes. Australia has a variation on binding say-on-pay called the “two-strikes” rule, which requires a company's entire board of directors to stand for re-election if at least 25% of shareholders vote against executive compensation in two consecutive meetings.

The Netherlands, Norway and Sweden already had some form of binding say-on-pay rules. The United Kingdom is expected to join this group, pending passage of legislation this year that would require a binding say-on-pay vote every three years. Germany and the European Union are also expected to introduce binding votes before the end of 2013.

Except for India, say-on-pay policies have not yet become an accepted aspect of corporate governance in Asia. Shareowner Rights Across the Markets, a publication of CFA Institute that provides individual reports for 28 different markets, surveyed whether shareholders are able to affect a company's remuneration (pay) policies through either binding or non-binding votes. It reports, in part:

In India, compensation policies and limits are approved by shareholders and may be altered by shareholders. Indian companies generally provide incentives through a commission on profits, rather than through options or other equity-based plans.

In Indonesia, the picture is somewhat mixed. Company practices vary in the approval of compensation for boards of directors. In some cases, compensation of board members is approved by a board of commissioners, but other companies require the approval of both commissioners and shareholders.

In China, shareholders are not usually given any vote on compensation issues or on a compensation report produced by a company, although in the banking sector, shareholders have sometimes been given a binding vote on specific compensation, such as bonuses.

The Bottom Line
It's clear that there's a huge gap between how companies compensate executives and what they pay their regular workers. The SEC's proposed rule on CEO pay ratios, however, may be less about providing additional information to investors and more about creating public outrage over executive pay. After all, the SEC already requires companies to disclose the salaries of top management. The question is whether showing the disparity between the pay of executives and rank and file will prompt enough of a reaction from shareholders - or the public - to really make a difference.

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