From its very beginning, the "say on pay" movement was an attempt to reduce executive pay. Instead, since becoming a requirement for all public companies in 2011, "say on pay" has led to the routine endorsement of C-suite compensation. In fact, it may even be encouraging rising pay for top executives who can now point to direct shareholder approval of their pay packages.
It's not as if shareholders are endorsing executive pay because boards have dramatically scaled back on the amounts top executives receive. According to a recent analysis in the New York Times, last year the median pay of the top 200 chief executives at public companies with at least $1 billion in revenue rose 16 percent.
"The 'say on pay' experiment is a bust," writes Jesse Eisinger of Pro Publica.
So what went wrong?
Perhaps shareholders just never shared the conviction of self-styled shareholder advocates that executives were overpaid. As UCLA law professor Stephen Bainbridge has pointed out, over the long term CEO pay growth has largely been matched or exceeded by gains by shareholders. Shareholders might just be convinced that things are working just fine.
Or, maybe, shareholder opinion of executive pay is a lot like voter opinions about Congress. Everyone hates Congress in general, yet every single sitting member of the House of Representatives received the majority endorsement of voters. Shareholders may loathe high levels of executive pay in the abstract but endorse it for the companies they own.
(Read more: Why Shareholder's Don't Want Shareholder Democracy)
A more sophisticated response may be that shareholders face a version of the prisoner's dilemma. If that's a new phrase for you, here's how James Stewart describes it:
This is about as close as possible to what in game theory is known as the "prisoner's dilemma," Randal Picker, University of Chicago law professor and a co-author of "Game Theory and the Law," pointed out. The game was developed by RAND Corporation scientists and formalized in 1950 by a Princeton mathematician, Albert W. Tucker, who gave the game its name.
In the now-classic version, the police have arrested two suspects and are interrogating them in separate rooms. Each can either confess and implicate the other, or remain silent. If only one confesses, he goes free and the other gets a harsh sentence. If both confess, each gets a reduced sentence, but still goes to jail. If neither confesses, the government lacks the evidence needed to convict and both go free.
Game theorists have demonstrated that the rational choice, or dominant strategy, is always to confess and implicate the other, even though the optimal outcome for both occurs if neither cooperates. That's because, as Professor Picker explained, if one prisoner has confessed, the best the other can hope for is also to confess and get the moderate sentence rather than the harsher sentence reserved for those who don't cooperate. If one prisoner doesn't confess, the other can go free by implicating him. Although they collectively are better off if neither cooperates, their individual self-interest dictates cooperation.
Something along these lines could apply to shareholder votes. If shareholders of Company A attempt to reign in the pay of their executives (the equivalent of refusing to confess), shareholders of executive B could attempt to poach those executives with better pay. The rational choice, the dominant strategy, is to agree to keep endorsing high levels of executive pay.
Notice, however, that there's nothing special about this. It's just a way of describing the market process of bidding for talented executives.
Eisinger blames rising stock prices for the failure of shareholders to be more assertive. The share prices of the companies in the New York Times analysis rose by 19 percent, exceeding the rise of executive pay.
"These results demonstrate that shareholders don't care about pay if their stocks are going up. But if say on pay merely takes the temperature of the stock market, why bother?" Eisinger says.
That's a nice testable thesis. If Eisinger is right, we should be see a lot more shareholder rejections in the next bear market.
But there's good reason to suspect that Eisinger is only half right. It's not just that shareholders don't care about pay if stocks are going up—they might not care about pay regardless of the direction of the stock market. A rational investor holds shares in a diversified portfolio of stocks. Diversified investors aren't much interested in the details of corporate governance or executive compensation at a particular company. They are interested in the overall performance of the market. This means that they lack the incentives and information to make the kind of critical judgments the "say on pay" advocates hoped they would.
Here's how Bainbridge put it a few years ago:
A rational shareholder will expend the effort to make an informed decision only if the expected benefits of doing so outweigh the costs. Given the length and complexity of corporate disclosure documents, especially in a proxy contest where the shareholder is receiving multiple communications from the contending parties, the opportunity cost entailed in becoming informed before voting is quite high and very apparent. In addition, most shareholders' holdings are too small to have any significant effect on the vote's outcome. Accordingly, shareholders can be expected to assign a relatively low value to the expected benefits of careful consideration. Shareholders are thus rationally apathetic. For the average shareholder, the necessary investment of time and effort in making informed voting decisions simply is not worthwhile.
American corporate law has generally responded to the ineffectiveness of shareholder governance by creating a system that Bainbridge described as "director primacy." Shareholders delegate supervision of corporate management—including decisions about pay—to directors. Corporate boards take on the task of collecting and assessing the relevant information and transmit their assessment to shareholders, saving shareholders the trouble of having to collect and analyze it themselves.
(Read more: Why Shareholder Democracy is a bad idea)
"Say on pay" tried to unwind this process, asking shareholders to second guess the board. But shareholders refused to go along.
This is probably the best explanation of why "say on pay" has failed to spark a shareholder revolt. It's not so much that shareholders approve of executive pay, or that they are apathetic in the face of rising share prices. It's that they endorse the delegation of decision-making on pay to the board of directors.
Perhaps a better way of putting it is that "say on pay" is a bust if your model was an Arab Spring-like uprising against dictatorial corporate executives. But it's working out just fine—perhaps better than expected—as a demonstration of shareholder enthusiasm for director primacy in corporate governance.