When Say on Pay Becomes Binding: Australia's Two Strike Rule

Hello from Perth, Australia.  As some of you know, I am on sabbatical, currently touring Australia.  Last night I had the honor of talking to a local CPA society on Corporate Governance.  The question of Australia's two strike rule came up during the discussion.

The two strike rule is an interesting, if controversial rule in corporate governance.  If a board receives a 25%, no-vote on its compensation policy for two consecutive years, shareholders vote to decide if the the entire board must stand for re-election.  The rule, implemented in Australia in 2011, gives teeth to the previously advisory Say on Pay.

See this interesting article in The Sydney Herald.

One can imagine the pluses and minuses of such a system.  First, if directors are not responsive to shareholders a second year in a row, the shareholders get additional power to alter that situation.  It is reminiscent of the provisions in some preferred stocks, where if a firm misses dividends for say three years, the stock acquires voting rights.)

On the other hand, 25% might be a low threshold, and less than a majority could hold a firm hostage. Or, as directors often fear during a Say on Pay vote,  a low vote may be the result of something quite different from problems with compensation.  

David Trebeck, the Chairman of Penrice Soda, which recently survived a close call on the two strike rule, commented, ‘‘I think directors generally are more than capable of identifying and responding to prevailing shareholder sentiment without needing a legislative sledgehammer to do it for them."

(Source:  http://www.smh.com.au/business/axe-twostrikes-rule-penrice-directors-say-20130125-2dbam.html#ixzz2hJu9p5li)

The two strike rule isn't the case in the US but, by the way, Australia had Say on Pay, well before the United States.  It makes sense to keep track of what is happening in other venues and use that knowledge to improve practice.  This is NOT to say, I'm endorsing this idea, but it bears watching the empirical results.  

See our related post on Swiss Say on Pay.

All the best,

Ralp;h

Say on Pay in the US: The Early Evidence

Joe and I have been debating the merits of the new Swiss Say on Pay regulation.   (See Mad as Hell and I'm Not Going to Take This and Swiss Say on Pay - The Dangers. 

The US now has it's own, non-binding Say on Pay legislation, but it is a relatively new development.  A few years ago, my colleague Jay Cai and I performed the first empirical analysis of Say on Pay in the United States in the academic literature.

The starting point for our analysis was April 20, 2007, when underdog Presidential Candidate Barack Obama introduced the legislation into the Senate.  It had just passed the house on the same day.  Thinking about the impact of this legislation on shareholder wealth you can immediately envision three possible impacts.

First, it could be beneficial, prodding boards to rein in excessive pay and to be more careful in the compensation packages they offer.  In this case, the share price of firms would increase with the bill.

Second, such a law could be detrimental to shareholders.  Boards are responsible for executive compensation and can always hire additional expertise to advise them as needed.  Outside pressures from shareholders, some of whom may have narrow agendas, could produce unnecessary complications within the boardroom which could reduce shareholder wealth.

Finally, we might find that the mere introduction of the bill in the Senate (and it's passage in the house) have no impact on shareholder wealth.  After all, we are talking about the introduction of a bill, not its passage.  Moreover, even if it passed the Senate, then-President Bush said he would veto it.  Besides, it is an advisory vote - boards don't have to do anything even if a majority of shareholders disagree with the level of executive compensation.  (In this regard, I note that previous evidence on advisory votes finds them to have little impact on shareholder wealth.)  So in my mind, the probabilities were stacked towards no impact.  

What did we find?  Some interesting results.

First, we find that one size doesn't fit all with this legislation.  Our results indicate that situations where the law appears beneficial and situations where shareholder votes are likely to be seriously considered are associated with increases in shareholder wealth.  In other situations, the bill would appear to reduce shareholder wealth.  

So where was it beneficial?  In firms with high, abnormal CEO compensation, those with low pay for performance sensitivity and for those firms that had been responsive to shareholder votes in the past.  The latter result is in line with the fact that firms don't have to implement changes, even if a majority of shareholders disagree with pay packages.  

But Say on Pay could have been voluntarily implemented by boards if they deemed it beneficial.  They didn't need legislation to do this.  Moreover, shareholders themselves could have proposed Say on Pay to their boards.  In fact, this did happen.  We found numerous cases where activists (primarily unions) had sponsored Say on Pay proposals.  Unfortunately, they appeared to target the wrong firms.  The firms they targeted were large firms that, on average, appeared to have reasonable performance, governance and pay characteristics. As a result, the share price dropped for firms targeted in this way.  Our research suggests that say-on-pay creates value for companies with inefficient compensation, but can destroy value for others. 

The complete paper can be downloaded here: Shareholders’ Say on Pay: Does It Create Value? 

Swiss Say on Pay: The Dangers

In Wednesday's post, (Mad as Hell and Not Going to Take This Anymore) Joe discussed shareholder frustration inherent in Switzerland's recent decision to give shareholders a binding say on pay.  He anticipated that I might take a different view and he was correct.  I promised a response.  As I reread the post, however, I found sympathy with some of the concepts.  It is tough to justify some of the pay packages that we see awarded.  And, Joe notes that the Binding Say on Pay may not be the right vehicle to vent frustration.  I agree, and I'm generally less excited about this new law.  Here are some thoughts.

First, concern about executive compensation is not new.  A quick search of the New York Times headlines finds complaints similar to today even back in the 1920's.   Now this could mean that a) executive comp attracts attention, b) big salaries attract attention or that c) executive compensation - was and continues to be -  a problem.  Probably all three are correct.  However, while the first two items are probably true without qualification, the same cannot be said for item (c).  Not all executive compensation is a problem.

So my second point is that we must be careful with new regulation.  Boards exist to find the best solutions for their shareholders.  Yes, there are excesses and they attract our attention and yes, boards must be held accountable.  But compensation is a board responsibility.  Boards are capable and should hire whatever expertise they require to get compensation right.  The board is the expert  on this or can hire the expert.  The same cannot be said for the mass public, particularly if they are inflamed by headlines or influenced by single item advocates.  Binding Say on Pay on all companies is dangerous.  I'll discuss our own research on Say on Pay in the US next week.  It shows that one size doesn't fit all with regard to US legislation.  The same can be said of any other type of corporate governance.  Boards need the flexibility to handle the individualized needs of their companies.

Third, as I've written elsewhere, the regulatory pendulum swings from too little to too much, but tends to get stuck on one side - the side of too much regulation.  It is easier to see egregious problems and create new regulation.  But it is more difficult to dismantle that legislation when it is excessive.  Regulatory agencies like all life forms, develop defense mechanisms.

Fourth, a ban on all golden parachutes is dangerous.  I too, have great skepticism on some golden parachutes.  And our own research shows that when the parachutes are out of line with other elements of a merger pay package, bad results follow.  (See Golden Parachutes and the Art of the Deal.)   But parachutes can serve useful functions as well.  In particular, they help align incentives and protect CEOs from a new owner reneging on implicit contracts about pay for performance.  When designing a pay package boards can't anticipate every contingency.  Hence, implicit contracts arise, such as a board telling a CEO 'trust us, if you enhance value, we'll do right by you.'  Such a contract is meaningless with a change in control.  Golden parachutes can ease that problem.  They also mitigate the moral hazard problem that arises when the best thing a CEO can do for shareholders is step aside and recommend going along with a takeover.  Admittedly, boards should be monitoring self-serving behavior on the part of the CEO but a well designed parachute can align incentives.  Our own research shows that a poorly aligned parachute can create a rush to sale or unyielding resistance to a deal.   Neither will benefit shareholders.  But the solution is not to ban all parachutes, but to get the GP right.

Fifth, where does this type of legislation stop?  Some have already argued for binding votes on the ratio of CEO pay to that of the average worker.  Such rules are foolish attempts to legislate the laws of economics.  However, (and fortunately) the laws of economics answer to a higher authority: supply and demand.  As a colleague once told his University Dean, "You don't determine my salary - you only influence where it get's paid."   So watch what happens when salaries are rigidly capped regardless of market value.  The most highly valued leave,  reducing the quality of the organization.  Alternatively, (and as press reports already note) some companies are talking of moving their headquarters from Switzerland.

In the US, of course, where Say on Pay votes are not binding, almost all Say on Pay votes are highly supportive of executive pay, so all of this may be of little concern.  To my way of thinking, however, it is a dangerous development.

Mad as Hell and Not Going to Take This Anymore

                                                      

Joe and I have a lot of fun when we are on the opposite side of an issue, and he anticipated my response to his blog today, sending it to me with the subject: perhaps we'll have another debate?  Yes, I think we will.  Look for an alternate view this Friday.  

Ralph

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Just like Howard Beale in Network, the Swiss voters overwhelming passed legislation requiring shareholder approval on all executive and director compensation. Additionally, they banned golden handshakes and parachute severance arrangements. The law goes beyond shareholder say on pay (SOP) rules in other countries, including our own Dodd Frank nonbinding SOP rules.

My initial reaction was to dismiss it as typical European socialism. Upon further reflection, I think it suggests something deeper may be happening. It reflects a justifiable voter frustration over weak corporate governance allowing seemingly incompetent managers to be unjustly rewarded. They may have used the wrong tool, but they have identified the right problem; namely the poor state of corporate governance at many large public firms.

The close knit world of executives, directors and professionals has neutered governance at many firms. The executives nominate the directors and chose the consultants who recommend the compensation programs. External control from activist shareholders and takeover threats has been weakened by legal developments including, inter alia, poison pills and staggered boards. Large institutional shareholders prefer to vote with their feet rather than make waves. Things have to get really bad before any actions are taken.

The result is the perception of corporate looting-or if you prefer a softer tem-rent seeking by executives. This includes both executive compensation and value destructive misguided M&A e.g. HP.The Swiss voters may be signaling a non market response to a perceived market failure. A governance revolution may be developing from outside the system. Executives, Directors and Professionals- ignore this at your peril. The citizens are getting mad as hell and are not going to take this anymore.

j