A good way out of our CEO compensation conundrum

This proxy season has seen institutional minority shareholders expressing themselves strongly on CEO pay. During the month of September, the pay proposals of Ekta and Shobha Kapoor of Balaji Telefilms were turned down by shareholders. Earlier, Eicher Motors failed to get approval for the proposed remuneration for CEO Siddhartha Lal. Institutional investors have opposed other pay packets as well, although in these cases the resolutions passed with the help of promoter votes. Seventy eight percent of institutional shareholders voted against Hero Motors’s proposal to offer 10% higher compensation to the promoter CEO Pawan Munjal, who has been one of the highest-paid executives of India for several years. Bajaj Auto’s proposal to offer its chairman emeritus Rahul Bajaj a pay package of 6 crores was opposed by over half of the institutional investors.

Several changes in the regulatory environment enabled increased participation of minority shareholders. First, e-voting, although introduced in SEBI regulations and the Companies Act years ago, has gained traction due to the pandemic. Second, the proxy advisory business in India has evolved into an active promoter of shareholder awareness, supporting institutional shareholders with analytical insights and recommendations. Most of the recent voting activity by Institutions is driven by the negative recommendations on proxy proposals by advisory firms such as IiAS, InGovern, and SES.

Examples such as Infosys suggest that professional CEOs would be paid more than promoter CEOs who also earn dividends on their stock ownership. However, our analysis of pay package trends of NSE500 companies over the last 5 years shows the opposite: Promoter-CEOs’ pay is 50% higher on average as compared to that of their professional counterparts. Further, this pay-gap is not explained by the size of companies managed and the result holds even after controlling for firm size measured by total assets.

The average ratio of CEO pay to that of the median employee for NSE500 companies in 2020 is 213:1 for promoter CEOs, compared to 152:1 for professional CEOs. These numbers are similar to those in the US, where the ratio is 299:1 for S&P500 companies in 2020, up from 264:1 in 2019. A comparison across countries for 2018 indicates that India is second only after the USA in the pay-ratio, higher than several other countries such as China, Canada, and the UK.

Economic logic dictates that pay packages need to be adequate to attract, motivate, and retain the right kind of talent. Besides economics, social views about legitimacy are also important. Organizations and organizational arrangements that lack legitimacy are unsustainable. Legitimacy also confers more immediate advantages to the organization in terms of enabling it to obtain resources such as capital, satisfied employees, and competent independent directors. Severe erosion of legitimacy could well find us slipping back into the days when Central Govt. permission was required for pay packages which were capped at a relatively low level.

Promoter votes in-favor of promoter CEO pay packages may suffice to get shareholder approval for the resolutions, but obviously do not confer legitimacy. This is where the role of the Nominations and Remuneration Committee of the Board (NRC) comes in. SEBI has recently modified the regulations to require that the NRC be composed of, not just a simple majority but a two-thirds majority of independent directors. This is a step in the right direction.

NRCs must now fulfil their role by justifying the pay packages in comparison with similar organizations, and through the link to performance. These factors are relevant both for economic reasons and legitimacy. The proxy advisory firms and institutional investors are a useful barometer for NRCs in fulfilling their role, and even an ally: their approval could help the NRCs establish legitimacy. Engaging in a dialogue with them could establish trust with the broader shareholder base. Institutional investors have a significant stake in the company and are not driven by extraneous factors such as political agendas. They are therefore an ally rather than an adversary.

The Balaji Telefilms case highlights the importance of engaging with shareholders, particularly institutional investors. The promoters abstained from voting on their own pay packages. The institutional investors, holding 18% of the shares, did not vote either. Only a few public shareholders holding 0.21% of the shares voted, and a majority of these votes turned out to be against the proposal. Engaging with institutional investors could have prevented this outcome.

Another basis for legitimacy is transparency in disclosures. Companies should disclose in the annual reports or proxy statements the rationale and basis for how the proposed compensation is arrived at, and what specific performance measures are used. Compensation need not, indeed should not, be based on a mechanical formula, but the basis for judgment should be disclosed.

In conclusion, we are not expressing a view on whether promoter CEO pay is excessive. We are calling for establishing the legitimacy of the chosen compensation practices. To do so, the NRC or the Stakeholder Relationship Committee of the Board should engage meaningfully with stakeholders such as proxy advisors and institutional investors. Passing shareholder resolutions on the strength of promoter stakes is not a recipe for legitimacy or sustainability.

Co-authored with Prof. Sanjay Kallapur, Professor of Accounting at the Indian School of Business (ISB), and an independent director on the Board of IDBI Bank.

Published in The Mint on 12-Oct-2021