Business forum: Investors want a say on executive pay

Compensation decisions at U.S. public companies used to be a private matter. Of course, pay for top executives must be disclosed in the proxy statement to shareholders each year. But it's been the exclusive province of corporate directors serving on a company's compensation committee to set executive pay as they see fit, at levels they feel are competitive and appropriate to motivate top performance.

At least, that's the way it used to work. With efforts by investors and even Congress to give shareholders an advisory vote on executive pay, that may be changing. Companies must respond effectively to the current climate or they may need a bigger boardroom to accommodate the crowd that wants a say in how executives are paid.

The spotlight on poor pay practices at some U.S. public companies has not been flattering. Severance packages dubbed "pay-for-failure" and option backdating scandals have left compensation committees looking bad.

In 2006, the Securities and Exchange Commission (SEC) adopted new executive pay rules that sought to improve disclosure of performance incentives, retirement benefits, severance arrangements, option grants and perks and to reveal the "why" behind pay decisions.

The SEC reviewed 350 proxy statements showing the new disclosure last year and essentially told the companies who drafted them, "Nice try, but try harder." The SEC's biggest beefs were that companies were still not clear about why they paid what they paid; that the presentation was too dense and obscured key data, and that some companies failed to disclose details about how performance pay was set and earned.

Key investor groups, such as one led by the American Federation of State County and Municipal Employees' (AFCSME) Employee Pension Plan and Walden Asset Management, also are unsatisfied with company disclosure and with pay packages deemed too generous or not sufficiently aligned with company performance. Such activist groups have introduced pay-related shareholder proposals for vote at annual meetings.

'Say on pay'

One shareholder proposal rapidly gathering steam asks companies to give shareholders an advisory vote on executive compensation shown in the proxy statement. These advisory votes would not be binding on the company, but would allow shareholders to signal their dissatisfaction to directors with the power to change pay practices. A "no" vote on pay would tell directors: "Fix the problem or fail to be reelected."

Such "say-on-pay" proposals first appeared in a handful of proxy statements in 2006. By 2007, the proposal appeared in more than 60 proxy statements and received strong shareholder support. So far, more than 90 companies have received the proposal for the 2008 proxy season.

Congress has jumped in too, with Rep. Barney Frank, D-Mass., introducing say-on-pay legislation in 2007. Its fate likely will be determined after the 2008 election.

So far, three U.S. companies have agreed to give shareholders an advisory vote on pay: Aflac, Verizon and Par Pharmaceuticals. Many more companies will need to decide about using the practice when faced with a proposal that receives a majority vote.

Most companies will want to avoid this result. Giving shareholders a vote on pay is problematic, as leverage over complex pay decisions shifts from boards to corporate governance activists and proxy advisory firms, such as ISS (part of RiskMetrics Group).

Companies and their compensation committees may feel compelled to negotiate with these firms in order to assess or resolve any investor dissatisfaction with executive pay before the annual vote. Companies already know what it's like to negotiate with ISS over stock option plans, because those plans must be approved by shareholders, and ISS will not recommend a favorable vote unless the plan meets its requirements. Companies dislike this process, because it is expensive (ISS charges a substantial fee for its analysis) and often baffling (the firm's analysis metrics are a "black box").

So, how can companies avoid giving others a say on pay? First, they should treat pay disclosure in their proxy statement as a key strategic communication and not just a response to technical SEC rules. Companies should explain clearly the competitive environment in which they vie for talent and be very specific about how they tie pay to company performance.

Companies also may benefit from measuring their pay practices and disclosures against other investor standards. For example, ISS has offered "global principles" for pay that emphasize good disclosure, pay-for-performance and board independence in the pay-setting process.

In some cases, compensation committees may want to eliminate aspects of their pay programs and processes that contravene these principles or, at least, not adopt pay policies, severance packages or perks that will put them in the spotlight.