The Future of 'Say on Pay' in Current Economic Times - www.law.com - 30-Oct-2008

The Future of 'Say on Pay' in Current Economic Times

Katayun I. Jaffari and Mu'min Islam
The Legal Intelligencer
October 30, 2008

http://www.law.com/jsp/ihc/PubArticleIHC.jsp?id=1202425644318

 

For more than a decade, determining the appropriate level of
compensation for corporate executives has been a controversial issue
within the courtroom, the boardroom and among shareholders. During a
period of increased activism by shareholders, more authority, commonly
referred to as "say on pay,"
is being demanded over executive compensation packages. Say on pay
importance will most likely increase in popularity in the wake of the
subprime mortgage and financial institutions crisis affecting the U.S.
financial markets and the federal economic stimulus plan. Within the
debate over the federal economic stimulus plan, one of the issues
included the outcry for compensation limits on executive pay as well as
restrictions on golden parachutes for failing corporations. This
article will briefly outline the components and history of say on pay,
describe support and opposition to its implementation and finally
discuss the future of say on pay proposals.

WHAT IS SAY ON PAY?

On April 20, 2007, the U.S. House of Representatives passed a bill
addressing shareholders' concerns over excessive executive pay. The "Shareholder Vote on Executive Compensation Act,"
sponsored by Rep. Barney Frank, D-Mass., provides shareholders with an
opportunity to voice their opinion as to the reasonableness of an
executive compensation package. The bill entitles shareholders to a
non-binding vote to approve executive compensation packages and golden
parachutes provided to executives in the event of a purchase or sale of
the company. To grant shareholders this power, the bill intends to
amend the Securities Exchange Act of 1934 and supplement the Securities
and Exchange Commission's executive compensation disclosure rules. A
companion Senate bill by Sen. Barack Obama, D-Ill., is in debate in the
Senate Committee on Banking, Housing, and Urban Affairs.

During 2008, say on pay proposals received increased media
attention. However, they were not overwhelmingly accepted by
corporations. This year more than 90 corporations received stockholder
resolutions for say on pay. Because of the economic downturn and the
tightened credit crunch, the amount of resolutions from 2007 more than
doubled. Earlier this year, Aflac Inc. became the first publicly traded
American corporation to give shareholders a non-binding vote on
executive compensation. Only a handful of corporations, such as Verizon
Communications Inc., Par Pharmaceutical Companies Inc., Blockbuster
Inc. and Riskmetrics Group Inc., have agreed to adopt say on pay in the
coming years. Avoiding the potential distortion of the traditional
corporate structure -- directors managing corporate affairs and
shareholders voting for directors -- there remains a significant
hesitance on adopting say on pay resolutions.

PROPONENTS OF SAY ON PAY

Amidst the economic boom of the 1990s, executive compensation of
publicly traded corporations reached extraordinary levels. The growth
of executive compensation grew exponentially in comparison to the
growth of the average worker. In 1991, an average worker's salary was
1/140th in comparison to the salary of a large company chief executive
officer. Less than 15 years later, that ratio skyrocketed to 1/500th.
Responding to a media backlash against lucrative compensation packages,
legislators and regulatory bodies enacted additional regulation
intending to curtail CEO pay. Some of these restrictive measures from
the recent past have included executive cash compensation limits of $1
million before implicating negative tax consequences, disclosure of
executive compensation within regularly filed SEC documents, and the
New York Stock Exchange governance standard requiring listed
corporations to hold mandatory shareholder voting for all executive
equity compensation awards. Controversy surrounding executive
compensation increases daily with the approaching presidential
election. During the campaign trial, Obama and Sen. John McCain both
issued statements supporting mandatory non-binding say on pay for
shareholders of publicly traded corporations. Many similar proponents
of say on pay point to this curtailing measure regarding excessive
executive compensation and assurance that directors' actions are
aligned with shareholders' interests as justification for implementing
say on pay.

Proponents suggest that say on pay intends to provide additional
support to government's continued efforts to curtail executive
compensation. They believe that corporate directors will less likely
provide golden parachutes and egregious compensation packages to
executives if the compensation package requires shareholder approval.
Although under say on pay proposals, a shareholder's vote is not
binding, a corporate director would not want to vote against the
shareholder's desires, for fear the dissenting shareholders may
retaliate by voting the director off the board. In a recent research
paper titled,

"Shareholders' Say on pay: Does it Create Value?" by Jie Cai and
Ralph A. Walkling, the authors introduce statistical findings that
corporations with the highest "abnormal CEO pay and low CEO pay for
performance react positively to the say on pay Bill." Shareholders are
able to alter compensation packages under conditions where the
corporation has overpaid or underpaid executives.

In 2007, Walden Asset Management and the employees' pension plan of
American Federation of State, County and Municipal Employees organized
an institutional investor network that demanded a voice in determining
executive compensation. What started with 41 institutional investors
has now grown to about 70 institutional investors heavily active in
preventing corporate executives from walking away with hundreds of
millions of dollars amidst regular corporate bankruptcy filings. As
reported by Dow Jones Newswires, according to figures disclosed for
executives named in their proxy filings and compiled by Standard &
Poor's, The Bear Stearns Cos. Inc., Citigroup Inc., The Goldman Sachs
Group Inc., JP Morgan Chase & Co., Lehman Brothers Holdings Inc.,
Merrill Lynch & Co. Inc. and Morgan Stanley paid about $3.63
billion in salary bonuses, stock grants and exercised options to top
executives from 2004 to 2007. Not surprisingly, five of these firms
received shareholder say on pay proposals in 2008. Say on pay
proposals, however, were filed with more than just underperforming and
overpaying firms. Corporations in generally good standing with
shareholders, such as General Electric also received a 2008 shareholder
say on pay proposal. Supporter of the proposal, Tim Smith, senior vice
president of Walden Asset Management, stated that the proposal was
filed to lobby GE to "provide leadership in adopting an advisory vote."

OPPONENTS TO SAY ON PAY

Although the say on pay bill moved expeditiously through the House
of Representatives, and while it still sits in the Senate Committee on
Banking, Housing, and Urban Affairs, say on pay has not been widely
implemented within corporations. Corporate governance experts are split
concerning whether say on pay provides beneficial value to all
corporations. Critics point to low shareholder support for say on pay
proposals received this year as a testament to their ineffectiveness in
lowering executive compensation. Critics also note that SEC executive
compensation disclosure requirements provide shareholders with enough
knowledge of excessive compensation packages, thereby making a vote on
such packages unnecessary. Lastly, some argue that establishing say on
pay policies reduces management responsibility from the board of
directors and disrupts the traditional corporate roles of shareholders
and directors.

Providing say on pay to shareholders of corporations with reasonable
executive compensation packages may result in additional costs without
providing any additional value to the corporation. In Cai's statistical
study, shareholder say on pay proposals for such corporations resulted
in a negative market reaction once announced. The negative reaction
became even greater when the proposals were sponsored by labor unions.
During the House Financial Services Committee hearings on the say on
pay bill, Steven Kaplan, professor at Chicago Graduate School of
Business, pioneered this conclusion, stating that companies without an
executive compensation problem would be subject to "increased pressure
from interest groups that they do not incur today." The "increased
pressure" from special interest groups will lead to increased cost in
potential proxy fights and the generation of positive public relations
to offset any negative market reactions.

There is uncertainty as to whether say on pay proposals are truly
effective in lowering executive compensation. With more than 90
proposals filed this year, only 10 proposals passed with a majority
vote. According to Riskmetrics, the average shareholder support for say
on pay in 2008 is around 42 percent. The most puzzling shareholder
votes occurred at Wall Street firms such as Citigroup, JP Morgan Chase,
Merrill Lynch and Morgan Stanley, receiving an average of approximately
37 percent shareholder support, a decrease of 6 percent shareholder
support for similar proposals received by the same firms in the 2007
proxy season. In fact, at Oracle Corp.'s annual meeting, a say on pay
proposal garnered only 29 percent of support amid Larry Ellison's $72
million CEO compensation award. Does this not support the argument that
the media exaggerates the level of shareholders' concern with executive
pay?

Regulatory agencies, such as the SEC, and national stock exchanges,
such as the NYSE, have implemented rules providing transparency
regarding executive compensation. SEC disclosure rules require publicly
traded corporations to include with their regular filings a new report
titled, "Compensation, Discussion and Analysis." The CD&A provides
full disclosure of the material factors underlying the executive
compensation process. Under NYSE's Corporate Governance Standard
303A.08, listed corporations must hold shareholder approval votes for
equity based compensation awards. In light of such rules, critics of
say on pay believe that a mandatory say on pay proposal is redundant
and ineffective. The NYSE listing standard already provides
shareholders with a say on pay for more than 2,700 corporations issuing
equity compensation awards to executives. Moreover, the SEC disclosure
requirements provide shareholders with ample information regarding
executive compensation and dissatisfied shareholders are able to
withhold their vote or vote for alternative directors as a method to
demonstrate concern with poor compensation decisions.

One of the strongest attacks on say on pay proposals comes from
critics fearful of distorting shareholders' and directors'
responsibilities by providing shareholders' managerial authority. In
his remarks made at the University of Pennsylvania's March 2007 Law and
Economic Institute's Chancery Court Program, professor Stephen M.
Bainbridge stated say on pay "is part of an ongoing effort by a handful
of activists to shift substantially the locus of [corporate] decision
making authority." In traditional public corporations, shareholders
should not be involved in the management and daily activities of the
corporation. They should be passive investors. Instead, the
shareholders' role is to vote for directors who will place the
shareholders' interests first and foremost and ultimately make
decisions in the best interest of the corporation. Requiring
shareholders to approve executive compensation packages essentially
takes away the directors' power to manage corporations in general and
specifically compensation levels. Although the shareholder vote is
nonbinding, directors face the difficult decision of either accepting
the shareholders' vote or facing public embarrassment for going against
the shareholders' will. Critics of say on pay warn that the slippery
slope of shareholder activism is the gateway to shifting the
traditional paradigm of the corporate structure, which could lead to
the ineffective management of corporations.

THE FUTURE OF SAY ON PAY PROPOSALS

There is no clear conclusion as to whether the universal
implementation of say on pay proposals has positive or negative
implications upon corporations. Because of rising executive
compensation packages many politicians, academics and institutional
investors believe more say on pay proposals would settle the
exponential growth of CEO pay. However, a mandatory implementation of
say on pay on corporations with good corporate governance and
market-rate executive pay will increase their costs. Say on pay is an
assessment to be made by each individual corporation prior to
implementation. It is not a one-size-fits-all approach. Providing
shareholders with corporate decision making power has unique varied
effects posed to individual corporations.

The future of say on pay proposals seems positive regardless of the
outcome of the presidential election. Both major party presidential
candidates are trumpeting say on pay as a method of reform for Wall
Street and as a symbol of support for the average American worker.
However, until the stalled Senate bill leaves the confines of the
Senate Committee on Banking, Housing, and Urban Affairs and reaches the
president's desk, neither Obama nor McCain can put the law into effect.
As such, entering its third year, say on pay continues to be viable for
shareholder activism as an internal method of change and will remain a
hot topic during the 2009 proxy season. Its lasting effect will be
determined by shareholder support spurned during recent turbulent
economic times, seeking to trim corporate costs and send a message to
the leadership of our corporate culture.

Katayun I. Jaffari is a partner in Saul Ewing's Business
Department and co-chairman of the securities transactions practice
group and vice-chairman of the corporate governance group. She has
extensive experience counseling public companies in the area of
securities law compliance, including reporting requirements under NYSE,
NASDAQ and AMEX regulations. She represents public companies in initial
public offerings, primary and secondary offerings and private
placements, including PIPE transactions as well as 144A transactions.
Jaffari can be reached at kjaffari@saul.com or 215-972-7161.



Mu'min Islam is an associate in the firm's business department
where he concentrates his practice in securities transactions and
general corporate. Islam can be reached at mislam@saul.com or 215-972-7772.