Research

CEO compensation: What’s the impact of say-on-pay?

The Dodd-Frank Wall Street Reform and Consumer Protection Act provides stockholders with a way to express their displeasure when a CEO’s compensation seems outrageously high. But, only a tiny percentage of corporations and their CEOs have been on the losing end of so-called “say-on-pay” votes. New research by Associate Management Professor Matthew Semadeni explains why.

2015-02-09

Thanks to 2010 legislation designed to reform Wall Street, stockholders have a new way to express their displeasure when a CEO’s compensation seems outrageously high. But despite the hype over the Dodd-Frank Wall Street Reform and Consumer Protection Act, only a tiny percentage of corporations and their CEOs have been on the losing end of so-called “say-on-pay” votes.

New research by Matthew Semadeni, associate professor of management, sheds light on why so few stockholders use the tool the law created. It turns out that people focus much more on whether their stocks are doing well and less on how the CEOs are doing, he says. (Power to the Principals! An experimental look at shareholder say-on-pay voting)

“It’s a very human thing, right? If you’re doing fine, even if someone else is maybe not, you’re going to not care as much as when you’re not doing fine,” Semadeni said.

The research by Semadeni and former doctoral students Ryan Krause and Kimberly Whitler showed that the only time shareholders feel a loss and tend to vote no is when a company performs below average and its CEO’s pay is high. When a company performs above average and the CEO is well-paid, or when a company performs poorly under a poorly paid CEO, shareholders feel neutral and tend to vote yes. When a company performs well and the CEO is underpaid, shareholders feel they’ve gained and again vote yes.

The results suggest that shareholders are more concerned with company performance than with executive pay, Semadeni found. He predicts that shareholders will care about high CEO pay, and vote against it, only when their investments are losing money.

“The signal is pretty clear: ‘I’m paying you a lot, and you’re not doing anything,’” Semadeni said. “But if you get into any of these other conditions, particularly where ‘I’m not paying you a lot and you’re doing very well,’ let’s not talk about that. I’m getting a deal.”

How “say-on-pay” got started

The law sponsored by U.S. Rep. Barney Frank, D-Mass., and U.S. Sen. Chris Dodd, D-Conn., mandates that publicly traded corporations submit top executives’ compensation to shareholders for a non-binding vote for or against the pay.

Dodd-Frank came on the heels of the mortgage crisis and the Great Recession, as the gulf between executive pay and workers’ wages widened and corporate America was criticized as failing to regulate itself. The law aimed to rein in powerful CEOs and give shareholders, as owners of corporations, another mechanism to control management.

Under “say-on-pay,” some high-profile no votes have occurred. Shareholders of Stanley Black & Decker Inc. voted no in 2011, and the board slashed its CEO’s pay and made other changes. Shareholders of Citigroup Inc. voted no in 2012, later forcing out the CEO. In the first half of 2014, 51 companies reported failed votes.

But overwhelmingly, shareholders vote yes. More than 90 percent of “say-on-pay” votes taken in the first half of 2013 passed with greater than two-thirds majority, according to a Georgeson Securities study. Fewer than 4 percent failed.

“Most of these votes are pretty perfunctory,” Semadeni said. “People really aren’t using it for what I think both Dodd and Frank intended, which was to try to discipline management.”

Semadeni and his team wondered what it would take for shareholders to vote no. Earlier research on what shareholders might do when pay and performance don’t match was unclear, making it hard to predict the “say-on-pay” vote outcome.

One school of thought suggested that shareholders will look logically at whether executive compensation matches stock performance — in short, a link between pay and performance. This approach predicts that shareholders would vote approval when pay and performance are aligned — for higher pay if the stock had gained, for lower pay if the stock had fallen — but that they would vote disapproval when the two are misaligned — against high pay if the stock had lost, against low pay if the stock had gained.

Another school of thought suggested that shareholders who were losing money on their investment would respond much more strongly than shareholders who had gained. This approach predicts that shareholders would vote against pay packages when their investments were in the red, but for pay packages when their investments did well.

Semadeni’s team thought using both schools of thought might better explain voter behavior. They agreed that shareholders would focus on the link between pay and performance, but they predicted the link would hold true only when shareholders faced losses.

They also took a different approach to finding answers. Typically, researchers pour through historical data, but data on “no” votes is sparse and fails to show any cause and effect. Semadeni opted for experiments that would allow the researchers to present decision makers with various combinations of pay and performance and see which combinations resulted in “no” votes.

MBA students, most of whom were shareholders with at least five years of work experience, took part in the experiments. The first group was told to act as shareholders, and, because institutional investors hold more than 70 percent of large company shares, a second group was told to act as mutual fund managers. Each group was asked to vote on one of four scenarios:

1. Pay increased and performance lagged.
2. Pay increased and performance increased.
3. Pay decreased and performance lagged.
4. Pay decreased and performance increased.

The results showed that the frame of reference — namely, company performance — mattered to both groups. Shareholders voted no in the first scenario of higher pay and lagging performance, but they voted yes in all other scenarios.

One result surprised Semadeni. He expected the students who were acting as mutual fund managers to take a longer-term view and be concerned that underpaid CEOs might leave well-run companies, but they actually showed similar and even stronger behavior than those acting as individuals.

Implications for companies

Failed votes are probably rare for several reasons. When company performance is a problem, Semadeni noted, boards often sack the CEO. Unhappy shareholders have their own options — they can vote the directors off a board, they can sell their stock and if they hold many shares, they can pressure management for change.

Nevertheless, failed votes affect a company. They create bad press, distract management and the board and signal other top executives that compensation opportunities are limited. If a company is struggling in a tough marketplace, such votes can make it harder to attract and pay for the premium talent often needed to turn things around.

Semadeni believes that a no vote is really a vote against the directors who approved the CEO’s pay targets and compensation.

“A ‘no’ vote is a vote of no confidence in the board because the board is not doing their job. I think that’s something that’s lost in the broader conversation,” he said. “The shareholders may feel like they’re voting against the CEO, but in effect they’re really taking on their own representatives.”

He also sees pitfalls when shareholders approve low compensation for CEOs delivering great performances. Those shareholders might think they’re getting a deal, and in some cases they are: CEOs might be concerned with their legacy, or see themselves as stewards or their work as a calling. Shareholders also might assume that the board is minding the store, or that the CEOs are looking out for themselves. But shareholders should look long term to really create value, Semadeni said. CEOs who are underpaid yet deliver good performance might leave for better opportunities.

The research also suggests that the law has added to the burden of compliance on corporations, but the small percentage of no votes shows the law created little benefit.

“It gets to this: how good are shareholders at really doing their job? If they’re really not that good at doing their job, which the evidence would suggest, then why on earth are we giving them a say in this whole process?” Semadeni said. “Sure, they’re owners, but the mechanism they have is through the board, not through directly commenting on management.”

The bottom line

Semadeni says his research holds these takeaways for the various stakeholders in “say-on-pay” issues:

• For boards: be aware of how “say-on-pay” votes can be perceived and act accordingly. When the company is underperforming and compensation is high, reconsider the pay package or educate shareholders on the reasons for it. Be more transparent about goals and targets CEOs must reach to earn their compensation.
• For CEOs: you know that compensation is often tied to performance, and there are many types of compensation. If you agree to excessively low compensation, be aware that the board might have difficulty raising your pay if future performance is poor.
• For shareholders: hold the board accountable for the CEO’s compensation, even when a company is performing well. A company that pays its top managers too little risks losing superior performers.
• For lawmakers: the notion of “say-on-pay” was catchy, but its value is questionable. Making the votes binding would only gut boards’ responsibility to represent shareholders and decide on compensation. “Say-on-pay” poses an additional burden on companies, and as more of them go private, oversight and shareholder control are lost.

Director's notes on the Academy of Management paper

Governance Management