TOP corporate executives of US-listed firms will have a new worry next year: Their pay packages will be scrutinized as never before. Starting in January, shareholders by law will be able to vote regularly to approve or disapprove executive pay packages. What will investors consider before casting their votes?

The so-called "say on pay" advisory shareholder vote was first required by law for US financial institutions receiving bailout funds under the Troubled Asset Relief Program (TARP) in 2008.

About 70 other US companies have adopted similar voting voluntarily in recent times. This summer, the Obama administration went a step further with the Dodd-Frank Wall Street Reform and Consumer Protection Act. Starting with annual shareholder meetings taking place after January 21, the act requires all public companies to conduct say-on-pay votes at least once every three years and ask shareholders to vote on the frequency of those votes every six years. Shareholders will also be asked their views on golden parachute awards after a merger, acquisition or any other type of restructuring.

Meanwhile, the country's pension funds and other large institutional investors that will be casting ballots must disclose publicly how they voted and why.

Think carefully

While the general public will be disappointed that the new law won't necessarily put an end to fat-cat pay, it should go some way toward raising the accountability of many executives who have been paid handsomely despite shoddy performance that has harmed, rather than helped, increases in the value of their companies for shareholders. But casting votes that push firms to link pay to performance requires careful analysis by investors, according to experts from Wharton and compensation advisers.

Fat-cat pay has drawn the ire of investors and the general public for years, but their outcry reached a fever pitch after the banking meltdown in 2008. Taxpayers, who were asked to bail out the banks, were particularly infuriated by compensation to Lehman Brothers CEO Richard Fuld in the years before the company filed the largest bankruptcy in US history in September 2008. While Fuld said he received US$310 million in compensation over the period between 2000 and 2007 and that he had not sold much of his stock, observers put his pay much higher, to as much as US$500 million.

Fuld wasn't alone. The reasons? The sector's excessive cash bonuses, a focus on short-term annual growth measures, and "pay levels that were so high they effectively insured executives against failure" and fueled an aggressive risk-taking culture, according to a new report commissioned by the Council of Institutional Investors (CII), which represents about 130 pension funds. The report found that Wall Street's median compensation levels were between two and three times the levels of the rest of the Fortune 50 during the five years from 2003 to 2007.

"The differential was driven for the most part by Wall Street's appetite for larger awards of time-restricted stock," noted the report's author, Paul Hodgson, a senior research associate at the Corporate Library, a corporate governance research outfit.

But experts question whether a mandatory say-on-pay system will help improve the size and structure of pay packages. "The amount of work [institutional investors] can do [to analyze and improve pay packages] is trivial compared to what the board has already done," says Wayne Guay, a Wharton accounting professor who consults on executive compensation plans. "The chance that they'll come up with a flaw in the plan is slim. I'm confident most boards are doing a pretty good job."

According to the CII's report, say-on-pay votes should also be wielded carefully. "A high say-on-pay 'against' vote is a blunt instrument," it stated, adding that there are other, potentially more effective steps investors can take to voice their displeasure with excessive pay.

Skin in the Game

"Share owners should ensure that if they do vote against compensation, they explain their objections in a letter to the company ... If change is not forthcoming, owners can let the company know that they will vote against the reelection of compensation committee members. As a last step, they can consider filing a shareowner resolution seeking improvements in specific pay practices."

Despite the intense public scrutiny and frequent criticism of executive pay packages in the media, however, most US shareholders who have been able to cast votes on executive pay have been supportive of company practices. Thus far in 2010, only three companies have failed to receive majority support for their compensation programs, and no company failed to receive majority support for pay programs in 2009.

According to Wharton finance professor Alex Edmans, short-term holders may have different objectives than long-term holders. "Short-term holders usually don't have as much 'skin' in the game," so their focus when analyzing pay packages might be different than long-term investors, he notes.

As for golden parachutes, even though they are usually frowned upon by the investor community and are not popular among the general public, shareholders should not automatically vote against them.

Understandably, shareholders are unhappy when an executive who is asked to leave a company after years of poor performance walks away with a multimillion-dollar retirement plan.

But in other cases, without a parachute clause, a CEO might try to scupper a takeover bid, ultimately at a high price to shareholders.

But "yes" or "no" votes aside, the big benefit of the new law will be the increased transparency as to how executive pay structures are designed.

Under greater scrutiny, he says, companies will work harder to improve the information about pay in proxy statements and annual reports.

(Reproduced with permission from Knowledge@Wharton, http://www.knowledgeatwharton.com.cn. All rights reserved. Shanghai Daily condensed the article.)