Shareholders to the Rescue

Congress’s plan for giving investors a voice
The eternal optimist can take heart that Wall Street’s near-meltdown over the past year has at least pushed financial services reform to the top of Congress’ agenda. Though some proposals, such as creating a Consumer Financial Protection Agency and beefing up the Federal Reserve’s regulatory authority, have attracted significant debate, a plan to grant shareholders an advisory vote on executive compensation has flown under the radar. Yet the idea deserves attention, as it represents a sensible path towards curbing excessive CEO pay without shifting too much power to activist investors.
Linking Pay to Performance
On July 31, the House passed the Corporate and Financial Institution Compensation Fairness Act. The bill would grant shareholders in public corporations an annual, nonbinding vote on senior management‘s pay packages, and would impose new rules regarding compensation committees; similar legislation is under debate in the Senate. According to its supporters, the legislation would more closely tie executive remuneration to job performance. The bill targets executives such as Stan O’Neal, a former CEO of Merrill Lynch who received $160 million upon his departure even as the bank announced record losses.
How do such excesses occur in an ostensibly efficient market? Clark McKinley, an information officer at CalPERS, the nation’s largest public pension fund, told the HPR that this imbalance is partially attributable to the common practice of directors serving on one another’s boards. In some cases, McKinley continued, an “old boys’ network” allows directors to “approve egregious pay packages while expecting their own pay to be raised in return.” Furthermore, outside consultants hired to serve on pay committees are often biased in that they work for large firms that provide other services to corporations; often, consultants recommend munificent pay packages to bolster other business relationships with their client. These practices contribute greatly to the disparity between pay and performance
Power to the Shareholders?
But the bill does not enjoy universal support. Some executives think it will allow shareholders to micromanage companies and politicize business decisions, arguing that investors value short-term returns to the detriment of future earnings. If true, these factors could drive top executives to private corporations. However, these objections incorrectly conflate the formulation of executive pay packages with day-to-day corporate operations, as the latter would remain under the Board of Directors’ purview.
There is also concern that mere advisory votes on compensation are ineffectual, and should be made binding. To support this claim, one can point to trends in the United Kingdom, which enacted advisory “say on pay” in 2002 but has seen few executive pay proposals voted down. In an interview with the HPR, Harvard Business School professor Jay Lorsch suggested that the high rate of “yes” votes could reflect most boards’ unwillingness to propose unjustifiable compensation packages. Last May, however, Royal Dutch Shell’s shareholders did reject management’s executive pay proposal, only to see the Board of Directors approve it anyway.
The Reformer’s Middle Way
Ultimately, “say on pay” will probably lead to more subtle changes in corporate governance than most observers expect. Though Robert Kaplan, a Harvard Business School professor, doubts that the policy will significantly lower compensation levels, he believes it will increase shareholder scrutiny. As he explained to the HPR, although managers could pass an unpopular pay package over shareholders’ objections, the company would risk embarrassment and negative media attention, such as occurred in the case of Royal Dutch Shell. According to Kaplan, an advisory vote would “further encourage Boards of Directors to ensure they have a sound process for formulating executive pay.” This should increase the correlation between CEO pay and company performance.
Famed investor Carl Icahn said, “In life and business, there are two cardinal sins. The first is to act precipitously without thought, and the second is not to act at all.” Advisory “say on pay,” in keeping with Icahn’s maxim, counters an undesirable status quo without upending the shareholder-manager balance. Though the fight for lasting change on Wall Street will be contentious, this bill could represent an early victory for reformers.