Executive Pay – the Days of the Golden Packages Are Numbered?

The disquiet over excessive executive remuneration packages and a lack of appropriate links with relevant performance measures has been a matter of concern in recent years.  After the financial crisis, there is even more of a focus on this aspect with shareholders becoming increasingly frustrated with both the amount and the design of executive remuneration packages.

 

Recent trends

The latest Manifest and MM&K Total Remuneration Survey 2011 finds little link between remuneration, performance and shareholder value, reporting that the median FTSE100 CEO remuneration increased by 32% to £3.5million in 2010 compared to 2009, whilst the FTSE100 index only rose 9% over the same period.  Moreover over a 12 year time horizon, CEO remuneration has quadrupled whilst share prices have been flat.

In the US, the BDO 600: 2011 Survey of Board Compensation Practices of 600 Mid-Market Public Companies reported that ‘director pay in the middle market is up seven percent, reflecting the increased responsibilities, time commitment, and regulatory issues – such as the Dodd-Frank Act – that boards face today’. The report states that these factors, coupled with a rebounding stock market, have allowed companies to increase director pay to $110,155, up from $102,809 in 2009, and that much of this increase can be attributed to a greater use of full-value equity vehicles, which are up 22% from last year, indicating that the recovering stock market is adding to compensation growth overall.

 

Issues of concern

Concern has been expressed at a number of companies where shareholders have thought that executive directors would receive remuneration in excess of what they deserved in relation to their performance or in relation to the company’s performance.  For example, Andrew Parker in his articles (FT, Page 17, 29^th June 2011 ‘Strategy and pay fuel anger at C&WW’ and FT, Page 15, 5^th July 2011 ‘Amber-top alert over C&W pay’) highlighted that the Association of British Insurers (ABI) issued an ‘amber top’ to alert shareholders about a number of issues at C&W including aspects of the planned new pay scheme at C&W Worldwide.  The ABI was concerned that ‘given C&W Worldwide’s depressed stock price, the chief executive and finance director could be awarded too many performance shares’.

Robert Wright in his article (FT, Page 4, 24^th June 2011) ‘Ex-rail chief defends £1m payoff’ stated that that Mr Coucher, the former CEO of Network Rail, had defended the £1.07m payout that he received on leaving the company saying that it represented a payment in lieu of his notice period and the bonuses he would have received if he had been allowed to work his notice period after resigning. 

In some companies chief executives have forfeited their bonus if the company has not performed to expected standards.  In his article (FT, Page 16, 28^th June 2011) ‘TalkTalk struggles see chief’s bonus cut’, Andrew Parker pointed out that Dido Harding, chief executive of TalkTalk, had secured only 20% of her maximum potential bonus in 2010/11 as there were ‘acute customer service problems’.  Justin King, the CEO of J. Sainsbury, saw his salary and bonus fall significantly because the company did not achieve key profit targets, reported Andrea Felsted (FT, Page 19, 8^th June 2011) ‘Sainsbury chief’s pay drops sharply after missed targets’.

Elsewhere Vodafone has decided to place more emphasis on profit improvement in its executive pay plan.  Andrew Parker in his article (FT, page 20, 2^nd June 2011) ‘Vodafone refocuses executive pay plan’, reported that greater account would be taken in future of profit-based targets by reducing the relative importance of revenue-based targets.

 

Banking and insurance sector

In the banking and insurance sector, some banks have slashed cash bonuses, for example, Michiyo Nakamoto reported in his article (FT, Page 15, 4-5 June 2011) ‘Nomura slashes cash bonuses’  that Japan’s largest investment bank, Nomura, had slashed the cash bonuses paid to its top executives and directors by 95% after suffering a decline in profits and its share price.  As a result only 6 out of 23 directors/executives received a cash bonus in the year to March 2011.  Patrick Jenkins reported in his article (FT, page 19, 1^st July 2011) ‘Europe’s banks and insurers lead in withholding bonuses’, that nearly three-quarters of banks and insurers in Europe have introduced a system to withhold bonuses from staff if their performance does not match up to expectations.  One of the contributors to the financial crisis was thought to be overly generous short-term bonuses, and many banks have decided to put in place a system of deferred payments. There are also malus or clawback arrangements which may be used, for example, for a breach of code of conduct.

 

Increased use of ‘say on pay’

The use of ‘say on pay’, whereby shareholders have an advisory vote on executive pay proposals (remuneration committee report), has been utilised much more in recent months.  Tim Bradshaw and Kate Burgess (FT, page 20, 3^rd June 2011) in their article ‘WPP suffers shareholder revolt over pay’ highlighted that WPP had a large shareholder revolt when over 40% of shareholders voted against the WPP pay policies. They report that one large fund manager stated ‘Investors are increasingly concerned by salary creep.  It is a topical issue at the moment.  Some companies seem to think after a couple of years of restraint that they can claw back the pay rises they would have got’.  Roger Blitz (FT, Page 19, 14^th June 2011) ‘William Hill expects fallout over chief’s pay deal’ points out that some 38% of votes cast either opposed or did not endorse the group’s remuneration report, with Ralph Topping, the Chief Executive, receiving a salary increase of 11% and shares worth £1.2m by way of a ‘golden handcuffs’ retention payment. 

In the US, the say on pay has also been used frequently in recent weeks, as Dan McCrum finds in his article (FT, Page 17, 6^th July 2011) ‘Shareholders quick to put ‘say on pay’ powers to work’. He reports that Hewlett-Packard and Jacobs Engineering saw their pay packages rejected outright whilst Monsanto and Northern Trust faced stiff shareholder protest votes, during this, the first year that large public companies have been required to have an advisory vote on executive compensation as part of the Dodd Frank legislation.

It may be that, with the advent of a more widespread use of say on pay in a number of markets, the days of golden executive remuneration packages are numbered.

 

Chris Mallin 13^th July 2011

UK Corporate Governance Code

The Financial Reporting Council (FRC) has issued an updated corporate governance code for UK companies. Formerly known as the Combined Code, the newly issued UK Corporate Governance Code is a response to the financial crisis which caused shock waves around the world.

The FRC traces the roots of the UK Corporate Governance Code to the Cadbury Committee Report (1992) http://www.ecgi.org/codes/documents/cadbury.pdf and its successor reports. They recognise that ‘The Code has been enduring, but it is not immutable. Its fitness for purpose in a permanently changing economic and social business environment requires its evaluation at appropriate intervals’.

The UK Corporate Governance Code (hereafter ‘the Code’) continues to have at its heart the ‘comply or explain’ approach which was introduced in the Cadbury Committee Report. Sir Adrian Cadbury in his seminal book ‘Corporate Governance and Chairmanship, A Personal View’(2002) stated ‘The most obvious consequences of the publication of the 1992 Code of Best Practice was that it put corporate governance on the board agenda. Boards were asked to state in their reports and accounts how far they complied with the Code and to identify and give reasons for areas of non-compliance’. The flexible approach provided by the ‘comply or explain’ approach is a great strength and has been adopted in many countries.

Code structure

The Code has five sections being Section A: Leadership; Section B: Effectiveness; Section C: Accountability; Section D: Remuneration, and Section E: Relations with Shareholders. There is also currently a Schedule in the Code (Schedule C) ‘Engagement Principles for Institutional Shareholders’. This schedule contains three principles: dialogue with companies; evaluation of governance disclosures; and shareholder voting. However it will cease to apply when the Stewardship Code for institutional investors which is being developed by the FRC comes into effect.

Main changes to the Code

The FRC identifies six main changes http://www.frc.org.uk/press/pub2282.html as follows:

(i)     ‘To improve risk management, the company‘s business model should be explained and the board should be responsible for determining the nature and extent of the significant risks it is willing to take.

(ii)    Performance-related pay should be aligned to the long-term interests of the company and its risk policy and systems.

(iii)   To increase accountability, all directors of FTSE 350 companies should be put forward for re-election every year.

(iv)   To promote proper debate in the boardroom, there are new principles on the leadership of the chairman, the responsibility of the non-executive directors to provide constructive challenge, and the time commitment expected of all directors.

(v)    To encourage boards to be well balanced and avoid “group think” there are new principles on the composition and selection of the board, including the need to appoint members on merit, against objective criteria, and with due regard for the benefits of diversity, including gender diversity.

(vi)   To help enhance the board’s performance and awareness of its strengths and weaknesses, the chairman should hold regular development reviews with each director and FTSE 350 companies should have externally facilitated board effectiveness reviews at least every three years.’

Contentious changes?

The changes that seem most likely to be contentious and attract most debate relate to the annual re-election of directors and the move to encourage boards to consider diversity, including gender, in board appointments.

 

Annual re-election of directors

According to Rachel Sanderson and Kate Burgess, in their article ‘Directors must be re-elected annually’ (FT, page 17, 28^th May 2010), the annual re-election of directors in FTSE 350 companies is the most controversial aspect of the Code. They state ‘Critics, including the Institute of Directors, have said it will encourage short-termism and be disruptive. Those in favour have said it will make boards more accountable to shareholders’.

The widespread concern about the underperformance of some UK board directors prior to, and during, the recent financial crisis no doubt led to increased support for the idea of the annual re-election of directors.

Diversity

Another potentially contentious change is the fact that boards are now encouraged to consider the benefits of diversity, including gender, to try to ensure a well-balanced board and avoid ‘group think’. Similar provisions may be seen in the German Corporate Governance Code (2009) ‘The Supervisory Board appoints and dismisses the members of the Management Board. When appointing the Management Board, the Supervisory Board shall also respect diversity’ (5.1.2) and the Dutch Code of Corporate Governance (2008) ‘The supervisory board shall aim for a diverse composition in terms of such factors as gender and age (111.3).

The UK has not gone as far as Norway which has, since 2008, enforced a quota of 40% female directors on boards of all publicly listed companies. Similarly Spain introduced an equality law in 2007 requiring companies with 250+ employees to develop gender equality plans which clearly has implications for female appointments to the board.

Whilst it is fair to say that the number of females with experience at board level in large UK companies is relatively limited, non-executive directors can be drawn from a much wider pool including the public sector and voluntary organisations. Their experience can bring new insights to the board, maybe challenging long-accepted views and hence adding value.

Institutional shareholders

As mentioned above, the Code currently contains Schedule C ‘Engagement Principles for Institutional Shareholders’ but this will be withdrawn when the Stewardship Code becomes operational. The Stewardship Code is being developed separately by the FRC and will set out standards of good governance for institutional investors, the FRC hopes to publish it by the end of June 2010.

Andrew Hill in the FT Lombard column (FT, page 18, 28^th May 2010) ‘New code sets the high-water mark for governance’ discussed the new Code. He points out that ‘Now it is up to shareholders, encouraged by their own forthcoming stewardship code, to rise to the challenge……the FRC has set a new high watermark for post-crisis governance standards. The test will be whether investors use it responsibly and maintain sensible pressure on boards, as recession turns to recovery and chief executives’ and directors’ risk aversion dissipates’.

Concluding comments

The FRC has produced a robust UK Corporate Governance Code, building on the earlier Codes and retaining the flexibility of the ‘comply or explain’ approach. Future success will be measured by companies following the substance, or spirit of the Code, and not just its form and by institutional shareholders and boards engaging more fully.

The new edition of the Code will apply to financial years beginning on or after 29 June 2010. The Code, and a report explaining the main changes, can be found at: http://www.frc.org.uk/corporate/ukcgcode.cfm

Chris Mallin 28^th May 2010

Rethinking the Exercise of Power over Corporate Entities

Society, acting through their legislative processes, provides for the incorporation of corporate entities in their midst, and permits companies to limit the liability of their shareholders for the debts of those companies.   But over time, the accountability of those companies to society, and the way that power is exercised over them has slipped for society to shareholders, and from shareholders to incumbent management.

We need to re-think the way that power is exercised over companies for the good of all affected by their activities. But before such ideas can evolve, some fundamental dilemmas have to be resolved.  We lack a coherent unifying theory of corporate governance.  The most widely used research tool, agency theory, is proving to be a straight jacket: useful in context but inevitably constraining. We need some new theoretical insights that will take us beyond agency theory or the perspectives of jurisprudence.

The corporate governance principles published by the Organisation for Economic Co-operation and Development (OECD) were designed to assist countries develop their own corporate governance codes.  They reflected what was considered best practice in the UK and USA.  This so-called Anglo-Saxon model of corporate governance required listed companies to have unitary boards, independent outside directors, and board committees.  The principles focused on enhancing shareholder value, and in the process richly rewarded top executives. In this model shareholders are widely dispersed, in markets that are liquid, with the discipline of hostile bids.

This so-called ‘Anglo-American approach’ to corporate governance, became the basis for governance codes around the world.  Indeed, in the United States it was widely assumed that the rest of the world would eventually converge with American corporate governance norms and reporting requirements, simply because it was thought the rest of the world needed access to American capital.

But a schism has emerged in the ‘Anglo-American approach’.  In the United States, Sarbanes Oxley mandated conformance with corporate governance by law.  Whilst in the United Kingdom and those other jurisdictions whose company law has been influenced over the years by UK common law, including Australia, Hong Kong, India, Singapore and South Africa, compliance is based on a voluntary ‘comply or explain’ philosophy.  Companies report compliance with the corporate governance code or explain why they have not.  This ‘rules versus principles’ dilemma seems to have been amplified by the ongoing global financial crisis.  It needs resolving.

But the Anglo-Saxon system is not the only governance model and some are questioning whether it is necessarily the best. Corporate governance is concerned with the way power is exercised over corporate entities.  In other parts of the world, alternative insider-relationship systems exercise power through corporate groups in chains, pyramids or power networks, by dominant families, or by states.  These markets are less likely to be liquid, the market for control poor, and the interests of employees, and other stakeholders more important.

In Japan, keiretsu organizational networks spread power around a group of inter-connected companies in ways that might provide insights for complex western groups.  The view that business involves relationships with all those involved – employees, customers, suppliers, and society, as well as shareholders, has only recently been recognized in the West under the umbrella of ‘corporate social responsibility’.

The governance of Chinese family businesses throughout East Asia can provide some valuable insights: for example, the emphasis on top-level leadership, the view that the independence of outside directors is less important than their character and business ability, and the way that the Chinese family business sees business more as a succession of trades rather than the building of empires.

In China, the link between state, at the national, provincial and local levels, and companies relies on a network of relationships, and policies can be pursued in the interests of the people, seen as the Party.

Of course there are problems with Asian approaches: corruption, insider trading, unfair treatment of minority shareholders, and domination by company leaders, to name a few.  But these are not uniquely eastern attributes as case-studies of US and UK company failures show.

These diverse models reflect more concentrated ownership, different cultures, and varied company law jurisdictions. But they also show different perceptions about the way power should be exercised over corporate entities. The eastern experience suggests that board leadership and board-level culture, in other words people and the way they behave, are more important than board structures and strictures, rules and regulations.  New theoretical perspectives will need to embrace such diversity.

Bob Tricker

Risk Management

One of the main areas in corporate governance that has caught the headlines recently is risk management.  There is a widely held perception that in recent years many boards have not managed the risks associated with their businesses well – whether that was because they did not identify the risks fully or whether because having identified the risks, they did not take appropriate action to manage them.

 Review of UK’s Combined Code

The Financial Reporting Council (FRC)’s Review of the UK’s Combined Code published in December 2009 http://www.frc.org.uk/corporate/reviewCombined.cfm states that ‘One of the strongest themes to emerge from the review was the need for boards to take responsibility for assessing the major risks facing the company, agreeing the company’s risk profile and tolerance of risk, and overseeing the risk management systems. There was a view that not all boards had carried out this role adequately and in discussion with the

chairmen of listed companies many agreed that the financial crisis had led their boards to devote more time to consideration of the major risks facing the company.’  The FRC therefore proposes to make the board’s responsibility for risk more explicit in the Code through a new principle and provision.  Moreover it also intends to carry out a limited review of the Turnbull Guidance on internal control during 2010.  

Many companies, and especially those in the financial sector, have already established risk committees whilst other companies especially smaller companies, may combine the consideration of risk with the role and responsibilities of the audit committee.

Alternative investment market

The UK’s Alternative Investment Market (AIM) expanded rapidly during the 12 years following its inception in 1995.  Then from 2007 onwards it went into decline.  David Blackwell, in his article ‘Signs of recovery seen after years of famine’ (FT, page 23, 16^th December 2009) states that ‘Hundreds of companies have left the market, the number of flotations has collapsed and fines for Regal Petroleum and others – albeit for regulatory infringements dating back years – have once again sullied the market’s reputation’.  Nonetheless he points out that 2009 saw an improvement with the AIM index rising by 62 per cent over the year compared to a rise of 22 per cent in the FTSE 100. 

The lighter regulatory touch on AIM has both attractions and drawbacks.  On the one hand, companies find it easier to gain a London listing (albeit on AIM rather than the main market); on the other hand, this may bring concomitant risks for investors as they will be investing in companies which may well be riskier than their main market counterparts.

Family firms

Family firms are the dominant form of business in many countries around the world and range from very small businesses to multinational corporations.  Richard Milne in his article ‘Blood ties serve business well during the crisis’ (FT, Page 19, 28^th December 2009) points out that the attributes of a typical family business will have stood it in good stead during the recent financial crisis: ‘Long-term thinking, conservative, risk-averse: the very characteristics of the typical family business seem to be the ones needed in the economic crisis of the past two years’.  Given that they tend to be more conservative, family firms will take less risks, for example, by not over extending themselves with their gearing (leverage).

Banks and financial institutions

Many banks and financial institutions were widely criticised because of the perceived overly generous bonuses paid to some executive directors and senior management at a time when the world is suffering the consequences of a global financial crisis precipitated by bankers who did not seem to fully appreciate the risks involved with some of the products they were trading in.  And yet already we see banks again paying out enormous bonuses.  Megan Murphy in her article ‘Tycoon attacks return of bankers’ bonuses’ (FT, Page 3, 28^th December 2009) quotes Guy Hands, the private equity tycoon, who is highly critical of these big bonuses and speaks of bankers ‘taking home “wheelbarrows of money” on the back of taxpayers’ support’.  Moreover he is quoted as saying ‘It cannot be right to continue with a system that allows risk to be taken in the knowledge that, if things go right, bankers will take on average 60-80 per cent of the profits generated through compensation and, if they go wrong, shareholders and ultimately the government will pick up the costs’.

Asset managers

Managing risk is, of course, relevant to all parties in the business and financial world as the article by Sophia Grene ‘Managing risk is the main task ahead’ (FTfm, Pg 1, 4^thJanuary 2010) illustrates.  In her article, Sophia points out that ‘many financial models failed in the past two years as markets demonstrated they did not behave according to conventional assumptions’ and that ‘the main challenge for asset managers in the coming decade is understanding, managing and communicating risk’.

Concluding comments

Managing risk and managing it well is an important consideration for boards of directors, whether in main market firms, second tier markets, or family firms.  Firms, and especially those in the banking and financial sector, need to pay particular attention to executive director remuneration packages which should not encourage adverse decision-making in terms of the impact on risk, that is, remuneration packages should be designed so that they do not lead to unacceptable risk-taking which may be to the detriment of the long-term sustainability of the company and potentially, as we have already seen, the wider economy.

Please refer to the newly published third edition of my book ‘Corporate Governance’ for updates to various national and international corporate governance codes and guidelines; board committees including risk and ethics committees; the Alternative Investment Market (AIM); family firms; remuneration packages, and the global financial crisis.  

In addition, new material on many other areas including: private equity and sovereign wealth funds; governance in NGOs, public sector/non-profit organisations, and charities; and board diversity.  Many examples, mini case studies and clippings from the Financial Times are included to illustrate the application of corporate governance in the real world.

 Chris Mallin 7^th January 2010

Institutional Investors and Corporate Governance Reform

Corporate governance codes and guidelines have long recognised the important role that institutional investors have to play in corporate governance.  As well as being influential in their home countries, institutional investors have increasingly become a more significant force in other countries through their cross-border holdings. Recent corporate governance reforms motivated by the global financial crisis have placed even more emphasis on the role of institutional investors.

Role of Institutional Investors

Back in 1992, the Cadbury Report recognised the role played by institutional investors  stating that ‘we look to the institutions in particular ‘ to use their influence as owners to ensure that the companies in which they have invested comply with the Code’.  Various codes since then have emphasised the importance of the role.  The Financial Reporting Council (FRC) publishes the UK’s Combined Code on Corporate Governance (commonly known as the Combined Code).  The Combined Code (2008), in Section E, identifies three main principles.  Firstly it states that ‘institutional shareholders should enter into a dialogue with companies based on the mutual understanding of objectives’; secondly ‘when evaluating companies’ governance arrangements, particularly those relating to board structure and composition, institutional shareholders should give due weight to all relevant factors drawn to their attention’; thirdly, ‘institutional shareholders have a responsibility to make considered use of their votes http://www.frc.org.uk/corporate/combinedcode.cfm The first and third principles relate to two of the tools of governance being dialogue and voting.  All three principles essentially require institutional investors to behave in a responsible and conscientious way, taking all relevant factors into account and making considered decisions.

Corporate Governance Reform

The UK Treasury commissioned the Walker Review of Corporate Governance of UK Banking Industry which reported in November 2009. The Walker Review recommends ‘strengthening the role of non-executives and giving them new responsibilities to monitor risk and remuneration; it also recommends a stewardship duty on institutional shareholders to play a more active role as owners of businesses.’ http://www.hm-treasury.gov.uk/walker_review_information.htm  Kate Burgess and Brooke Masters in their article ‘Institutions urged to adopt tougher stance’  (FT, Pg 21, 26^th November 2009) states ‘Institutional investors are being urged to be tougher on company boards by Sir David Walker, as the City grandee adds his weight to pressure for them to take their responsibilities more seriously.’

The FRC’s statement welcoming the Walker Report can be found at: http://www.frc.org.uk/press/pub2174.html. The FRC has agreed to implement those recommendations that it considers should apply to all listed companies. In addition the FRC has agreed to consult on adoption of a Stewardship Code for institutional investors as recommended by Sir David.   

A recent review of the Combined Code http://www.frc.org.uk/corporate/reviewCombined.cfm has however recommended that Section E of the Code (addressed to institutional shareholders) be removed, ‘subject to sufficient progress being made on the Stewardship Code for institutional investors and its associated governance arrangements.’  The Stewardship Code for institutional investors as was proposed by Sir David Walker, and is an area on which the Financial Reporting Council (FRC) will be consulting separately http://www.frc.org.uk/corporate/walker.cfm

The final report on the review of the Combined Code (2008) makes various recommendations which include, inter alia, annual re-election of the chairman or the whole board; new principles for the roles of the chairman and non-executive directors.  Kate Burgess in her article ‘Sir Christopher misses out on succession planning’ (Pg 21, FT, 2^nd December 2009) highlights that more emphasis should have been put on succession planning in companies as this tends to be a weakness in many firms.  Moreover it would be beneficial to investors in their stewardship role to have more knowledge of the process in place for succession planning.

Stewardship Code

The Institutional Shareholders’ Committee (ISC) membership comprises the Association of British Insurers, the Association of Investment Trust Companies, the National Association of Pension Funds, and the Investment Management Association.  The ISC has previously published guidance on the responsibilities of institutional investors in 2002, 2005 and 2007.  In November 2009, the ISC published its Code on the Responsibilities of Institutional Investors which is included as an Annex in the Walker Review and which is widely viewed as the basis for the Stewardship Code which will be monitored for the adherence of institutional investors on a ‘comply or explain’ basis.  The ISC states that ‘the Code aims to enhance the quality of the dialogue of institutional investors with companies to help improve long-term returns to shareholders, reduce the risk of catastrophic outcomes due to bad strategic decisions, and help with the efficient exercise of governance responsibilities.’ http://www.institutionalshareholderscommittee.org.uk/ The Code discusses the stewardship responsibilities of institutional investors which include effective monitoring of investee companies and voting of all shares held. 

Effective Stewardship

Of course in order to carry out their responsibilities as shareholders, institutional investors need to be able to exercise their rights effectively – if they cannot, then they may be tempted to exit, i.e. to sell their shares.  An article in the Financial Times, ‘Shareholder rights’ (FT, page 12, 30^th November 2009) points out that ‘if selling the shares is a blunt instrument, then removing board members is the sharpest.  More than nine in 10 international investors say the ability to nominate, appoint and remove directors is the most valuable shareholder right.  It is wrong that efforts to boost this power in the US have been delayed by the business lobby.’  Clearly it is in the interests of effective stewardship for institutional investors to be able to exercise their rights.  This will enable them to take action on prominent topical issues such as having a ‘say on pay’ in relation to directors’ remuneration, and removing underperforming directors from the board. 

However another dimension to consider is that of free riders.  Ruth Sullivan in her article ‘Walker plan points finger at freeriders’ (FTfm Pg 3, 30^th November 2009) points out that some institutional investors will not engage more with their investee companies and be active owners, rather they will save their time and money and free ride on the efforts of other institutional investors. 

Concluding comments

The recent reforms mooted by the Walker Review and the Review of the Combined Code have made recommendations which will help to strengthen corporate governance in the UK.  The role of institutional investors is seen an important one and institutional investors are being encouraged to engage more fully in their role as owners and adhere to the ISC Code of Responsibility for Investors. 

Chris Mallin 2^nd December 2009

On Shareholder Democracy: what democracy?

The mid-nineteenth century vision of the joint stock, limited-liability company was exquisitely simple and superbly successful.  Ownership was the basis of power.  Shareholders appointed the directors, who reported regularly on their stewardship over the company. Shareholder democracy was based on one share – one vote. 

 Then something went wrong.  Directors took control.  As long ago as 1932, in research that is still among the most cited in the corporate governance lexicon, Berle and Means showed that power over public corporations in the United States had become concentrated in corporate boardrooms.  What happened to the original notion that power over a corporation should be exercised by the owners?  A similar erosion of shareholder power occurred in the United Kingdom, and indeed in most other countries whose company law reflected the old Commonwealth company law traditions.

 The UK Cadbury Report (1992) and corporate governance codes in other countries attempted to redress the balance by requiring board-level nomination committees, with independent non-executive director members, to put forward the names of potential directors.  But these non-executives, themselves, had been approved by the chairman and CEO, and owed some allegiance to them. The board then put their proposals to the members, who got to vote.  But incumbent directors effectively could re-appoint themselves and, when the time came, appoint their successors.  

 The shareholders of a UK public company can now call for a special meeting of the members, at which a simple majority can vote to remove any (or indeed all) of the directors.  Section 338 of the UK Companies Act 2006, broadly, enables members of a public company to require the company to give all shareholders notice of their resolution, provided they hold 5% of the total voting rights or total at least 100 members.  But the financial risk and uncertainty of such actions make them newsworthy.

 In the United States the situation is worse.  One share one vote still prevails, but the board decides which names get on the ballot paper.  The only way for outsider candidates to get nominated is through proxies circulated to all the other shareholders at the proposer’s expense.  This financial exposure results in most board appointments being uncontested, with incumbent directors keeping their seats around the board room table, with the attendant benefits, even though in practice only a small proportion of shareholders actually voted for them

 Attempts to persuade the Securities and Exchange Commission and state regulators to change the rules have been frustrated by aggressive lobbying from corporate director interest groups.  The latest attempt by the SEC to reform the system was put on hold earlier this year. 

Companies in the United States, of course, are incorporated by individual states. There are no provisions for incorporation at the federal level.  Many companies are incorporated in Delaware, because company law and the Delaware companies’ court tend to be sympathetic to their interests.  But Delaware company law was changed earlier this year to allow companies to reimburse the costs of circulating the names of outsider directors to other shareholders.

 A straw in the wind was reported in the Economist (31 October 2009).  The American company, HealthSouth, a company that runs private hospitals and clinics, which in the past has been criticized for poor corporate governance, changed its corporate governance rules to allow activist shareholders to propose candidates for election to its board.  The company even offered to cover the costs involved, if 40% of the votes were subsequently cast for the outside candidates. 

 In his clumsily titled, but brilliantly perceptive book Corpocracy (Wiley, New Jersey, 2008), Robert (Bob) Monks showed how modern corporations have maximized their wealth, balked at government regulation, and locked-out their shareholders, whilst the executives rewarded themselves with massive pay packages.  Shareholder control over large corporations, he argued, is weaker now than ever.  Not only are these corporations rarely held to account by regulators, they face even less control by those whose interests they are ostensibly there to serve. 

 Bob Monks feels that shareholders, particularly institutional shareholders, should attempt to influence corporate behaviour and governance for the benefit of all shareholders and society. He has called for the United States to adopt the British approach, with a federal statute that would give investors the right to call a special meeting to remove directors. 

 The Economist commented “in a healthy shareholder democracy, such a rule would not be controversial.”

 Bob Tricker

 

 

Say on Pay

Widespread concern at the high levels of executive director remuneration has led to calls for wider adoption of a ‘say on pay’ in the US.  Investors in the UK and Australia have, for many years, had the right to vote on the remuneration committee report of the companies in which they invest.  The vote on the remuneration committee report is an advisory one meaning that it is not binding on the company.    However in practice institutional investors have tended not to vote against the remuneration committee reports and on the -until recently – relatively rare occasions on which the remuneration committee report was voted against, it was seen as a strong signal of disapproval about some aspect of executive remuneration and one which the directors would be unwise to ignore.

Royal Bank of Scotland

It was no surprise to anyone that the Royal Bank of Scotland shareholders overwhelmingly rejected the banks remuneration committee report at the companies Annual General Meeting on 3^rd April.  Jane Croft and Andrew Bolger (FT, Page 12, 4/5^th April 09) in their article ‘Thumbs down for RBS pay report’ stated that some 90.42% of votes cast rejected the report.  UK Financial Investments Ltd (UKFI) the Government owned company which manages the taxpayers’ shareholding in RBS, and controls 58% of the RBS shares, voted against the report.   Manifest, the proxy voting agency, stated that ‘the resolution on the remuneration report at Royal Bank of Scotland Group plc represents the highest ever “Total Dissent” vote on the remuneration report since the introduction of the requirement for the report to be put forward to a non-binding vote’.

Remuneration (compensation) committees

Remuneration committees have previously been criticised for having a ratcheting effect on executive directors’ remuneration.  The composition of such committees is usually independent non-executive (outside) directors but nonetheless this has not stopped the increasing levels of executive remuneration.  This is probably in part attributable to the fact that remuneration committees would tend to recommend remuneration for executive directors in the upper quartile of their peer group hence the ratcheting effect over time.  The Corporate Library  points out that, in the US, chief executives pay rose 24 percent in 2007 giving a median remuneration of $8.8 million. 

Trade Unions Involvement 

An interesting development is for trade unions calling for more worker involvement in setting top executive pay.  Brian Groom (FT, Page 3, 6^th April 09) in his article ‘TUC leader urges staff input over chiefs’ pay’ highlights that Brendan Barber, General Secretary of the Trade Union Congress (TUC), stated ‘there was “massive anger” among workers at paying the price for a recession made in the boardroom, not on the shop floor’.  The directors of FTSE 100 companies came in for criticism as well as the directors of banks, with Mr Barber arguing for ‘workforce representation involved in remuneration committees of major companies’.  The idea of representation of the workforce on the board or board committees has traditionally not been given much consideration by UK boards but maybe that might change in the future.

Shareholder proposals/resolutions

Another are where we may see change is in relation to shareholder proposals or resolutions. Although it is possible in the UK for shareholders to put forward shareholder proposals or resolutions, it is not that easy to do and hence dialogue has been the most frequently used tool of corporate governance with shareholder proposals maybe numbering just five or six a year. 

In the US it is much easier to put forward a shareholder proposal and so we can see 800 or 900 of these each year in US companies.  It is likely that in the future more of these shareholder proposals will be relating to executive remuneration and that they will achieve strong support from institutional investors who are increasingly being criticised for not having taken more action to help limit executive remuneration.   Francesco  Guerrera and Deborah Brewster in their article (FT, Page 21, 6^th April 09) ‘Mutual funds helped to drive up executive pay’ highlight that mutual funds have tended to vote in favour of companies compensation plans and this has effectively sanctioned these spiralling executive remuneration packages.  Kristin Gribben (FTfm, Page 5, 6^th April 09) in ‘Pay proposals to dominate proxy season’ puts forward the view that, in future, mutual funds in the US will be more likely to support remuneration (compensation) related resolutions filed by shareholders. 

Back-door pay

There is concern that some companies may seek to remuneration executive directors via the ‘back-door’ if, for example, bonus schemes do not pay out.  Pauline Skypala (FTfm, Page 2, 6^th April 09) in ‘Warning over “back-door” pay’ highlights that this is a concern to some investors including Co-operative Asset Management whose corporate governance manager, Paul Wade, states ‘If a company fails to create value for its shareholders, it is totally inappropriate to grant rewards to management that are disproportionate to shareholder returns’.

Future developments

With the continuing focus on executive directors’ remuneration packages, the forthcoming AGMs promise to give rise to many interesting debates, much emotive discussion, more shareholder proposals, and many more instances where ‘say on pay’ will result in an emphatic ‘no’ to excessive remuneration or remuneration which does not have appropriately stretching performance links.

Chris Mallin 6^th April 2009.