A voice in the matter

Astronomic executive pay arouses shareholder ire like practically no other issue out there. So on February 14th, when Aflac announced that it would grant shareholders an annual, non-binding advisory vote on executive compensation starting in 2009, this increasingly popular proxy proposal became something of a cause celebre.

‘Say on pay,’ the shareholder proposal with a nickname worthy of Dr Seuss, is ‘the big issue this proxy season,’ according to Lauren Compere, director of shareholder advocacy for Boston Common Asset Management, the lead proponent on the Aflac proposal. Richard Ferlauto, director of pension and benefit policy at the American Federation of State, County and Municipal Employees, or AFSCME, notes that there are currently 50 companies facing ‘say on pay’ resolutions and the total will likely top 60 by the end of the proxy season.

Meanwhile, the advisory vote concept gained further momentum on March 1, when Rep. Barney Frank (D-MA), chairman of the House Financial Services Committee, introduced HR 1257, a bill that would allow shareholders to vote ‘yes’ or ‘no’ on a company’s executive pay practices.

Corporate secretaries are scrambling to present ‘say on pay’ to their boards, teasing out the implications and trying to envision how something like this might work. They’re also meeting with one another through a working group devoted to understanding this concept founded by Ferlauto, Pfizer’s corporate secretary Peggy Foran and Walden Asset Management’s senior vice president Timothy Smith. Around ten companies participated in the first working-group meeting on February 9, including Intel, Tyco, Schering-Plough, American International Group, Colgate-Palmolive, and Bristol-Myers Squibb.

Although Smith says that the participants have ‘come to an agreement on the significant merits’ of an advisory vote on executive compensation, even this fairly innocuous statement is subject to debate. Some of the corporate participants emphasize that they haven’t yet made up their minds beyond welcoming a principled discussion.

Aflac, which received Boston Common’s proposal in mid-November and embraced ‘say on pay’ a mere three months later, viewed this as an opportunity to ‘do the right thing,’ says Joey Loudermilk, executive vice president, general counsel, and corporate secretary at the Columbus, Georgia-based insurer. ‘The bottom line is that shareholders are the owners of our company,’ he says. ‘And it was hard to disagree with the notion that shareholders should have a right to express their opinion, yes or no, as to whether our executive compensation was appropriate.’

Why say on pay?

Until quite recently, shareholder proposals tended to move at a glacial pace. Not so with ‘say on pay,’ which Carol Bowie, vice president of the governance research service of Institutional Shareholder Services (ISS), describes as the ‘sleeper issue’ of 2006. This resolution clearly ‘struck a chord with investors who had been struggling with the issue of how they could influence pay decisions,’ says Bowie. She notes that at the seven companies where an advisory vote on executive compensation actually came to a vote in 2006, it garnered very strong support at around 40 percent.

Press reports on executive compensation are resulting in what Smith calls ‘holy cow moments,’ in which shareholders examine pay packages and find them wildly excessive. He believes that 2007 is ‘the year that executive compensation is probably going to get as much intense review as has ever happened.’

Ferlauto attributes the success of ‘say on pay’ to a pair of catalytic events: the mind-blowing pay packages received first by exiting CEO Henry McKinnell of Pfizer and then by Robert Nardelli, CEO of Home Depot. In spite of shareholder complaints about excessive compensation, McKinnell and Nardelli left with $198 million and $210 million in severance, respectively. The pay-outs were considered so egregious that even President Bush issued a public admonishment, reminding board members to pay close attention to the compensation packages that they approve. Ferlauto also emphasizes that the revelations garnered from Pfizer and Home Depot crystallized shareholders’ need for another tool [to combat such excesses].’

In a January speech at the National Press Club, Frank cited research by Harvard professor Lucian Bebchuk showing that between 1993 and 2002, compensation for the top five officers of the country’s public companies totaled about $250 billion – nearly ten percent of aggregate profits. Since then, little has changed. In 2005, for instance, The Corporate Library says that CEO pay grew by a median 11.3 percent. ‘If money’s not going out in terms of shareholder dividends or value to the company but is going straight into the executives’ pockets,’ says Compere, ‘it’s not being reinvested into the company appropriately.’

A successful track record

One thing that distinguishes ‘say on pay’ from other potential remedies is its track record outside the US. ‘American companies aren’t stepping into the wilderness’ on this issue, says Ferlauto, noting that advisory votes on pay are required in the United Kingdom, Australia, Sweden, and the Netherlands.

Understandably, corporate secretaries are looking mainly toward the UK, where an advisory vote on remuneration tables first went into effect in 2003. Stephen Davis, a fellow at Yale University’s Millstein Center for Corporate Governance and Performance and co-author of The New Capitalists: How Citizen Investors Are Reshaping the Corporate Agenda, is helping companies parse this issue. ‘All the major parties now accept that say on pay has been very much a net plus to the UK market,’ he says.

The measure, continues Davis, ‘has produced a dramatic increase in dialogue between investors and boards.’ In 2003, GlaxoSmithKline lost a vote ‘and that produced a shockwave throughout British boards.’ Since then, says Davis, boards have become far more proactive, approaching shareholders to ask: ‘Do you have concerns about this we should know about beforehand and that we should address? Let’s talk.’

Reining in pay

Whether UK-style votes of confidence on corporate pay have had a dampening effect on what executives take home is a thornier question. In a white paper titled ‘Does Say on Pay Work?: Lessons on Making CEO Compensation Accountable’, due out in April, Davis will argue that ‘for the most part, performance-related pay has gone up and performance triggers have gotten stricter.’ Although UK chairmen aren’t experiencing pay cuts, there has been a reduction in the rate of increase in their pay levels.

Ferlauto is satisfied with this outcome, noting that ‘even if you have a ratcheting up in pay in the UK, the pay delivers value, which is not the case here.’

Naturally, the effects of an advisory vote on US CEOs’ pay is a matter of conjecture. Aflac’s Loudermilk doubts that the vote will alter his company’s compensation practices. After completing the Compensation Discussion & Analysis (CD&A) in order to meet the SEC’s new executive compensation disclosure requirements, Loudermilk is convinced that ‘shareholders are going to be very impressed with how we do things.’ However, should investors prove unhappy, Loudermilk says that Aflac would need to revisit its practices: ‘If the no vote is in the mid-to-high 40 percent range, that’s when a company really needs to look and see what’s going on.’

Finally, Nell Minow, founder of The Corporate Library, points out that it’s a mistake to suppose advisory votes on pay will result in criticism of the board – they may do just the opposite. ‘Ultimately,’ she says, ‘it should be a tremendous credibility enhancer when you get a vote in favor. It shows that you’re doing the right thing and it inoculates you from a lot of misery.’

What’s more, directors who say that they’ve felt pressure to accede to management’s demands on pay could find an advisory vote a welcome tonic. This measure ‘gives boards more ability to say to the CEO: We don’t think we can get the pay package you’re proposing through,’ says Minow. In the end, letting shareholders play ‘bad cop’ might free directors from assuming this role themselves.

Reading the tea leaves

It’s possible to sift through numerous articles on ‘say on pay’ without getting a clear picture of precisely what this measure would mean. That’s one of the reasons Cary Klafter, vice president of legal and corporate affairs and corporate secretary at Intel, welcomes the chance to participate in the ‘say on pay’ working group: ‘Perhaps the most fundamental questions are: What is the vote asking? And what is the message that a company is going to receive in connection with the vote?’

Some are describing this as a gestalt vote, a chance to take the pulse of shareholders when it comes to executive pay. Others see it as a referendum on very specific pay practices – and they fear that a simple thumbs up or down might not be sufficient to identify and correct the source of the discontent.

Amy Goodman, a partner in the Washington, DC office of Gibson, Dunn & Crutcher, faults ‘say on pay’ for being a ‘very blunt instrument.’ She elaborates: ‘You need to make it clear what’s going to be voted upon – is it all the executive compensation disclosure in your proxy statement, both the tables and the CD&A? And what does a ‘no’ vote mean?  How do you know what the shareholders didn’t like?’

Ferlauto, who is lead proponent on a number of advisory vote proposals, maintains that the CD&A is really the heart of the matter, and shareholder support will hinge on the extent and clarity of the disclosures made there. He anticipates that shareholders would vote on the relevant parts of the CD&A, such as the narrative philosophy, the pay metrics, and the total compensation summary table.

No matter where you stand on ‘say on pay,’ experts agree that this idea needs to be brought to the board. Ferlauto also advises paying close attention to the CD&A, making sure ‘the new disclosures can be communicated in a plain-language way that doesn’t obfuscate the pay philosophy of the company.’ What shareholders want, he emphasizes, are pay disclosures that are ‘compact, concise, well written, discuss pay philosophy, and talk specifically and clearly about measurement and benchmarks.’

Is talk cheap?

Whenever the ‘blunt instrument’ argument is raised, shareholder advocates contend that an advisory vote is only the opening salvo in an ongoing process of dialogue or consultation.

Davis acknowledges that one of the significant differences between the US and the UK shareholder landscapes is that dialogue is far easier in the UK. In Britain, he says, simply phoning the Association of British Insurers and the National Association of Pension Funds will give you an idea of what more than half your shareholders think. Without that type of trade association culture US companies would need to engage in some innovative tactics.

One of Davis’ recommendations is that public companies produce roadshows designed to ‘enter into a dialogue with shareholders about pay packages.’ He emphasizes that this isn’t ‘rocket science,’ and that conversations with a few top investors would quickly create a snapshot of shareholders’ likes and dislikes. Of course, a suggestion like Davis’ raises the question of how expensive and time-consuming ‘say on pay’ votes might ultimately prove to be.

Another concern about ‘say on pay’ is that it might concentrate more governance power in the hands of the few proxy advisory firms out there. Davis acknowledges that inflating the role of the proxy advisories is a concern, especially given how worried companies already are about the influence ISS wields. What’s more, should the proxy advisory firms become the gatekeepers on executive compensation votes some fret that a ‘one-size-fits-all approach’ to executive compensation would be the inevitable outcome.

And in fact, JP Morgan Chase decided that it would oppose the advisory pay vote proposal at its company for that reason, among others. Corporate secretary Anthony Horan expresses concern that ‘say on pay’ might erode ‘the nuanced, individual decision making that is the essence of compensation determinations.’ Specifically, he fears that an advisory vote would lead to ‘simplified, one-size-fits all metrics, applied across large groups of companies.’ After examining some UK disclosures and listening to experts, Horan believes that ‘standardized compensation plans’ are a distinct possibility if ‘say on pay’ happens.

Too much too soon

Timing is everything, and some companies complain that the ‘say on pay’ resolution is complicating an already rapidly-changing proxy landscape. ‘The CD&A process has been revamped and that’s going to provide a lot of information to shareholders,’ says Horan. ‘We think that has to be given a chance to work before taking a next step in this direction.’

Which shareholder initiatives will come to pass – and how they will work together – is difficult to predict. Companies currently face majority voting, proxy access, electronic proxy rules, and far greater executive compensation disclosure, as mandated by the SEC. ‘It’s clear,’ says Klafter, ‘that institutional investors are beyond the point of waiting any longer to see how any one particular tool or change plays itself out.’

The general climate of uncertainty has companies wondering where all these changes will lead. For instance, John Jenkins, vice president and corporate secretary at Tyco, points out that an advisory vote on pay ‘presents some tension between what has been the historic, American tradition of vesting the board of directors with broad authority to supervise the management of the company and set policies in a number of areas, compensation being one of them.’

And Goodman says: ‘If we’re going to start having shareholders have an advisory vote on pay, are we going to have them vote on things like where to locate plants? This seems to me to be turning the whole system on its head in the allocation of power between shareholders, boards, and management.’ In testimony before the House of Representatives on March 8, Rep. Scott Garrett (R-NJ) raises a similar point. Garrett likened the advisory vote in Frank’s bill to ‘letting the camel’s nose under the tent.’ Where, he wondered, might we go next?

Bowie and other shareholder advocates see these worries as overblown. ‘Investors don’t really want to get involved in managing pay,’ she says. ‘They want the board to do that.’

Finally, given the zeitgeist, shareholder advocates argue that ‘say on pay’ may be the lesser of a whole range of evils that might befall corporate boards.

Ferlauto and Minow argue that the beauty of ‘say on pay’ is that it’s a very measured step – after all, the vote is non-binding and it’s far less drastic than many other initiatives companies are facing today. In fact, Ferlauto argues that the advisory vote is important precisely because it gives shareholders a safety valve before turning to measures like voting down the entire compensation committee. ‘Do you really want to pull that trigger,’ he asks, ‘if your only concern is about a variety of compensation issues, but you basically think the board has strategically been going in the right direction?’

To regulate or not

Proponents of ‘say on pay’ hope for a legislative solution because it would apply to all companies, not just those facing a proxy vote on this contentious issue. Steve Adamske, a spokesman for Barney Frank, puts it this way: ‘If there’s not a legislative fix, only the good companies will go to voluntary agreements and the bad companies won’t.’ Adamske explains that after testimony on the bill is heard, HR 1257 will be marked up and then a vote in the House of Representatives scheduled.

Another possible solution would be for the SEC to intervene and make ‘say on pay’ a reality. Although there were no signs of this happening as of early March, in mid-February the SEC did reject AT&T’s petition to exclude a ‘say on pay’ proposal from the telecommunication giant’s proxy.

Regardless of the ultimate fate of ‘say on pay,’ companies will soon know where shareholders stand regarding this idea because the votes will begin pouring in. Shareholders at companies like Citigroup, WellPoint, Apple, Wells Fargo, Wachovia, Ingersoll-Rand, Merrill Lynch, and Countrywide Financial, all of which face ‘say on pay’ resolutions, will have their voices heard.

Perhaps the best argument in favor of ‘say on pay’ is that investor dismay about executive compensation won’t disappear simply because an advisory vote is squelched. A disgruntled shareholder base should worry a board, whether the extent of the discontent can be expressed numerically or not.

Love it or hate it, corporate secretaries need to seriously consider ‘say on pay,’ emphasizes Smith. ‘This is a moving train. It’s not going to happen all at once, but it’s likely to be happening in a couple of years. And companies,’ he concludes, ‘don’t want to appear to be rigidly set in stone.’