Corporate Governance Failures: The Role of Institutional Investors in the Global Financial Crisis

6 Great Expectations: Institutional Investors, Executive Remuneration, and ``Say on Pay''

C h a p t e r 6 Great Expectations: Institutional Investors, Executive Remuneration, and ‘‘Say on Pay’’ Kym Sheehan Introduction The year 2009 was a watershed for the regulation of executive remuneration . Around the world, governments considered how best to regulate in light of evidence from the global financial crisis of a link between certain remuneration structures and excessive risk-taking.1 Two clear categories of regulatory response emerge from this latest crisis. First, there is the local adoption of the Financial Stability Board’s Principles for Sound Compensation Practices.2 Governments are translating these principles into national standards and allocating the monitoring task typically to the prudential regulator (the regulator with primary responsibility for ensuring financial stability). The second pattern of regulatory responses targets executive remuneration practices in public or listed companies more generally. These initiatives can include what is known as a ‘‘say on pay’’: a rule that gives the company ’s shareholders an annual vote on executive remuneration, either as a binding vote (for example, the binding vote on remuneration policy in the Netherlands) or an advisory-only vote (for example, the annual advisory vote on the remuneration report, as in the U.K. and Australia). This last 116 Kym Sheehan type of vote has existed in the U.K. since 2003 and Australia since 2005 and is attracting increasing attention from researchers3 and politicians (for example, in the U.S. the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, H.R.4173). However, before introducing a say on pay, governments should pause to consider how institutional investors can use this ‘‘say’’ to ensure companies adopt appropriate executive remuneration practices. The evidence of poor remuneration practices in a number of financial institutions in the FTSE 1004 confirms that the vote has not invariably ensured appropriate remuneration practices. A number of financial institutions subject to either full nationalization (for example, Northern Rock) or some partial intervention (for example, the Royal Bank of Scotland, and the merger between HBOS and the former Lloyds TSB, now the Lloyds Banking Group) were required to prepare a remuneration report and to put that report to an annual advisory vote. By and large, shareholders in these companies did not signal that they were displeased with the practices disclosed. For example, the lowest level of support received by the Royal Bank of Scotland for its remuneration report was 84 percent in 2003, followed by 85 percent in 2005. In all other years (2004, 2006, 2007, and 2008), the remuneration report has received over 90 percent of votes cast in favor of the resolution to adopt it. Institutional investors in U.K.-listed financial institutions collectively failed to ensure that good executive remuneration practices were adopted. Hence institutional shareholders have to accept some responsibility for these practices: to extend the sentiments expressed by the United Nations Environment Programme Finance Initiative ,5 the failure by institutional investors to collectively challenge financial institutions’ remuneration practices meant the practices remained. Understanding how the ‘‘say on pay’’ regulates executive remuneration demonstrates the ‘‘elements’’ that must exist if the say is to be effective . This chapter contributes to this understanding by presenting a model of the regulatory framework for executive remuneration in the U.K. and Australia. The next section presents a holistic model of the regulatory framework for executive remuneration applicable in Australia and the U.K., known as the regulated remuneration cycle.6 Closer inspection of the four activities in this cycle (practice, disclosure, engagement, and voting) highlights the three important roles institutional investors play in this framework. First, institutional investors act as rule makers by issuing Great Expectations 117 statements of best practice on executive remuneration. Second, institutional investors engage with remuneration committees on the remuneration practices the committee discloses in the remuneration report. Finally, institutional investors vote on remuneration-related resolutions, including the advisory vote on the remuneration report. In other words, say on pay is not just about governments legislating to give shareholders the right to vote on remuneration. Its effectiveness depends on the quality of shareholders’ actions in the three roles identified, and the synergy between these roles. The chapter then examines the expectations on institutional shareholders to ‘‘do something’’ about executive remuneration. Both government and institutional investors expect that institutional investors will actively monitor executive remuneration. Governments will legislate to give shareholders additional voting rights such as a mandatory annual say on pay, but government...