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Nottingham University Business School MSc in Business and Management 2015/16 Individual Coursework Coversheet – Electronic Submission NAME: Pierfrancesco Bresolini Eibenstein Student ID: 4257378 MODULE TITLE: Corporate Governance (N14104 UK)

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Nottingham University Business School

MSc in Business and Management

2015/16

Individual Coursework Coversheet – Electronic

Submission

NAME: Pierfrancesco Bresolini Eibenstein

Student ID: 4257378

MODULE TITLE: Corporate Governance (N14104 UK)

Topic 2

Say-on-pay: characteristics, literature review and findings from

various countries

Contents

Introduction .......................................................................................... 1

1 Say-on-pay: characteristics and literature review ........................... 2

2 The UK experience of say-on-pay ................................................. 4

3 The US experience of say-on-pay ................................................. 5

4 Say-on-pay in the rest of the world ............................................... 6

Conclusion............................................................................................. 7

References

1

Introduction

The past decades have been characterized by a dramatic rise in Chief Executive Officer

(CEO) compensation and benefits (Frydman and Jenter, 2010). This phenomenon was

highly criticized during the financial crisis, when CEO pay-package structures encouraged

them to take excessive risks. The result was often financial ruin for many companies

(Bhagat and Romano, 2009). Nevertheless, CEOs continue to earn millions of dollars

when leaving a company. This so-called “golden parachute” practice is also called “pay-

for-failure” and is one that generates a high level of unhappiness amongst investors (Cai

and Walkling, 2011).

So as to solve this problem and give a voice to shareholders, the governments of

various countries have set-up a tool called “say-on-pay”. Say-on-pay gives investors a

binding or non-binding opportunity to vote and approve the composition and level of the

compensation package awarded to executives. Its aim is to improve the transparency

and accountability of executives’ compensation, as well as attempting to link the

compensation payments and company performance more effectively (Baird and

Stowasser, 2002). However, some important researchers are not convinced by the

effectiveness of say-on-pay. In fact, according to Deane (2007), the current market

system for compensation is already effective and say-on-pay only distracts and reduces

the authority of company boards.

The purpose of this essay is to describe and assess the true effectiveness of this

policy through the analysis of the academic articles and studies.

The essay proceeds as follows: section 1 offers a definition and the characteristics

of say-on-pay through a literature review. Section 2 describes say-on-pay and findings

from the UK, and then say-on-pay and findings from the US in section 3. Section 4 gives

a brief panorama of say-on-pay in the rest of the world, followed by the conclusion.

2

1 Say-on-pay: characteristics and literature review

In 1976, Jensen and Meckling developed the principal-agent problem. This agency

problem is a risk for companies. In fact, the ownership of public firms is usually

widespread and shareholders delegate to the company’s board to negotiate managers

compensation. This could create misalignments of interest between owners and

managers. As Gabaix and Landier (2006) show, from 1980 to 2003 there was a six-fold

increase in CEO salaries. Furthermore, in recent years, generous severance contracts

and controversial pay structures have made shareholders unhappy and feel powerless

(Ferri and Maber, 2013). To increase the shareholders voice in the matter of CEO

compensation, governments have adopted a say-on-pay policy. Say-on-pay is the

shareholders’ right to vote on executive pay (Ferri and Maber, 2013). It can be binding

or non-binding. In the latter scenario, the final decision is for the board to make.

However, even if the board does not take shareholders opinion into consideration,

negative publicity in the media could still help to achieve the desires of the shareholders

(Conyon and Sadler, 2010). Before Say-on-pay, Ertimur et al. (2010) indicate that

shareholder proposals were generally ineffective in forcing changes, especially if

proposed by trade unions. Instead, Brav et al. (2008) show that hedge funds activism

gain success in 60-70% of cases. Levit and Malenko (2011) also indicate that non-

binding advice was often ignored. However, in recent years, the use of majority voting

for shareholder proposals has risen together with their implementation (Ferri and Maber,

2013). Hodgson (2015) shows over 90% of companies approve executive pay packages,

while Chasan (2015) describes how just 2% of companies voted against the pay

proposals. These results show few companies have shareholders who are unsatisfied

with CEO pay proposals. Conyon and Sadler (2010) find the higher the pay of a CEO, the

higher the dissent of shareholders, and to vote against it allows an opportunity to

manifest their dissent. They find that, in general, shareholder dissent is usually low.

However, this level of dissent rises dramatically when concerned with issues of higher

compensation levels, huge bonuses and weak pay-for-performance. Perhaps, Say-on-pay

is the most effective tool that shareholders have to influence compensation and having

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worthwhile dialogue with the board. Also, endorsement of the board by shareholders

encourages directors to negotiate more effectively with CEOs (Ferri and Maber, 2013).

Say-on-pay is both more diplomatic and effective than shareholder proposals, which

constitute strong actions that could strain relationships with management (Conyon and

Sadler, 2010).

Cai and Walkling (2011) indicate three necessary conditions to benefit from say-

on-pay: 1) a firm’s compensation policy should be excessive, ineffective and inadequate;

2) shareholders should be actively participating; 3) especially in the case of non-binding,

the firm must be open to discussion, renegotiation and improvement of their

compensation policy. They also indicate that say-on-pay could reduce agency cost and

improve the value of the firm through the alignment of owner-manager interests.

However, opponents of say-on-pay consider the current payment system effective

enough thanks to market efficiency and competition (Fama, 1980; Cai and Walkling,

2011). In addition, say-on-pay could distract the board from its work and push it to

make suboptimal decisions (Bainbridge, 2008). Furthermore, the existing free market

can regulate the inefficiencies through mechanisms such as Market for Corporate Control

(Wright et al., 2009) and the possibility, if unsatisfied, of selling shares to reinvest in

companies with a more effective system of pay management. Core et al. (1999) suggest

that higher CEO pay is associated with less than effective boards. This could be

problematic for company sustainability and ability to generate future profits. However,

with say-on-pay, shareholders could have the opportunity to improve the compensation

design, align interests and increase a firm’s sustainability without selling assets (Ferri

and Maber, 2013). Say-on-pay is an additional tool of control with respect to shareholder

rights. Finally, there is no evidence of it being influenced by micromanage compensation

from various interest groups (Ertimur et al., 2010). Thus, there is no evidence of abuse

of say-on-pay due to conflict of interest.

There are many arguments for and against say-on-pay, but the free market as the

sole determiner of profitable companies is not a reality. Given this, say-on-pay could act

as an external governance tool in terms of control. (Alissa, 2015).

4

2 The UK experience of say-on-pay

As logic suggests, shareholders are not willing to sanction high levels of compensation

for poor performance (Conyon and Sadler, 2010). Thus, there is evidence that suggests

say-on-pay increases the sensitivity between pay and performance (Ferri and Maber,

2013). Given that, the Directors’ Remuneration Report (DRR) was introduced in the UK

in 2002, which permitted shareholders an advisory non-binding vote on executive

remuneration at least once every three years (Ferri and Maber, 2013). They also found

there to be a positive market reaction to the introduction of say-on-pay. This positive

reaction was the result of optimistic expectations from investors. It was especially

positive for firms with excessive executive pay and low performance or generous

severance contracts (Ferri and Maber, 2013). However, Conyon and Sadler (2010)

showed that only less than 10% vote against CEO remuneration. This could indicate that

90% of shareholders vote in favour. They also found that shareholder dissent decreases

over time. Moreover, Balachandran et al. (2007) found a rise in sensitivity of CEO

payment to operating performance but not to market performance. Hooghiemstra et al.

(2015) underline the importance of media. They found that negative media coverage is

associated with a higher rate of dissent in voting.

In 2013, the UK enhanced the regulation with the Enterprise and Regulatory

Reform Act. This new regulation introduced a say-on-pay binding system (Gregory-Smith

and Main, 2014). They found a reduction in dissenting votes due to the concern that a

negative signal would trigger a negative market reaction. However, Alissa (2015)

showed that boards react to shareholders discontent by increasing CEO turnover and

reducing CEO pay when performance is low. Thus, overall say-on-pay could increase

“transparency, performance-linkage and accountability” Alissa (2015: 750).

Gregory‐Smith et al. (2014) found that say-on-pay voting constrains pay but only to a

small degree, and instead primarily acts on excessive rewards. They also found an

increment in CEO resignation and turnover. Recently, a government report has shown

long-term incentives have increased while salary and bonus growth rates have reduced

(DBIS, 2015).

5

3 The US experience of say-on-pay

Prior studies of individual shareholder proposals found there to be no impact on

executive pay (Ertimur et al., 2011). However, after 2002, when proposals were

sponsored by institutional investors, they were starting to help achieve more

transparency and better pay-for-performance (Ertimur et al., 2011). During the financial

crisis, President Obama limited CEO salary to $500,000 for bailout firms, and in 2010, he

signed the Dodd-Frank Act (Cai and Walkling, 2011). This law gives shareholders a non-

binding say-on-pay right. Cai and Walkling (2011) analysed the market reaction to this

say-on-pay announcement. They found it to be positive for companies with excessive

CEO remuneration and lower pay-for-performance linkage, but a negative reaction for

firms with the lowest governance. This suggests that say-on-pay could create value, but

it is up to a board to implement improvements.

Semler Brossy (2016) shows that 92.4% of companies approved compensations

every year. Additionally, WTW (2016) indicates that only 3% failed to achieve

shareholder majority during 2015. They also see a general positive trend in these four

years of mandatory say-on-pay. HayGroup (2014) sees say-on-pay positively in terms of

building a closer relationship between shareholders and a company. It addresses

compensation strategy to pay-for-performance and a long-term horizon (Bachelder,

2015). However, the non-binding nature of the vote allows for companies to ignore

shareholder complaints (Chasan, 2014). The problem is more acute in firms where the

founder is both CEO and main shareholder, and the person is identified with the

company.

Overall, the US findings seem to confirm that say-on-pay creates value for firms

open to change (Cai and Walkling, 2011), and generates a lower growth rate in CEO pay

(Conyon, 2015).

6

4 Say-on-pay in the rest of the world

Ng et al. (2011: 1510) stated: “If well designed, equity compensation provides powerful

and effective incentives to managers that help align their interests with those of

shareholders”. For this, many other countries in the world implemented say-on-pay

regulation. The European Commission introduced say-on-pay for over 10,000 listed

companies in 2014 (EC, 2014). Denmark, The Netherlands, Norway, Sweden,

Switzerland have a binding system, while Australia, Belgium, France, Germany, Italy

have a non-binding system (Orsagh, 2013).

The Italian and German cases are interesting as both countries are characterized

by SMEs, which are generally family-run and having low widespread control. In Italy,

non-binding (binding for financial sector) say-on-pay was introduced in 2010. Even if

ownership structure is highly concentrated, the level of dissent is comparable to other

countries with widespread ownership (Belcredi et al., 2014). Dissent is higher for

excessive and opaque remuneration. Also, the non-binding nature does not reduce

dissent. In contrast, the level of dissent is lower in binding for fear of a negative market

reaction (Belcredi et al., 2014). In Germany, Eulerich et al. (2014) found higher say-on-

pay use for large firms, where media and public pressure often leads to find a solution

for the dissent. However, smaller firms use of say-on-pay is less, thus there is less

transparency in their compensation structures (Powell and Rapp, 2015).

7

Conclusion

Rising executive compensation, poor pay-for-performance, low transparency and pay-

for-failure have made the introduction of new legislation a necessity: say-on-pay. This

paper supports the advantages and improvements brought by say-on-pay through the

analysis of academic papers and studies.

It was concluded that say-on-pay could be a way to improve and try to solve the

principal-agent problem with the alignment of interests amongst owners and executives.

It was also described as an additional tool for monitoring executive activity and

performance and, above all, it seems to be a way to foster democracy and discussion

inside firms, whilst also having the aim of increasing value, transparency and fairness.

This description-analysis was conducted using only secondary research. It would be

interesting to collate the different findings from different countries, and see if there are

correlations as there appears to be. In terms of limitations, some details and aspects of

this topic have not been included in this paper, but it would be interesting to investigate

say-on-pay further.

(Total words: 2000)

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