Investors Must Have Power, Not Just Figures on Pay

The Financial Times
Lucian Bebchuk
July 27, 2006

The US Securities and Exchange Commission’s vote this week to expand disclosure requirements for executive pay is a major step forward. To fully address the problems of compensation, however, this reform should be accompanied by additional steps giving investors the power they need to use the extra information they will receive.

Companies have long been able to camouflage large amounts of pay that have nothing to do with performance. The reform would make transparent the magnitude of executives’ total pay, providing a check on the escalation of remuneration levels.

Furthermore, making all compensation transparent would eliminate the incentives that companies have had to pay executives in ways that are better hidden, such as through retirement benefits, but are less linked to performance.

The figures that will come out in the next couple of years, I expect, will show increases in the levels of total pay as well as compensation not linked to performance. But this would not mean that the reform is having a perverse effect. Rather, it would reflect the fact that compensation that was ­previously hidden had now come to the surface.

The motivation for reform comes partly from the increased recognition that, without sufficient outside scrutiny, corporate boards cannot be expected to resist favourable pay arrangements for their executives. In Wednesday’s meeting, one of the SEC commissioners expressed the hope that improved disclosure would enable investors to cast votes in a more informed way. For this to make a difference, however, shareholders need more voting power. Without this, improved transparency will not fix the problems that disclosure reveals.

After all, due to investors’ limited power, some flaws in compensation arrangements have persisted in spite of being long evident. For example, companies have largely continued to adopt arrangements providing soft landings for executives pushed out due to utter failure; to establish minimum levels for bonuses, however poor performance is; and to design option plans rewarding executives for gains from market-wide and industry-wide movements rather than managers’ own performance. Similarly, in spite of repeated calls for change, companies have largely failed to adopt claw-back provisions that enable the reversal of compensation based on accounting figures that have had to be restated as well as limits on executives’ broad freedom to exercise vested options.

Indeed, the very need to expand mandated disclosure indicates the limits of shareholders’ power. In spite of the dissatisfaction of investors, companies have continued to avoid making pay arrangements transparent, as they could have easily done on their own.

What else needs to be done? To ensure that directors focus on shareholder interests, they must be made not only independent of insiders but dependent on shareholders. Share­holders’ power to remove directors must be turned from a fiction into a reality. The SEC should follow its disclosure reform with the adoption of the rule it proposed – but withdrew under pressure from management groups – to enable shareholders to place director candidates on the corporate ballot. In addition, directors should not be re-elected when they fail to get a majority of the votes cast; voting in corporate elections should be by secret ballot; and all directors should stand for re-election annually.

Furthermore, shareholders should be given more power to influence cor­porate decision-making. Shareholders’ involvement should not be limited, as it has been, to the passing of advisory resolutions that boards often fail to follow. Shareholders should have the power to initiate changes in the cor­porate charters and be allowed to place any proposed bylaw amendments on the corporate ballot. They should get to vote on compensation matters or at least be able to opt into having such power.

Investors should welcome reforms that will provide them with an accurate picture of the magnitude and make-up of executive pay. But they should also press for the power they need if the added disclosures are to have a significant impact on executive compensation and corporate performance.

The writer is a professor of law, economics and finance and director of the programme on corporate governance at Harvard Law School. He is co-author, with Jesse Fried, of Pay Without Performance: The Unfulfilled Promise of Executive Compensation (Harvard University Press)