By Jason Zweig, WSJ
New rules will allow shareholders to cast advisory votes on executive compensation. But proxy statements are still written in gibberish, and CEOs still call the shots.
Investors are getting more "say on pay." Before you start warming up your vocal cords, you should know a few things about using your new rights intelligently.
Under rules adopted this week by the Securities and Exchange Commission, companies whose stock-market value exceeds $75 million must give shareholders the opportunity, at least once every three years, to voice their approval or disapproval of how top management is being paid.
Shareholders have always been able to call for such a vote, but now it will be mandatory. The vote remains "advisory"; companies will be free to ignore the results. So you might conclude nothing is likely to change—and be tempted to feed your proxy statements directly into the paper shredder, as usual.
But your vote may discourage corporate boards from pampering managers with pushover pay hurdles; it might even end up making disclosures easier to understand.
Ralph Walkling of the Center for Corporate Governance at Drexel University has found that voting against directors may discourage them from acting like rubber stamps. Each 1% increase in "no" votes knocks up to $222,000 off the excess compensation of the chief executive officer the next year—and even raises the odds that the CEO will be replaced.
By making investors pay closer attention to their proxy statements, say-on-pay also might make them think a little bit more like owners.
You should start by watching how a board justifies the boss' pay. According to Michael Faulkender, a finance professor at the University of Maryland who has analyzed thousands of proxy statements, the "peer group" that companies choose for evaluating their own profitability contains 31 stocks on average. Meanwhile, when benchmarking the compensation of their chief executive and other top managers, companies compare themselves to an average of just 18 firms.
You don't have to be a cynic to see what this can mean. By comparing its earnings or stock performance to big baskets of companies, a firm increases the odds that the resulting averages will be easy to beat. At the same time, it compares its own bosses' pay to much smaller groups of companies that—perhaps not by coincidence—tend to have highly compensated managers.
Prof. Faulkender found that, among firms that disclose their pay benchmarks, 98% set the target for paying their CEO at or above the midpoint of the peer group. "There was definitely a gaming of the system" among the 429 companies Prof. Faulkender looked at, he says. By comparing themselves to firms with bosses who are amply paid—instead of companies comparable in other respects—these concerns made their CEOs $1.2 million richer a year, on average.
Meanwhile, proxy statements have gotten so incomprehensible, they might as well be written in Ugaritic. "I think there are still a lot of cases where the compensation committee [of the board of directors] could not tell you what's in the [proxy statement] or what it all means," says Kurt Schacht, a managing director at the CFA Institute, the industry group for financial analysts.
Christoph Pereira, deputy general counsel at General Electric, helps write GE's annual pay disclosures—but jokes that he stands over a trash can while he reads the proxies for the other stocks he owns. "The last thing I want to read is a 40-page proxy full of algorithms or a Kafkaesque description of process," he says. "In the Twitter age, people want to know: Is this a good number based on what you've done for me lately?"
Next week, the CFA Institute will release a standardized model of pay disclosure. By encouraging firms to explain how they set and measure pay targets, this approach should help outsiders "see whether the incentives are in place for the company to meet your investment objectives," says Donna Anderson, corporate-governance analyst at T. Rowe Price.
If the proxy statement shows that performance and pay are measured against drastically different peer groups, that the CEO has been rewarded for short-term performance, low rates of return or for making a bad acquisition—or even if you can't understand what the proxy shows—then you should vote accordingly. Cast your vote against the pay package, against any "golden parachute" deals that award executives special payouts in a merger, and in favor of a say-on-pay vote every year.
Don't stop there; vote against every director. That will show them you are paying attention. As the investor Benjamin Graham wrote in 1951: "Poor management is often paid more than it deserves; but here, if the stockholders bestir themselves at all, they should devote their efforts to changing personnel rather than pay."
Write to Jason Zweig at email@example.com