In the last three years, regulatory and shareholder activists have put the heat on boards of directors “in a way I have not seen in a generation,” says Richard Leblanc, an international expert on corporate governance and accountability.

Leblanc calls this the “second wave of corporate governance.” The first wave resulted from the U.S.-based Sarbanes–Oxley Act of 2002, which was a consequence of notorious company-specific implosions and fraud (think Enron, Tyco, and WorldCom).

Nowadays, shareholder activists, such as the umbrella group of institutional shareholders known as the Canadian Coalition for Good Governance (CCGG), are concerned about many aspects of corporate governance, including composition and roles of nominating committees and pay committees, skills of directors, board diversity, and the way risk is handled. The CCGG is asking for proxy access, and it recommends a say-on-pay advisory vote. But its main concern is say on pay.

Of all the governance issues, “the say-on-pay movement has been a catalyst for shareholder engagement,” says Leblanc. Executive pay packages are huge, particularly when executives leave a company, he continues. But most galling of all is the fact that pay is not linked to improved outcomes for the company.

Michael Cooper’s research at the University of Utah concluded that “the more CEOs are paid, the worse the firm does over the next three years.” From pooled data for the years 1994 to 2011, the researchers found that “firms that pay their CEOs in the top 10 percent… earn negative abnormal returns over the next three years of approximately -8 percent. The effect is stronger for CEOs who receive higher incentive pay relative to their peers and stronger for CEOs with greater tenure.” The researchers attributed this to “CEO overconfidence, which leads to shareholder wealth losses from activities such as over-investment and value-destroying mergers and acquisitions.” “You really can’t talk about pay without talking about risk and governance,” Leblanc says.

As part of the Dodd–Frank Act, signed into law in 2010, the U.S. brought in say-on-pay rules as a means to link pay and performance. “But there has not been greater alignment,” says Leblanc. “Most say on pay has been approved, but the quantum of pay has not gone down,” he says, even when companies perform poorly. Shareholders often give CEOs the benefit of the doubt—or don’t want to admit an error in choosing the top dog.

“You really can’t talk about pay without talking about risk and governance” – Richard Leblanc

After 2009, in Canada, many large publicly traded companies voluntarily adopted an advisory proposal permitting shareholders to vote for or against the executive compensation plan proposed by the company in the annual proxy circular. It’s a means to voice shareholder displeasure with executive compensation without selling shares or pursuing more drastic action such as voting against pay committee members.

Recently, large pension plans have voted against boards of directors at three Canadian companies (Barrick Gold, Yamana Gold, and CIBC) in say-on-pay advisory votes. The companies are not obliged to implement any changes, but clearly something is afoot.

Regulators tried to solve the pay/performance misalignment through greater transparency, requiring companies to disclose all components of pay, but the solution backfired, says Leblanc. The extra data led to peer benchmarking. Compensation consultants collect what is known as a peer basket of companies and compare the pay of those senior executives to the pay of the home company CEO. The consultants benchmark CEO pay at the percentile the company wants. Most companies want the 75th to 90th percentile even though the peer companies are often larger and more complex than the home company. In other words, most companies choose “well above average,” and each succeeding year, the actual average spirals upward.

Charles Elson at the University of Delaware shows that the practice of peer benchmarking has built in a structural pay increase unrelated to performance, year after year. Elson describes three components producing upward pressure: “(1) Given the lack of subjective criteria for peer inclusion, the group is easily manipulated in their composition, (2) the practice of above-median targeting creates upward bias, which leads to the popularly referenced ‘Lake Wobegon Effect,’ and (3) structurally, they allow systemic effects to propagate through the constructed networks, creating a situation where the unrelated high pay and performance of one executive may drive up wages for many others (so-called leap-frogging).”

Another problem is that most compensation is based on a short-term view linked solely to quantitative financial metrics. “We know the effects of a CEO’s actions might last [as long as] seven years, and the majority of the value of the company is not financial,” says Leblanc. “When you focus on total shareholder return and earnings per share, the line of sight for a manager is just not there. You end up incorporating exogenous variables beyond the control of the manager.” An example of an exogenous variable is a change in customer tastes or preferences. He notes progressive regulators, largely in Europe, such as the U.K.’s Financial Reporting Council and the Swiss Financial Market Supervisory Authority, are trying to restructure the way CEOs get paid. They’re trying to link it to longer-term risk-adjusted metrics such as risk-adjusted return on capital.

Leblanc admits he’s sympathetic to pay committees. “It’s not up to [an individual] pay committee to solve the executive pay problem. It’s one of thousands of companies.” Furthermore, if one company ignores peer benchmarking and bases compensation on long-term creation of value within the company, “that’s a disincentive because you could lose your CEO if you try to reform executive pay.” He says it’s up to the regulators to level the playing field by setting some guidelines for executive compensation. Leblanc is currently preparing his new textbook, Handbook of Corporate Governance, for release in 2016. It’s a scramble to keep up with the numerous changes in the second wave of corporate governance, particularly when writing about it, he says, but corporate reforms are necessary, and, ultimately, good governance leads to improved, sustainable economic growth.