The recent bail-outs of global banking institutions by various governments, as well as general concerns about executive pay, have fueled a debate about the adequacy of “say on pay” regimes around the world. In particular, questions have been raised about whether further regulation is required. This articles discusses the current “say on pay” regime in the United Kingdom and the United States, and considers the movements for change.
Say on Pay in the United Kingdom
In the UK, the say on pay regime:
- Is largely non-legislative and non-mandatory, with few prescribed penalties for non-compliance
- Is not “one size fits all” — different companies can apply the rules and codes differently, provided that they explain their reasons for doing so
- Does not provide for a vote on individual directors’ pay — the shareholders’ vote (which is advisory only) is on a report of directors’ remuneration, and has led to a dialogue between investors and companies
Relevant UK Legislation and Guidance
Public companies in the UK are subject to both mandatory regulations, such as the Listing Rules and the Companies Act 2006 (the CA), and to non-mandatory guidance, such as the Combined Code on Corporate Governance (the Combined Code) and guidance issued by institutional investor bodies including the Association of British Insures (the ABI). This guidance collectively encourages transparency on directors’ pay, and requires companies to produce a Directors’ Remuneration Report setting out the compensation directors will receive and detailing how the level and manner of that remuneration came to be decided.
Companies can be penalized for failing to comply with the Listing Rules or the CA. While compliance with the Combined Code and the ABI Guidelines is non-mandatory, public companies are under pressure to apply their principles as (i) the Listing Rules require companies to explain how they have complied with the Combined Code and, if they have not, why they have not (the “comply and explain” principle) and (ii) institutional investor bodies such as the ABI will encourage their members not to invest in companies that do not adhere to these principles.
How Shareholders Have Their Say
The legislation requires companies to hold a shareholder vote to approve the Directors’ Remuneration Report at their annual general meetings (AGM). This vote is advisory only, and no action is required to be taken.
The shareholder vote is a vote on the whole of the Report, not on individual directors’ pay packages. However, companies are able to identify the points of concern for shareholders from the dialogue leading up to the vote and from press comment. The attitude of investors to the Directors’ Remuneration Report is partly driven by the company’s level of compliance with the Combined Code’s provisions on pay.
If a company were to ignore shareholder dissent about its executive remuneration policy, shareholders may refuse to re-elect the directors. This threat has been rarely made until recently, when shareholder bodies have become more exercised over the bonus policies of companies that are underperforming in the current downturn.
Theoretically, if a company’s Report is “voted down” at its AGM, it could ignore the vote, but in practice, they rarely have — although there are signs that this may be changing in the current economic climate. Usually, the company will withdraw the proposals, enter into greater discussion with investors and then in the next year, put forward revised proposals that it is confident (after background dialogue with significant shareholders) will be endorsed in the advisory vote.
The Effect of the Vote on Pay
Notwithstanding that there is now some form of say on pay in the UK that creates expectations of and requirements for transparency and investor approval, executive pay has increased at a rate far exceeding inflation in the last four years.
The main consequences of the introduction of the advisory vote in the UK have been:
- A reduction in severance packages awarded to directors
- A change in the vesting of stock awards, with fixed vesting periods giving way to scaled vesting over longer periods, with targets becoming more stretching
- Performance retesting has been largely eliminated
The say on pay regime in the UK has forged a much stronger link between pay and performance.
In 2008 several British household names were criticised over directors’ pay. Others have prompted disquiet when attempting to pay bonuses not tied to performance. One international bank faced shareholder opposition when seeking to lower performance targets for executive long-term incentive plans, and it responded by promising to freeze base salaries.
The economic downturn has seen a marked shift in the level of shareholder participation in the advisory vote. Manifest, a proxy voting agency, has reported that approximately 14 percent of shareholders voted against company remuneration plans this year, double that of last year and the highest since the say on pay regime was introduced in 2003.1 Other proxy agencies indicate that shareholder turnout at AGMs has increased in the last couple of years.
In the past, shareholders might have indicated their disapproval of prospective remuneration packages by abstaining from the advisory vote, but it is becoming increasingly common for voters to take the more active step of voting against reports. This year, a number of companies have seen over 50 percent of their shareholders vote against remuneration packages. In two cases, the ABI issued a “red top,” its most serious alert of a governance breach, urging members to demonstrate their discontent. Unfortunately for shareholders, this apparently did not result in further dialogue with the companies or a revision of the proposals. One company’s shareholders were told that contentious bonuses would be paid anyway, with a promise to review future policy on executive remuneration.
This apparent lack of regard for the advisory vote has called some commentators to question whether it gives members enough of a “say on pay.” It has been suggested that members should be given the option to elect directors on an annual basis as opposed to the current system of once every three years, in an effort to increase shareholder influence on executive pay. Arguably, this further measure may not achieve the desired result, as a refusal by shareholders to re-elect directors is still relatively uncommon in the UK. Over the coming months, it will be interesting to follow the extent to which shareholders do resort to using this ultimate sanction.
Say on Pay in the United States
Although say on pay comes in many forms in the US, it generally refers to a shareholder advisory vote on executive compensation policies, practices and/or pay for the “named executive officers” whose compensation is reported in a company’s annual proxy statement. Although such votes are non-binding and only advisory, say on pay provides shareholders with an opportunity to express satisfaction or dissatisfaction with companies’ executive compensation policies, practices and/or payments. In the US, how a company responds to a shareholder vote is likely to influence the outcome of their director elections, especially with respect to Compensation Committee members, and shareholder votes with respect to equity compensation plans.
Increased Shareholder Activism
Beginning in 2006, say on pay has been advocated in the US by shareholder activists via individual company proxy proposals requesting that companies permit say on pay votes by shareholders. The issue has recently gained significant momentum over the years:
- In 2006, seven proposals were submitted by shareholders for shareholder vote, receiving approximately 40 percent favorable votes on average.
- In 2007, 50 proposals were submitted by shareholders for shareholder vote, receiving approximately 40 percent favorable votes on average.
- In 2008, over 60 proposals were submitted by shareholders for shareholder vote, again receiving approximately 40 percent favorable votes on average.
- In 2009, over 75 proposals were submitted by shareholders for shareholder vote, receiving approximately 45.6 percent favorable votes on average.2
With the onset of the 2010 proxy season, approximately 100 such proposals are expected to be submitted by shareholders to US public companies.3
Changes in the US Regulatory Landscape
These results indicate an increased focus by shareholders on the issue, but also reflect the changing regulatory landscape in the US. “Say on pay” advisory votes were mandatory in 2009 for the more than 300 US companies participating in the Troubled Asset Relief Program (TARP), a program of the US government to invest in financial institutions impacted by the subprime mortgage crisis of 2008.
However, an increasing number of non-TARP companies have held (or have voluntarily adopted) shareholder say on pay votes. In 2008, just eight companies held shareholder votes on pay, while in 2009, 24 non-TARP companies, including Blockbuster, Intel, Motorola, Pfizer and Verizon, held shareholder votes on pay.4 Since then, many more US public companies across a variety of industries have voluntarily adopted say on pay, including Wells Fargo, CVS Caremark, Bristol-Myers Squibb, Colgate-Palmolive, Capital One, Morgan Stanley, US Bancorp, Fifth Third Bancorp, Sun Trust Banks and Honeywell International, bringing the total to 56 companies adopting say on pay as of March 8, 2010.5
According to an October 2009 report by the proxy advisory service, RiskMetrics Group, 255 companies (including TARP participants) had held shareholder votes on pay in 2009, averaging an 89.75% favorable vote.6 While the high number of favorable votes was likely impacted by factors such as the large number of favorable broker votes of non-directed shares (no longer allowed in the US for the 2010 proxy season as a result of a change to NYSE Rule 452 in July 2009) and the relatively low value of 2008 compensation levels and equity grants, the results could differ significantly in 2010.
In response, some companies have proactively developed alternatives to holding an annual say on pay vote. For example, the United Brotherhood of Carpenters and Joiners of America advocated a triennial say on pay vote at 18 companies in 2009. Microsoft was the first company to adopt the triennial vote in its November 19, 2009 shareholders meeting. Since many long-term incentive compensation plans are tied to three-year performance cycles, such an approach has the advantage of providing a bigger picture for shareholders to evaluate overall executive compensation strategy without the volatility that may take place on an annual basis.
Another alternative adopted for 2010 by at least four companies, including Colgate-Palmolive, Bristol-Myers, Prudential Financial and Pfizer is the biennial say on pay vote.7 Both triennial and biennial say on pay votes lessen the burden on both shareholders and companies to properly evaluate compensation plans. Given that there are over 12,000 public companies in the US and approximately six weeks to review their proxy statements, a significant amount of time and effort is required for institutional shareholders and advisors to carefully review the compensation plans of those companies in which they invest. In addition, once a vote has taken place, it also takes time for companies to redesign their compensation plans to properly react to the shareholder input.
While some companies are proactively adopting say on pay votes, including multi-year votes, in response to shareholder activism, legislation is also being considered in the US Senate and House of Representatives that, if passed, may require annual say on pay votes.
Development of Say on Pay Legislation in the US
A number of legislative proposals currently under consideration in the House and Senate would require all public companies to allow shareholders to vote on executive pay. On July 31, 2009, the House passed the Corporate and Financial Institution Compensation Fairness Act of 2009 (CFICFA), which required an annual vote on the pay of the top five executives at each company (as disclosed in the annual proxy statement), although such vote would be advisory. In December of 2009, the CFICFA was incorporated into a more expansive bill proposed by the House Committee on Financial Services to regulate the financial services industry. This bill, introduced by Rep. Barney Frank (D-Mass) is known as the “Wall Street Reform and Consumer Protection Act” (H.R. 4173), and was passed by the House in December of 2009. In the Senate, an omnibus bill intended to enact various corporate governance reforms, introduced by Senator Chris Dodd (D-CT) and entitled the “Restoring American Financial Stability Act of 2010,” also contains say on pay provisions, but differs in certain respects from Rep. Frank’s bill. As of March 22, 2010, this bill has been sent to the Senate floor for vote after approval by the Senate Banking Committee.
Rep. Frank, however, has expressed concern that the current draft of the bill in the Senate is a “watered down” version of H.R. 4173’s shareholder rights legislation. For example, the Senate bill limits the scope of the Consumer Financial Protection Agency (CFPA), intended to be an independent agency overseeing financial services with both rule-writing authority and enforcement powers, by housing the CFPA under the Federal Reserve instead of as an independent agency. Should the Senate bill pass, Rep. Frank has pledged to maintain the independence of the CFPA, in addition to the preservation of the shareholder rights in H.R. 4173, including say on pay, advisory votes on golden parachutes and independent compensation committees and compensation committee consultants, as the two legislative bodies work to reconcile the provisions of each bill.8 As exemplified by the development of both House and Senate bills, regulation of the financial services industry is highly complex and controversial, meaning such bills may be slow to finally enact. Thus, legislation regarding say on pay will likely not go into effect until the 2011 proxy season, at the earliest.
While it is unlikely legislative reforms requiring say on pay votes will be adopted in the immediate future, companies in the US should assume say on pay will become a requirement and, similar to their counterparts in the UK, begin to dialogue with their key shareholders regarding executive compensation and corporate governance matters. For example, companies might consider holding meetings with shareholders outside of the proxy season and use investor surveys and other electronic communications, such as web site or blog, to communicate with respect to such issues.