In this issue, answers to:

• What are the differences in say-on-pay laws in different regions?
• What voting outcomes have there been in the US and elsewhere?
  What function does say on pay serve within a broader context of shareholder activism and regulatory intervention?
• How can companies improve the likelihood of positive say-on-pay votes?

This past year, the United States joined an expanding list of countries with “say on pay” requirements that give shareholders an advisory vote on a company’s executive compensation program. In the US, say on pay initially was mandated in 2009 for recipients of funds under the Troubled Assets Relief Program (TARP); in 2011, it became generally applicable to all US public companies except smaller reporting companies, as part of the Wall Street Reform and Consumer Protection Act (“Dodd-Frank”). Smaller reporting companies must comply in 2013.

By the time say on pay was implemented for TARP participants, the concept of shareholders casting votes on executive compensation already had a precedent in the United Kingdom (2003), and the intervening years witnessed analogous rules in the Netherlands (2004), Australia (2005), Sweden (2006), Norway and Denmark (2007) and Germany (2009), among others.

In addition, some companies operating in jurisdictions without say-on-pay legislation have voluntarily given shareholders an opportunity to vote on executive pay at their annual meetings. The expanding presence of foreign investors who exercise say-on-pay authority in their home countries may also increase the pressure to enact say-on-pay legislation in countries that currently lack it. Given these circumstances, we believe say on pay is likely to become a corporate fact of life in parts of the world where shareholders form a robust, engaged constituency.

The background story that has led to say-on-pay legislation varies by country. A general theme has been shareholder frustration in cases where executive pay is perceived to be disproportionate to company performance. In the UK, the say-on-pay mandate complemented other legislation aimed at enhancing disclosure of executive compensation policies and practices. The impetus for instituting say on pay in the Netherlands and Australia was the unanticipated collapse of a few major companies, in large part due to weak corporate governance.

Although the historical context that gave rise to say on pay has varied by country, the outcome of say on pay has followed a common path: generally greater company awareness of hot-button compensation issues and more engagement and transparent communication with shareholders. This outcome appears to be fairly consistent, despite some significant differences in how say on pay is administered in various countries.

This article describes:

• Shareholder vote results in the US and general voting outcomes elsewhere
• Examples of differences in say-on-pay laws between selected jurisdictions
• The corporate governance landscape prior to say on pay
• Implications of say on pay worldwide

We also make explicit recommendations to improve the likelihood of favorable say-on-pay outcomes.

Shareholder support levels generally high

In every country that has implemented say on pay, shareholders have thus far generally registered strong levels of support for companies’ programs. Exceptions to this broad acceptance have been few but notable, occasionally prompted by specific instances of perceived corporate waste in severance or retirement packages, option grants, or poor pay-for-performance linkages. For example, in the UK and Australia, there have been few vote failures and most pay programs receive high levels of support. The US experience to date follows similar lines. The average favorable result has been about 90%, and only about 40 companies thus far failed to achieve a majority vote.

Say on pay appears to have increased the influence of large shareholder groups and proxy advisory firms in some countries. For example, in the UK, two main shareholder bodies that represent a large portion of the total shares traded on the London Stock Exchange have a great deal of leverage in shareholder votes. In the US, the growing influence of Institutional Shareholder Services (ISS) and Glass, Lewis & Co., proxy advisory firms that recommend how institutional investors should vote their shares, is evident in say-on-pay results. During the 2011 proxy season in the US, all of the companies that failed to receive majority support for their say-on-pay proposals received negative vote recommendations from ISS, although not all companies that received a negative ISS vote ecommendation failed their say-on-pay votes.

The many flavors of say on pay

The fairly consistent say-on-pay experience among the countries that have passed it into law belies some significant differences in those laws. Most notably, many countries (but not all) have adopted say on pay as a nonbinding advisory vote, rather than one that obligates the company to respond. Australia, Spain, the UK and the US require companies to give shareholders a nonbinding say-on-pay vote on their executive compensation programs. In countries such as Denmark, Norway and Sweden, the say-on-pay vote is binding. The Netherlands adds its own twist in that the say-on-pay vote is binding but limited to new remuneration policies or changes to existing policies.

Other jurisdictions have passed laws allowing companies to give shareholders a say-on-pay vote but not requiring them to do so. For example, in part owing to a European Commission recommendation that EU countries adopt say on pay, Germany gives shareholders an advisory vote at companies that volunteer to hold the vote. In Switzerland and Canada, some companies have voluntarily agreed to adopt say-on-pay policies even in the absence of a legal obligation to do so. These examples illustrate the diversity of practices worldwide.

The frequency of say-on-pay votes (“say on when”) also differs. In countries such as Australia, Norway, Sweden and the UK, the vote is mandated by law on an annual basis. In the US, a say-on-pay vote must be held at least once every three years – most companies have adopted an annual vote – but the frequency itself is subject to an advisory shareholder vote at least once every six years.

The corporate governance landscape prior to say on pay

Say-on-pay legislation is the most recent addition to a strengthening corporate governance movement and skepticism of executive remuneration that has its basis in regulatory intervention, proxy advisers’ influence and shareholder activism. While many of the changes from these forces have been positive, there is disagreement about the need for and efficacy of some of the changes.

Regulatory intervention:

• Proliferation of “comply or explain” requirements in the UK, the Netherlands and elsewhere. These rules provide a principles-based framework in which companies are required to identify and justify departures from best practices set forth in their national corporate governance codes and have caused companies to reconsider their pay and governance practices.

• Enhanced proxy disclosure requirements in the US, the UK, Canada and elsewhere. There is no question that enhanced pay and governance disclosure rules have given shareholders – along with academics, journalists and equity analysts – more information on the state of corporate governance and have increased the scrutiny of pay and governance decisions. Whether these benefits outweigh the increased burden on companies is debatable.

• Enhancements to exchange listing requirements. In North America, the New York Stock Exchange, NASDAQ stock market and Toronto Stock Exchange have instituted corporate governance rules that emphasize the independence of board members. In the US, the Dodd-Frank Act requires stock exchanges to enhance their independence rules. The London Stock Exchange requires its member organizations to subscribe to specified principles addressing board composition, director compensation and separation of the board from management influence.

Proxy advisers’ influence and shareholder activism:

• Influence of third-party proxy advisers. Over the past several years, organizations such as ISS and Glass Lewis have increased their influence on compensation programs and decisions in part by introducing progressively more stringent thresholds for securing positive vote recommendations on executive pay plans. For example, ISS’s bright-line test for CEO compensation relative to shareholder return has forced compensation committees to reconsider their pay-performance linkages. While proxy advisers traditionally have wielded the most influence when companies are proposing new equity plans or adding shares to existing equity plan reserves, their criteria for obtaining a positive recommendation have expanded beyond issues directly related to the use of shares.

• Rise of organized shareholder activism. Many institutional investors have developed guidelines to determine how they vote their shares in the event of a management proposal on say on pay or to augment current share reserve allotments for equity incentive plans. Likewise, shareholders have organized into public interest groups that monitor vote outcomes and follow developing issues. These groups constitute a crucial constituency for companies to convince when seeking shareholder approval.

Implications of say on pay

The addition of say on pay to the pay and governance landscape and the strengthening influence of governance watchdogs make it increasingly difficult for companies to hide or disguise their compensation decisions. Each of the mutually reinforcing dynamics discussed in this article – whether sanctioned by legislation or independent shareholder activism – contributes to a company’s prospects in say-on-pay votes.

Revised proxy rules in the US, Canada and elsewhere have led to an increase in public scrutiny of corporate policies and practices. Before the advent of the Compensation Discussion and Analysis section in US and Canadian proxy statements, for example, the issue of peer group selection – or the compensation decision-making process in general – was not disclosed in a consistent or clear way. This information plays a prominent role in determining say-on-pay outcomes.

Also, if a significant portion of institutional investors outsource their voting decisions to proxy advisory firms such as ISS or Glass Lewis, it is possible that the voting outcomes will become much more pronounced: the approvals will be higher, and the failures will fail by a wider margin. Therefore, we anticipate that the success of say-on-pay votes will become increasingly dependent on how closely a company’s pay program aligns with ISS and Glass Lewis prescriptions. In a similar vein, the two most influential UK-based shareholder bodies reported increased interest in pay and corporate governance issues from corporate directors following the advent of say on pay.

The trend among third-party proxy advisory services toward upping the ante in terms of setting standards for positive proxy recommendations is likely to continue. Say on pay has become a new focus for their advocacy,supplementing the traditional focus on stock-based compensation plans. Because say on pay applies to compensation policies in general, rather than only the policies stated in stock-based plans, say on pay extends the reach of organizations such as ISS and Glass Lewis to cash-based plans and compensation issues in general. The result is likely to be a sharper focus on topics as diverse as pay for performance, executive pay governance and succession planning.

At this point, there isn’t sufficient empirical data to suggest that companies refusing to modify their plans in the face of a negative say-on-pay outcome necessarily suffer in the financial markets, although it may immediately impact director re-election.

That being said, ignoring the shareholders’ say-on-pay mandate unquestionably has negative consequences. Even if the market does not initially reflect shareholder disappointment in a company’s pay policies or practices, the board – specifically members of the compensation committee – are likely to take considerable heat from shareholders and other interested parties, which may result in “against” votes in director elections. Say-on-pay voting results are public record and thus will serve as easily comparable, quantitative, single-point scores by which to assess shareholder satisfaction as a whole. Another negative consequence is the possibility of lawsuits where pay programs have failed to receive majority support. For example, there have been a handful of shareholder lawsuits alleging breach of fiduciary duty and other complaints in the US. However, the business judgment rule generally gives deference to board and compensation committee decisions about executive compensation, making it difficult for shareholders to prevail but resulting in negative publicity and possibly hefty settlement fees.

Finally, say on pay is not expected to reduce executive compensation in the US and did not appear to lower pay in the UK and Australia, based on empirical evidence of compensation levels. Although perceived excesses in executive compensation no doubt prompted legislators to take action in the US, the law serves much more to spur changes in governance and transparency than in pay levels. On the other hand, it is not anticipated that say on pay will have the consequence of increasing the level of compensation, which some claim was an adverse outcome of other legislative attempts aimed at curbing compensation in the US.

Critics argue that the objectives of say on pay could be realized without the necessity of a special governmental intervention, and that policies and influencing factors are already in place to support effective pay governance. Although the US has more prescriptive and detailed regulations pertaining to disclosure, companies in the UK have taken proactive steps to describe compensation programs to shareholders and solicit feedback prior to undergoing a say-on-pay vote. The Association of British Insurers and National Association of Pension Funds also are actively involved in advising their members on votes and facilitate board-level discussions with important external shareholders by providing a central forum for contact and negotiation. It could be that the confluence of these factors, more than say on pay alone, is responsible for a generally positive perspective on say on pay in the UK.

In Australia, which shares the UK’s “comply or explain” disclosure policy with respect to compensation decisions, the success of say on pay has been more mixed in that the regulation has not promoted the level of effective dialogue seen in the UK. At least part of this outcome may be attributed to a generally weaker governance support system in Australia; for example, adherence to the Australian Stock Exchange’s corporate governance code is voluntary, not mandatory, and many of the corporate watchdog groups in Australia have relatively inflexible guidelines that prompt some corporate boards to follow “acceptable” models rather than justify reasonable (and perhaps more appropriate) alternatives. In this regard, the UK’s generally principles-based approach to governance may itself indirectly contribute to say on pay’s success.

Mercer’s perspective

Like many attempts to legislate executive compensation across the globe, say-on-pay laws aim principally to modify corporate behavior. Regardless of say-on-pay’s variations across different jurisdictions, compliance with the mechanics of say on pay is the easy part. The bigger – and potentially transformational – challenge is to ensure that shareholders maintain a positive impression of how a company’s corporate assets are being used, specifically in terms of compensation to senior executives. To that end, companies should devote time to the following activities:

• Develop corporate governance policies that foster positive shareholder relations
• Stay continually vigilant for investor and proxy adviser concerns
• Keep open lines of communication with shareholders and proxy advisory firms

Develop corporate governance policies that foster positive shareholder relations

Enhanced executive pay disclosure has provided shareholders with unprecedented information about both pay levels and the compensation decision-making process. Shareholders and corporate governance watchdogs are using this information to assess a company’s compensation policies and governance practices – assessments that presumably feed directly into their say-on-pay voting decisions.

Companies can foster positive shareholder relations by following some basic precepts:

• Provide a complete and accurate account in pay disclosure documents of all matters related to the decision-making process with respect to executive compensation. Confusing or evasive disclosure may lead investors to presume the worst.
• Ensure that decisions governing executive compensation align with corporate priorities and follow best practices recommended by governance watchdogs.

Stay continually vigilant for investor and proxy adviser concerns

As interventions go, say on pay is a fairly opaque instrument. It provides a vehicle for shareholders to approve or disapprove a company’s pay arrangements in general but doesn’t clearly identify the specific source of grievances. Consequently, it is imperative that companies be cognizant of issues as they arise.

To that end, companies should review proxy voting guidelines of investor groups and large investors that hold a substantial equity position. For example, guidelines such as those set forth by the UK’s Association of British Insurers and National Association of Pension Funds, the Council of Institutional Investors, Vanguard, and Fidelity Investments are typically principles-based rather than prescriptive; in that regard, they are unlikely to delineate hard-and-fast rules about specific aspects of pay. However, they furnish useful general insight about sore spots and circumstances that could lead to negative votes.

Companies should also be aware of proxy advisers’ positions prior to seeking shareholder approval for any material change in their equity programs. For example, unlike proxy voting guidelines promulgated by the large institutional investors, ISS’s voting recommendations often are quite specific and prescriptive, including acceptable levels of share dilution and a pay-for-performance test. Most important (if anecdotally), there are several cases in which a negative recommendation from ISS may have contributed to a relatively low level of shareholder voting support or a vote failure. And in the UK, early experience with say on pay prompted companies to negotiate a compromise on compensation issues with established shareholder groups rather than risk a confrontational shareholder campaign.

Keep lines of communication open

Fundamentally, the message of say on pay is: We are your shareholders. Listen to us. In heeding that call, companies should recognize that the say-on-pay vote is not an end in itself, but simply a thumbs-up or thumbs-down indication of prevailing shareholder sentiment. Thus, it is important to engage shareholders periodically for discussions about compensation issues.

We advocate meeting at least annually with each significant non-employee, non-director shareholder to address executive compensation, among other issues. This meeting should take place regardless of whether any substantial departures from the company’s traditional pay practices are anticipated; the point of the meeting is to reconfirm a mutual understanding of the shareholders’ views, not necessarily to seek approval of changes that the company wants to make. This dialogue should address the following issues:

• Linkages of the compensation program to the company’s business objectives and human capital strategy and priorities
• Level of pay (how much relative to market norms)
• Compensation structure (fixed versus variable; service versus
• performance based; cash versus equity)
• Linkages of pay to performance
• Special circumstances (employment contracts; role of sign-on or
• other special compensation; termination provisions; clawbacks; share
  ownership/retention policies)
• Compensation decision process (compensation committee protocols; role of external consultants)

In sensitive circumstances, companies should increase their outreach efforts – perhaps through more frequent meetings with shareholders, securities analysts and influential shareholder rights groups. This could be particularly crucial if the company anticipates proposing a significant change in its compensation policies.

Ultimately, successful say-on-pay votes in the future will depend, in large part, on how well companies address shareholder concerns today. It helps to have a solid history of positive shareholder returns, but say-on-pay results so far imply that acceptable stock performance may not be enough.

Companies historically have had limited avenues for receiving feedback from their investors, except for proposals on specific pay and governance issues that are submitted for vote at the annual meeting. Say on pay aims to provide a regular forum for shareholders to register their satisfaction with or concerns about compensation matters. But the insight that companies can receive from the actual say-on-pay vote is limited, and conscientious research and follow-up are required to gain a true understanding of shareholder views.

In all jurisdictions where say on pay has been implemented, it has created some angst among companies in the first year or so after enactment;however, over time, say on pay becomes a relatively routine component of compensation governance. It has not been a significant problem for more than a small number of organizations in each country, but it has created an opportunity for all companies to increase their understanding of their shareholder base and to adopt pay and governance practices that will improve shareholder relations.