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The Honorable Barney Frank
Chairman
House Committee on Financial
Services
US House of Representatives
Washington,
DC
March 8 2007
Dear Congressman Frank:
As you know, the Millstein
Center
for Corporate Governance and Performance at the Yale School of
Management is in the process of producing a white paper on the practice
of annual advisory votes on compensation policy. The aim of Does ‘Say
on Pay’ Work? Lessons on Making CEO Compensation Accountable is to
assess the track record in
Britain and provide analysis on whether the advisory vote tool may be
adapted to the United States environment. While we expect to issue draft
and final versions later this spring, as director of the project I
wanted to provide the Committee herewith a preliminary summary of
principal findings for the record, as members deliberate on H.R. 1257.
Note that conclusions are those of the author and do not reflect the
opinion of the Millstein
Center as an institution.
First, a word of background on the
Millstein Center.
The Center is an international resource providing active support for
research in corporate governance. It disseminates its work to the
world’s academic, policy-making and professional communities. We produce
and sponsor scholarly research, policy-oriented white papers and a
unique online platform of databases on global corporate governance. The
Center’s affiliated faculty and fellows comprise leading scholars and
practitioners from a variety of disciplines. Our advisory board includes
leaders in the business and financial communities. A forum for
interdisciplinary research, the
Millstein
Center
for Corporate Governance and Performance brings together scholars from
the School of Management,
the Yale Law
School, the Yale Economics Department, and other graduate and
professional programs within Yale
University
to study governance mechanisms in a global context. For this white paper
project, the Center sourced information and conducted roundtables and
interviews in London in
February 2007 with cooperation from the Association of British Insurers,
Institute of
Chartered Secretaries
and Administrators, Institute
of Directors,
International Corporate Governance Network, Deloitte and others.
The overall conclusion of the
Does ‘Say on Pay’ Work? white paper is as follows.
Advisory votes on executive pay
policies are rational, timely, road-tested and practical for use in the
United States. Based on
reviews of the UK track
record, we find that advisory votes represent an important lever that
could strengthen both boards and shareholders in the quest to better
align top corporate pay with performance. A surprisingly broad consensus
of corporate directors, shareholders and government in Britain sees ‘say
on pay’ acting as a driver of corporate value, making public
corporations more competitive and, by raising confidence in governance
integrity, lowering risks for investors. Experience shows that advisory
votes on compensation are likely to serve as a potent stimulus to
dialogue between boards and shareholders. Moreover, advisory votes can
go hand-in-hand with new SEC-mandated rules on pay disclosure. The tool
is no panacea on its own. While constructive in and of themselves,
advisory votes on compensation policy generate best outcomes when fitted
with other measures, such as majority-rule director elections. Further,
to best tether pay to performance, boards, shareholders and service
providers face the challenge of hard-wiring material changes in their
operations to handle advisory votes. In this respect, market players in
the United States have an opportunity to take steps to avoid shortfalls
evident in Britain.
Underpinning the summary conclusions
above are seven principal findings from the UK which can inform the
process of adapting ‘say on pay’ to the
United States
environment. They are as follows.
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Votes on compensation policy
resulted in a marked rise in dialogue between corporate boards and
management, on the one hand, and institutional investors on the other.
This transformed the way compensation policies are constructed.
The introduction of ‘say on pay,’ and in particular the
GlaxoSmithKline board’s jolting defeat in 2003, produced a virtual
overnight increase in the level of dialogue between companies and
funds. Directors have shown a strong interest in avoiding the prospect
of individual and collective reputational damage resulting from
significant shareholder opposition. “Beforehand, we paid the CEOs what
we wanted to and told investors who objected ‘too bad,’” recalled one
former board member. But the Glaxo loss “concentrated the mind
wonderfully. Now the board must base remuneration on performance and
be scrupulous about it.” The Association of British Insurers (ABI)
estimates that contacts initiated by companies before they finalize
compensation plans tripled. And an arm of the National Association of
Pension Funds (NAPF), which had recorded an average 20 such outreach
efforts by companies each year prior to ‘say on pay,’ engaged in 150
instances of dialogue in 2005 and 130 in 2006. These consultations
ranged from a simple phone call to multiple high-level meetings. In
many cases such dialogue resulted in boards changing corporate plans
to strengthen performance triggers in ways that met shareholder
objections. Critics have raised concerns about minority shareholders
abusing a ‘say on pay’ system to enhance their sway over boards of
directors. In Britain, anxiety over a tide of investor uprisings
proved misplaced. In four years only Glaxo, among major companies, has
seen its remuneration report rejected in a non-binding vote. Proxy
advisors have exercised restraint. Between 2004 and 2006 RREV, the UK
arm of Institutional Shareholder Services (ISS), urged votes against
at less than 13% of 1,817 annual meetings. Investors have come to view
a vote against board pay policies as an option of near-last resort.
Just 64 companies out of 596 reporting voting results between 2002 and
2007 experienced combined dissent (‘no’ votes plus abstentions) of
more than 20%, according to Deloitte.
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While top executive pay in the UK
continues to exceed inflation and average workforce wage increases,
advisory votes have been an important contributing factor in taming
the rate of increase, curbing opportunities for ‘pay for failure’, and
linking compensation dramatically closer to performance.
As elsewhere, fuller disclosure of compensation in
Britain has proven a contributing
factor in rising pay levels among top executives. Advisory votes do
not appear to have reversed that trend. Absolute numbers continue to
climb, though at a more measured pace (the average annual increase has
slowed in the last four years to between 5 and 10%, say various
sources). However, advisory votes are credited by virtually all
parties with producing “dramatically better alignment between
incentive pay and shareholder value.” For instance, the latest
Deloitte study concluded that the level of variable pay has increased
significantly with meaningful performance conditions attached to
incentive compensation. Stock option plans are being replaced by share
grants tied to significant performance triggers advocated by
shareholder bodies. Payouts for average performance have dropped
significantly in response to investor pressure. New limits cap the
amount of options any one executive may be granted. Golden parachute
packages, swelled to three times final salary before a drive to curb
them began in 1999, have steadily shrunk to the equivalent of one
year’s wage. The quality of reporting on pay has improved
substantially. In short, “the level of transparency and disclosure and
explanation today can’t be compared to before,” contends one service
provider.
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Advisory votes are seen by
government as having succeeded not only in handing investors a voice
on compensation, but in contributing to the competitiveness of the
British economy and the attraction of London as an international
capital market. British
lawmakers may have initiated advisory votes “as a negative push to
correct scandals on pay,” asserted a key official the UK Department of
Trade and Industry (DTI), the agency which crafted and now oversees
‘say on pay’ legislation. But London now perceives them as part of
strategic measures that “enhance the competitiveness of the UK
economy.” The DTI has concluded that advisory votes result in “better
planning by corporations, fewer surprises, better dialogue with
investors.” They are “a prophylactic against poor management,” the
official said in an interview, keeping UK companies in fighting trim.
Advisory votes are among “appropriate steps to reduce risk…and we have
had no big scandals among quoted companies” in recent years. Public
authorities and the London Stock Exchange have touted the UK corporate
governance regime, including ‘say on pay’ voting rights, as equipping
the City with a competitive edge for attracting capital, especially in
comparison to New York. Echoing that perspective, four of the world’s
largest funds recently wrote to the Securities and Exchange Commission
asking for advisory votes to expand shareholder rights and, thereby,
to improve the attraction of the US for foreign capital.
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Corporate board compensation
committees have retooled the way they design and communicate about
executive pay plans so as to draw support from institutional
shareholders. Before
advisory votes came into force, the typical compensation committee had
to produce a package aimed at persuading the board. After advisory
votes, the board compensation committee had to design packages capable
of persuading shareholders. The difference has proven significant. Pay
panels now meet more frequently; engage in design-stage consultation
with key investors, investor trade organizations and/or proxy service
advisors; utilize more information; and hire more independent outside
advice. Directors “demonstrate more awareness that their work will be
subject to broad scrutiny” and are “more diligent” about crafting
policies that allow them “to defend decisions taken,” according to
corporate secretaries at a Yale roundtable in London. Moreover,
compensation committees “are much more constrained” in shaping
generous severance terms, since UK shareholder guidelines on CEO
employment contracts are prescriptive and relatively strict. Chairs of
compensation committee, in particular, have welcomed advisory votes as
they supply leverage in standing up to potential insider pressure.
However, corporations are on a learning curve. Some initiate early,
high-level dialogue with investors and produce fulsome disclosure
documents considered best in class. Others make only token efforts at
consultation and rely on boilerplate in reporting.
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Institutional investors have
stepped up scrutiny of executive pay packages but continue to search
for effective methods of monitoring compensation.
“There is no question that investors changed dramatically after
introduction” of advisory votes, observed one market player in
Britain. Before them, institutions
generally devoted fewer resources to systematic analysis of
compensation structures except in egregious cases brought to special
attention through media or other circumstances. The onset of universal
voting on pay at FTSE All-Share companies generated fresh demands on
both the time and skills of fund professionals as corporate boards
sought input on plans, and as complex incentive policies required
analysis for ballot decision-making. Funds have experienced mixed
success in facing challenges posed by the introduction of advisory
votes. Some funds responded by relying almost entirely on outsourced
agents, the proxy advisory services, to conduct such analysis and
consultation. Leading funds, however, sought to participate directly
in engagement with companies over pay practices. They report having
had striking success in persuading boards to tie incentive pay
directly to performance. However, institutional investors also worry
that they have entered into something of an arms race, where they are
struggling to match expertise with corporations’ remuneration
consultants who produce ever more complex arrangements. Said one
investor: “we risk getting lured into tweaking; of thinking we’ve
achieved objectives when we might be missing the big picture.” UK
funds are only beginning debate about whether to ease their own
prescriptive guidance on pay practices in favor of broader principles
that can be adapted to individual companies. They are also assessing
at what level of detail they must engage when reviewing compensation
plans.
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Advisory votes have proven
particularly effective in a context of measures that provide for
substantial board accountability.
Advisory ballots on compensation appear to carry particular weight in
the UK because of a related power. Investors retain authority under
corporate law to oust directors by majority vote. If members of a
remuneration committee fail to be responsive to shareholder concerns
over pay policies, investors have the real, but rarely exercised,
option in an annual meeting—or by a mid-term special meeting—of
supporting their ejection from a board. Therefore, directors choosing
to ignore significant dissent in an advisory ballot face the risk of
practical consequences. The ‘teeth’ of majority rule may be seen as
another reason why both corporations and investors in Britain have
come to endorse the concept of advisory votes on pay. Boards see the
measure as a way of channeling dissent away from elections so that
members can isolate and resolve a specific problem over pay rather
than risk stinging levels of opposition, or outright defeat, for a
director candidate. For their part, investors back votes of confidence
on remuneration because the tool allows them to register dissent over
pay without exercising their power to overthrow board members they
might otherwise support.
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Providers of proxy analysis and
recommendation services have found their role enhanced.
Investment funds in Britain expect proxy service providers affiliated
with their trade associations to vet remuneration plans with companies
and to engage in dialogue with boards in search of improvements before
plans are finalized. Other funds appear to rely on service providers
solely for guidance in voting. Either way, market concerns center on
two questions: First, whether too many investors follow service
provider voting advice automatically and, second, whether such
providers apply a “one-size-fits-all” framework instead of evaluating
compensation plans according to a company’s specific circumstances.
The services themselves have confronted other challenges. They
experienced intense new demands on internal resources in the wake of
advisory votes on compensation. Ventures providing recommendations had
to re-examine guidelines on pay as such best-practice advice now
related directly to a voting item. The two most influential
UK
services (ABI’s IVIS and the NAPF’s RREV, owned by Institutional
Shareholder Services) reported a substantial rise in outreach by
corporate boards and representatives, such as compensation
consultants. Services faced needs to improve the sophistication of
their analysis of compensation packages.
It follows from the observations
above that ‘say on pay’ is a demonstrated propellant of healthier
corporate-shareholder relations with a meaningful record of
strengthening performance links to CEO compensation. Further, insights
from the UK
experience illuminate variables US players should address in the course
of Americanizing advisory votes on pay. Some involve legislation; others
adaptation of market practices. Among them:
·
Advisory votes on pay
are best introduced on a legislative basis. The history of UK experience
before votes on pay became law makes clear that companies already
engaged in market-leading pay practices tended to be early voluntary
adopters. But companies deemed most in need of greater accountability
shunned the tool, despite significant government and investor pressure.
·
Advisory votes are
constructive in and of themselves. However, they can reach their full
potential when operating at companies which conduct director elections
according to the majority vote standard. Ongoing efforts to install
majority voting as the electoral standard at US companies can be an
important parallel development in the drive to better align executive
pay with performance.
·
Corporate boards can
readily develop effective proactive strategies to secure investor
loyalty in advisory votes. New SEC disclosure rules on pay are more
comprehensive than those in Britain. Compensation committees can oversee
design-stage consultation exercises with investors and/or their agents,
and road shows on pay policies in advance of the annual meeting.
·
Investors can prompt
entities such as the Council of Institutional Investors to develop
advanced collective guidance on best-practice compensation principles.
Thank you for the opportunity of
contributing to the debate over advisory votes. Please do not hesitate
to contact me should you have any questions or comments, or if the
Millstein Center
can be of any further assistance. We will of course provide the
Committee with the full white paper report when it is completed.
Sincerely,
Stephen Davis, Ph.D.
Fellow
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