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Say on Pay Votes and CEO Compensation: Evidence From the U.K. Fabrizio Ferri and David Maber Harvard Business School European Financial Management Symposium Corporate Governance and Control Judge Business School, Cambridge April 10, 2009 . Background.

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Background

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  1. Say on Pay Votes and CEO Compensation:Evidence From the U.K.Fabrizio Ferri and David MaberHarvard Business SchoolEuropean Financial Management Symposium Corporate Governance and ControlJudge Business School, CambridgeApril 10, 2009

  2. Background • “Say on Pay” regulation introduced in UK (2002) • Mandatory, but non-binding, annual shareholder vote on the executive compensation report • Response to concerns with US-style “fat cat” pay • E.g. “Rewards for failure” (severance payments) • Glaxo (2003): The vote heard around the world! • Similar regulation adopted by Australia, the Netherlands, Norway, and Sweden • Likely adoption in the U.S.? • ~150 Shareholder proposals by union pension funds • Bill approved by House, support by Obama

  3. Shareholder Votes and CEO pay • Advisory votes: public signal of dissatisfaction about board performance on CEO pay matters • Will they affect CEO pay? Potentially yes, if implicit incentives attached to voting outcome • Affect bargaining board/CEO (“outrage” theory) • Evidence: growing impact of shareholder votes on firms’ behavior and directors’ reputation • Will they improve CEO pay? • It will depend on quality of the signal and the communication between shareholders and boards • Ultimately, an empirical question

  4. Research Question & Predictions • Impetus for “say on pay” regulation in the UK: • Low pay-for-poor-performance sensitivity • Prediction – “Say on pay” associated with: • Increase in pay-to-poor performance sensitivity • …particularly where CEO pay is controversial • High voting dissent in proxy season 2003 • “Excessive” CEO pay prior to say on pay • Does say on pay act as substitute or complementary monitoring mechanism? Did “say on pay” affect CEO pay? How?

  5. Research Design:Ex Ante vs Ex Post Effect of Say on Pay • In equilibrium, effect of “say on pay” (if any) through ex antethreat of voting dissent. • Communication before the annual meeting • Ex post, high voting dissent only if boards: • …do not anticipate dissent (“off-equilibrium”; Glaxo) • …anticipate dissent but feel it is tolerable • Empirical implication: • Correlating voting outcome with subsequent changes in CEO pay may understate effect of “say on pay” • Research design: before/after test for full sample

  6. Research Design: a before/after approach • Sample: largest 700 UK firms, 2000-2005 • Estimate sensitivity of CEO cash and total pay to its economic determinants in the “Pre” (2000-2002) and “Post” period (2003-2005) in a ‘stacked’ regression • Test for differences between coefficients in Pre and Post period • Main focus on CEO cash pay • Relation with realized performance better specified • 67% of total pay for UK CEOs over sample period

  7. TABLE 5 Determinants of CEO Pay in the UK: Pre- vs. Post Period Cash Pay Total Pay • Greater sensitivity of CEO pay to poor performance • No evidence of change in level (Post) or growth rate (Trend)

  8. Is the effect more pronounced in firms with controversial pay practices? • High voting dissent in ‘03 (1st year say on pay) • Proxy for controversial pay features in Pre period • High Dissent if (against+abstain) votes > 20% • “Excessive” CEO Pay in the Pre period • Compute residual from yearly regressions of CEO Total Pay on economic determinants • Classify as “Excessive Pay” firms in the top 20% of the distribution of average yearly residual • Research design: “difference in difference” • Interact Pre and Post coefficients with sub-sample dummies (four stacked regressions) • Tests may also speak to causality

  9. Voting Outcome (FTSE 350) - Descriptives • Median voting dissent: 14% in ’03, 10% in ’04 • Dissent >50%: N=3 (in ’03), N=4 (in ’04) • Among N=3, no “repeat” cases • Average dissent down from 60% to 9% • Dissent >20%: N=65 (in ’03), N=29 (in ’04) • Among N=65, only 9 “repeat” cases • Average dissent down from 30% to 11% • Decrease for 61 of those 65 firms • #1: Firms somehow respond to voting dissent • #2: Actions taken reduce future voting dissent

  10. Example – GlaxoSmithKline(Annual Report FY 2003) • The remuneration policy set out in this report was finalized after undertaking an extensive consultation process with shareholders and institutional bodies during the course of 2003. During the year the Chairman of GlaxoSmithKline and the Chairman of the Committee met shareholders, representing nearly half of GlaxoSmithKline's share capital, to ensure that the Committee obtained a clear understanding of shareholder expectations and to communicate the competitive issues facing the company. The Committee has derived very considerable benefits from this process of consultation and as a result has instigated a major shift in the way GlaxoSmithKline sets the remuneration of its most senior executives.

  11. Example – GlaxoSmithKline(Annual Report FY 2003) • Dr Garnier and Mr Coombe have agreed to changes in their own contractual terms without compensation to come broadly in line with the new contractual framework, including the reduction of contractual notice period from 24 to 12 calendar months. • Comparative performance was previously measured by reference to the FTSE 100 but the Committee concluded that the measurement of performance against the performance comparator group of pharmaceutical companies …would provide a better assessment of the company's performance…[any future] changes…will be discussed with shareholders prior to implementation • This [new] performance condition is substantially consistent with UK shareholder guidelines and expectations and is considerably more demanding than any operated by other global pharmaceutical companies.

  12. Explicit Response to Votes - 30 Firms with Highest Dissent in 2003 • Reduction in notice period to 12 months: 10 firms (83% of those with notice period greater than 12 months) • Remove/reduce re-testing provisions: 6 firms (50% of those allowing retesting) • Tougher performance-based vesting conditions in equity awards (e.g. higher EPS growth over inflation): 6 firms (>20%) • Tougher comparator group (e.g. replace FTSE 100 with global industry index): 4 firms (14%) • Introduced new incentive plans: 9 firms (30%) • Introduced process of consultation w/shareholders (23%) • Specific changes explicitly linked to consultation process (27%) • Hired comp consultant for independent review: 10 firms (33%)

  13. TABLE 6 Determinants of CEO Cash Compensation Pre- vs. Post- Period, Partitioned by Degree of Voting Dissent Cash Pay Total Pay CEO pay more sensitive to poor operating performance only in firms with “high voting dissent” in 2003 (first year of “say on pay”)

  14. TABLE 7 Determinants of CEO Compensation Pre- vs. Post- Period, Partitioned by Excess CEO Pay Cash Pay Total Pay CEO pay more sensitive to poor operating performance only in Excess Pay firms

  15. Additional Tests Is the Say on Pay “Threat” Effective? • Excess Pay result holds within Low Voting Dissent group • Consistent with “ex ante” effect of the rule (threat of voting dissent works) • Anecdotal evidence of changes in Low Dissent firms Is Say on Pay a Scalpel or a Hatchet? • Replicate analysis using High vs Low CEO Pay • No differential impact on ‘High CEO Pay’ firms. • Consistent with say on pay affecting “intended” firms • Perhaps evidence of positive impact?

  16. Does Say on Pay Act as a Substitute or Complementary Monitoring Mechanism? • Complementary: more/only effective if there is ‘enough’ monitoring (e.g. high concentration of institutional ownership) • Substitute: more/only effective if monitoring is low (e.g. low board independence) • Test: create three ‘high-low’ sub-samples based on above/below median in terms of… • …concentration of institutional ownership, size and % independent directors • Finding: increase in sensitivity of pay to poor performance in both ‘high’ and ‘low’ groups

  17. Alternative Explanations • Changes in UK governance affecting CEO pay • Difference-in-differences: “within country” test • UK firms subject to say on pay vis-a-vis UK firms traded on AIM (not subject to say on pay) • Say on pay or additional mandatory disclosures? • Little new disclosure (termination payments) • Institutional investors point to say on pay • Say on pay seems to have improved voluntary disclosures through its effect on consultations

  18. Summary of Findings No effect on level and growth rate of pay Increase in pay to poor performance sensitivity Consistent with call for less “rewards for failure” and evidence of explicit changes in controversial features Stronger effect in “intended” firms More efficient CEO pay contracts? Perhaps Caveats for policy-making implications Pre-existing conditions in the UK Alternative mechanisms Side effects (positive and negative)

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