SOP and shareholder value

Professor Paul Kerin considers the impact of the “say on pay” legislation and asks whether it could lift the performance of boards.

Is “say on pay” a SOP?

It is almost five years since Australian legislation mandated “say on pay” (SOP) – annual non-binding shareholder votes on executive compensation. International research suggests that investors expected SOP legislation to significantly improve the shareholder value of some firms, while having only a small, positive impact on the shareholder value of all firms in aggregate – investors were broadly right. Economists have attempted to infer investors’ expectations of SOP legislation by looking at share price reactions to its introduction or passage. However, this is only valid if the passage was unexpected.

Only one introduction/passage event was truly unexpected: the 2002 introduction to the UK parliament of regulations mandating SOP (a world-first). Researchers found that the sharemarket’s overall reaction to this event was positive. In particular, share prices rose most (by about 0.5 per cent) for firms with deficient compensation practices – “overpaid” CEOs (paid above market, after adjusting for size, performance and other firm characteristics) and/or with the weakest links between CEO pay and performance.

Researchers also studied share price reactions to the US House of Representatives’ 2007 passage of a SOP bill. I didn’t expect much reaction to this event, as the bill still had to get through the Republican-controlled Senate (which it didn’t). Nevertheless, research results were similar to those in the UK: share prices rose for firms with deficient compensation practices. Furthermore, for firms in this category, those with relatively well-governed boards (high director quality, high independence and low entrenchment) experienced the largest share price gains. Share prices didn’t react for firms with highly paid – but not “overpaid” – CEOs.

In short, investors expected SOP legislation to improve shareholder value for firms that needed to change and had a high probability of responding positively to SOP. Subsequent research suggests that  this expectation was broadly right.

UK firms with deficient compensation practices prior to 2002 and firms that have received high “no” SOP votes have significantly improved those practices. However, research following the eventual US introduction of SOP in 2011 produced mixed results. Shareholders often fail to register sufficient “no” votes against deficient compensation plans to make boards act; in those cases, share prices fall post-vote.

Even with a high “no” vote, boards often respond with “window-dressing”; in those cases, SOP literally lives up to the dictionary definition of its acronym (“a thing of little value done to appease someone”). However, as markets see through window-dressing, it doesn’t improve shareholder value, nor subsequent SOP vote results. Overall, the US research suggests that SOP gives insufficient incentives to some boards to fix deficient compensation plans. Nevertheless, it does improve firms’ compensation disclosure practices, although mainly in those firms with good compensation practices.

SOP is most likely to increase the shareholder value of firms that have both deficient compensation plans and well-governed boards (as they’re most likely to appropriately fix the plans in response to negative SOP votes). While we might tend to think that generally well-governed boards wouldn’t have deficient compensation plans, the research shows that a significant number do.

Conversely, SOP is most likely to destroy the shareholder value of firms that have appropriate compensation plans but weak boards. Furthermore, SOP may not induce some weak boards to change deficient compensation practices.

However, these cases are not arguments against SOP – they’re arguments for better boards. SOP might prompt investors to push for them. It is possible that our “two strikes” rule might cause the downfall of a well-governed board, if shareholders are silly enough to register at least 25 per cent “no” votes on a good compensation plan at two consecutive shareholder meetings and then vote the board out. However, I’m yet to find a single instance of this.

While SOP is not a major driver of overall shareholder value, well-governed boards should not fear it. It may help some ensure they have appropriate compensation practices and make shareholders feel they’ve had a say. Also, it may help lift the performance of other boards.