30th July 2012 Blog
The Kay review of long-termism largely ducked the issue of the excessive pay of directors, which appears to me one of the biggest causes of short-termism in the modern corporate world. I suspect that, as his review was for a Conservative government and his advisors included corporate big-wigs, John felt this issue was too hot to handle, which is probably why his recommendations are fairly weak across the piece compared to the devastating analysis underpinning them. See my last blog on this – particularly John’s recommendation on mergers and takeovers (“the scale and effectiveness of merger activity of and by UK companies should be kept under careful review by BIS and by companies themselves” – !!)
In response to my blog, Karl Sternberg, former UK Chief Investment Officer of Morgan Grenfell Asset Management/Deutsche, has sent me an excellent lecture he gave last year, highlighting the corporate pay issue and the systematic malfunctioning of corporate boards in relation to it. I reproduce Karl’s lecture here in its entirety:
CORPORATE GOVERNANCE – JULY 2011
This lecture is about corporate governance. The term is a relative neologism, in general circulation only since the early 1990s, covering ‘standards of good practice in relation to board leadership and effectiveness, remuneration, accountability and relations with shareholders’ (UK Financial Reporting Council). Corporate governance is like progress: forever improving, and impossible to be against. Good governance is to companies as justice is to social institutions. The widespread adoption of the term has come about as a result of sequential reports, most in response to corporate crises or scandals of one sort or another. It began in the UK with the Cadbury Committee, which was followed by the Hempel and Greenbury Reports, which were aggregated into the Combined Code; it is now the UK Corporate Governance Code, issued by the Financial Reporting Council. In the US it is most recently synonymous with Sarbanes-Oxley legislation.
Each burst of reform in response to some failing has led to new improved corporate governance; each new improved system has been associated with even more spectacular failures. The reforms and renewed focus after the insolvency of Enron and WorldComm did not prevent widespread bank failures less than a decade later. Before even examining corporate governance, we must accept in advance that no system is infallible, and that corporations will always remain risky. Executives, non-executives and shareholders are all susceptible to the mass delusions of a boom; however many risk maps are examined, companies in market economies are assuming risk, and sometimes that means failure, however sensible its executives.
In this lecture I shall examine the following. What exactly is good corporate governance? What is it for? Can it be improved? Who is actually responsible for failure in corporate governance?
My focus is largely on the UK and the US – the Anglo-Saxon systems. They share many features (though they are by no means identical in their expectations of acceptability) which cannot be applied to the governance structures in Continental Europe and Japan.
So what is corporate governance all about? The definition from the FRC is wide and covers a number of discrete expectations; it also leaves out some expectations that wider society might have in deploying the term. I think that here are four different common understandings of corporate governance. Good corporate governance is simultaneously about the restoration and maintenance of trust; the strengthening of faith in corporate decision-taking; the linkage of pay with performance; and the application of social virtue to corporations.
Firstly, a little digression. Why is corporate governance such a big issue today? In fact, it has been a preoccupation for some time, particularly in the UK. Throughout the 1990s, financial market participants were concerned to improve governance after a number of corporate failures in the early part of the decade, like British & Commonwealth and Maxwell. A series of reports – Cadbury, Hempel and Greenbury – were brought together into a Combined Code, which consisted of 17 principles of corporate governance, along with the overarching requirement to ‘comply or explain’. At the same time in the US, there were parallel moves to strengthen the roles and functioning of Boards. But the whole topic remained very much an area for the financial market anoraks.
The proximate cause of the more widespread interest in corporate governance was the spate of scandals in the US: scandals in which thousands of investors lost money, and thousands of employees lost their livelihoods. Enron was the largest corporate failure in US history when it occurred. Then, less than a decade later, the banks collectively became insolvent; Lehman Brothers trumped Enron in its scale and significance. Public funds around the world were required to rescue insolvent banks. Opinion was rightly scandalised that large bonuses had been paid to executives and other employees for activities which had eventually led to the failure of their organisations.
This capped a decade of increasing concern about executive pay. Between 1992 and 2000, the average real pay of CEOs of companies in the S&P500 in America more than quadrupled, rising from $3.5 million to $ 14.7 million per annum; by 2009 it had fallen back to $9.25 million. In the UK, executive pay has tripled. In 1980, the average large-company CEO received approximately 47 times the pay of the average worker; that ratio rose to 525:1 in 2000; today it is 320:1. Whether the interest is concern for shareholder interests, or pure nosiness or jealousy, something has been going on which merits investigation – particularly when it is observed alongside corporate scandals.
So what does good corporate governance mean?
The first meaning of corporate governance is the prevention of malfeasance: to prevent the corporation as a collective from damaging other social institutions or individuals; and to prevent the corporate management from damaging the interests of their owners.
Corporate malfeasance includes everything from anti-competitive behaviour to corporate espionage; from the laws of tort to misrepresentation of the company’s financial health to investors, clients, staff and suppliers; and from fraud or theft to corporate manslaughter.
Corporate governance in this sense is to restoration or maintenance of trust. Trust has a significant, but unobservable, social value; but it also has an important economic value, in that trusted firms should, a priori, face a lower cost of capital raised from financial markets. Lenders should require a lower margin over the base rate; and equity shareholders should require a lower return for providing funds if they do not fear that the management will fleece them. This is clearly observable in the extreme case. Companies operating in corrupt corporate regimes have great difficulty raising any capital from western financial markets. Russian companies list in the UK and try to demonstrate the application of UK corporate governance rules. Sadly, that is the only time that the effect of trust is directly observable. The cost of capital is too variable, too influenced by other issues, and too indirectly derived to offer useful scientific proof of a concept like trust. Nevertheless, it is a concept which is intuitive; and most people would regard it as a reasonable assumption, the idea that well-governed companies should command a greater degree of trust. (Coombes and Watson,2004; Bauer and Guenster, 2003)
We have always relied on a combination of hard and soft controls to prevent malfeasance: legal deterrence, regulatory oversight and punishment, transparency, executive liability, boardroom diligence, reputation, and the advice and opinion of lawyers, security analysts, auditors and credit-rating agencies.
In the early 2000s there was a spate of executive misbehaviour. Enron, Worldcom and Tyco are the names everyone will have heard of. In fact, Enron and Worldcom were, at the time, the two biggest bankruptcies in US corporate history. Each was a case of the management defrauding the shareholders, and staff, by misrepresentation of the company’s worth. But it was not just those three. What was surprising was the sheer breadth of the problem: over 10% of US corporations had to restate their earnings or balance sheets between 1997 and 2002 – most frequently because they recognised revenues in advance of their actually occurring (exactly the same tactic as Enron and Worldcom).
Who was responsible for this catastrophic failure of oversight? The defendants in the dock are: the Board; the shareholders; and the gatekeepers.
The gatekeepers are all the external agencies who act as ‘reputational intermediaries’, enabling investors to rely on a corporation’s disclosures when they otherwise might not. In the words of John Coffee, Professor of Law at Columbia, ‘they are repeat players who provide certification or verification services……vouching for someone else who has a greater incentive than they do to deceive…..’, and they do this by ‘lending [their] reputational capital to the corporation.’
None of these gatekeepers barked in the run-up to Enron, or in many of the other less spectacular cases of financial mis-statement. The auditors, the lawyers, the investment banks, the Wall Street analysts, and the credit-rating agencies were all quiescent – if not, acquiescent – and reactive. Either the gatekeepers failed to notice or inquire; or they positively co-operated with a mass deception.
Why did this string of deceits occur? We can assume that the propensity to dishonesty is a permanent human frailty: the question is why so many sinned together and at the same time. John Coffee puts it down to a dangerous combination of issues, which together radically altered the calculus of incentives facing company management, and their gatekeepers.
Firstly, pre-existing conflicts of interest were exacerbated during the 1990s. The conflict of interest is that, typically, the party paying the gatekeeper will be the very party that the gatekeeper is expected to monitor. The accountants, lawyers and investment bankers are paid by the corporation that hires them. He who pays the piper calls the tune. The problem was exacerbated in the audit world by the growing importance of revenues from their consulting arms. At Arthur Anderson – the now-defunct Arthur Anderson – the audit partners were paid for selling consulting services to the firms which they were supposed to be auditing. In the investment banks, stock analysts were increasingly cross-subsidised by the corporate finance departments who earned juicy fees from advising firms on their financing options and corporate deals. In fact, in many cases the analysts were seconded to help in such deals. The shareholders, meanwhile, were busy trying to reduce their brokerage costs which had in the past supported wide and deep coverage of listed companies, and which now necessitated the cross-subsidies from corporate finance.
Secondly, in the United States there was a reduced threat of enforcement and litigation following two specific Acts of Congress (The Private Securities Litigation Reform Act of 1995 and the Securities Litigation Uniform Standards Act of 1998) and relevant Supreme Court decisions in the 1990s. There was a rapid succession of developments, the aggregate impact of which was to reduce the litigation exposure and the threat of enforcement from both public and private sources. In the second half of the 1990s, class-action plaintiffs virtually ceased suing secondary defendants such as lawyers and auditors.
Thirdly, the increased use of stock options raised the incentives facing management to cheat. I will have much more to say about the thorny issue of pay later on. All I need point out now is that in 1990, equity accounted for only 8% of the total compensation of executives in the S&P index; by 2001, two thirds of total compensation was equity-based. The main mechanism was the stock option, which creates asymmetric rewards, and incentivises management to focus on the short-term share price. They did anything to deliver earnings that raised the share price, even if that meant recognising earnings years in advance. The prospective rewards from cheating became bigger and bigger; and, for many, simply irresistible.
Finally, the ultimate protection of gatekeepers’ concern for their own reputations seems to have declined. In a market bubble, investors themselves seem to care less: more or less by definition in a bubble, they suspend their critical faculties, natural scepticism and curiosity in a wave of euphoria. That was certainly the case in the late 1990s. Within the audit firms, individual autonomony became too great; and individuals are much less concerned about the overall firm’s reputation than their own pay and preferment. Following the global mega-mergers of audit firms, they may have decided that competing on reputation may have had insufficient return attached to it: there was no longer a perceived hierarchy of quality amongst the auditors as there had been in previous decades. Perhaps it was a rational calculation that, given their size, each of them in turn would be affected by corporate scandals, and that these would therefore have little differential impact.
I think that this is a good autopsy of what happened. It is certainly the causality which was accepted by legislators and regulators who took steps to deal with the most egregious abuses. Auditors are now appointed by the Audit Committee of the Board, analysts are separated from the rest of the investment banks, and senior corporate managers are now required to certify personally the accuracy of their company’s financial statements; though Sarbanes-Oxley did not change the litigation risk facing the agent gatekeepers.
Clearly the gatekeepers failed, individually and collectively. But what about the other defendants in the dock: the Board and the shareholders?
Both were culpable. But there is an issue here of proximate versus ultimate responsibility. The immediate responsibility in the late 1990s was the gatekeeper. Once the Board and Shareholders have corrupt but certified data, there is very little they can do. Unless the Board is very skilled at financial forensics, fraud is difficult to detect in any one year. In the absence of any other whistleblowers, it is almost inevitable that the Board will add its agency commendation to the numbers, and forward them to the shareholders.
In my view, the Board bears a much greater share of the ultimate responsibility. John Coffee is too lenient in his assessment of Boards. Over recent decades, he says, the Board of Directors has been extensively reformed and is now a more independent, harder-working and more proactive body than at any time before. The same could be said in the UK. But to say that they have improved is not necessarily to imply ‘enough’. The quality of many boards remains deeply underwhelming. This assertion is a difficult one to prove by the application of scientific technique; though it was one conclusion of the Walker Review into the governance of financial services firms in the wake of the 2008 crisis. Look at the small pool from which non-execs are drawn. Look at how many of them fail in one job only to reappear as a non-exec at some other corporation. Look at the evidence that Boards have actually stood in the way of disciplining poor management. (Franks et al., 2001)
Boards were aware of the conflicts of interest, and did nothing about them. They embraced the use of executive share options, without realising the distortions in behaviour that they would introduce. They were unaware of how companies were delivering extraordinary profit growth year in and year out and failed to ask the basic – not expert, basic – questions about how businesses actually worked.
The same goes for shareholders. They too bear significant ultimate responsibility. They failed to pay for independent research, focusing instead on reducing brokerage costs. They suspended critical faculty and bought shares without proper thought or analysis. They did not do enough about aligning pay with performance. They ignored the poor quality of Boards.
The first objective or definition of corporate governance was about restoring trust in companies. It is essentially a negative meaning: reducing the likelihood of corporate misbehaviour. The second definition is a positive one. In this meaning, corporate governance is about giving us faith in management. Trust is necessary but not sufficient to achieve that outcome.
Faith means that shareholders believe that management take sensible decisions and exercise value-adding judgement: that decisions they take, are in the interests of shareholders, not about management egos, or grandstanding for public acclamation. Shareholders need to believe that their management will not be whimsical, or careless or opaque; and that their decisions will have been properly researched, the implications understood, the planning undertaken, the risk weighed intelligently versus the reward. The whole purpose of running companies – the raison d’être of executive management – is to deliver a return to shareholders on their capital. Management’s function is to be stewards of that capital. Better corporate governance implies better returns. Shareholders will, in short, have faith that management and Board will do a somewhat better job in delivering returns.
It may seem counterintuitive to suggest that management should or could do a better job: after all, corporate profits are at historically high levels, both in absolute terms and as a percentage of GDP.
Macroeconomic statistics are one thing. Microeconomic evidence is altogether different. Anecdotally, anybody who has worked in a large organisation can see the waste and inefficiencies tolerated. It is often executive management who are the worst perpetrators, with trophy offices, corporate jets, and other conspicuous self-pampering. Operational efficiency remains firmly a textbook concept for many executives rather than a reality. Management sometimes display the most basic operational incompetence.
Another management function is strategic decision-taking: what businesses to be in, where to invest shareholders’ funds, which businesses to exit, which businesses to buy. Can management grow the businesses they run faster than they would otherwise; and can they improve the returns to shareholders?
Shareholders are not well served by executive management in many cases. We know as a matter of empirical evidence that managements often invest – and keep investing – in projects which deliver a return to shareholders beneath the cost of capital: lower than the shareholders could have achieved by putting the money in the bank. We know from academic work that most takeovers do not actually add value for the shareholders of the acquiring company: management overpay for their purchases (Mayer, 1997). A Business Week study in 2002 calculated that nearly two-thirds of buyers destroyed their shareholders’ wealth by overpaying. The most egregious failures in the recent past were the RBOS takeover of ABN-Amro; and then the Lloyds acquisition of HBOS during the financial crises. Both decisions delivered the business into the hands of government.
How can we prevent such bad judgement?
Can the gatekeepers help? Not really. In the case of the lawyers and the auditors, their role is a largely technical one. They are not equipped to opine on the wisdom of operational or strategic decisions.
The investment banks, on the other hand, are full of just such people: clever corporate financiers who think about which clients should do which deals and at what price. But deals are their sine qua non, and that creates an inherent conflict of interest which is difficult to resolve. Since they are remunerated by deal flow, they are incentivised to persuade managers to transact, almost at any price. They would defend themselves by claiming that bad advice on price would have deleterious effects on reputation. Rather like the example of auditors, though, they are protected by the similar behaviour of their peer group. It may also be argued that they help improve shareholder value when they come up with strategies to defend a corporate from hostile takeover. True; but by this stage, it is the hostile bidder who has (by bidding) revealed inadequacies in decision-taking, and proposed their own remedies.
Another important protagonist is the management consultant.. Management consultants are not gatekeepers to the extent that management do not use their certification externally. But they are used widely for internal verification, with their advice often presented to the Board and to the staff more widely. They are often used by management to justify decisions already taken, and are therefore subject to inherent conflicts. The conflicts are exacerbated by the ephemeral involvement of the consultants, who have no ongoing accountability for the implementation of their advice. I think Boards and shareholders should be particularly sceptical about management consultants; if ever there was a mismatch between power and responsibility, this is it.
How about the Board of Directors? Boards did nothing to protect shareholder interests in the high-profile bank failures and takeovers. Can the Board do a better job of protecting shareholders from poor judgement in future? The Walker Review certainly expects Boards to do a better job. The Walker Review places much greater burden of understanding on the non-executives, particularly in financial services firms. Individuals’ suitability for the role of non-exec at financial services firms is to be tested more thoroughly by a committee of City grandees and the FSA. More generally, corporate governance is to be a culture rather than just a box-ticking exercise. Non-execs are to have much greater interaction with shareholders than in the past. They are to be drawn from a wider pool of talent than hitherto.
This is all very sensible. But there are significant dangers in placing too much responsibility on the shoulders of the Board members. There is a fine line between testing the robustness of management proposals, and exchanging experience, and becoming a second-guessing back-seat executive management, turning the Board into a major obstacle to important decisions. An hyperactive Board could raise so many concerns about future plans that management stasis results, or time-consuming political battles. There have already been complaints that the FSA is expecting non-execs to have executive expertise. It is the job of a non-exec to know what he does not know, rather than to replicate an executive’s knowledge base. Simultaneously, the fear regulators have of presiding over another financial services failure is creating huge burdens of information flow on directors. Too much information is as bad as no information. It is preventing some Boards from ever getting around to the more strategic discussions which firms should be having, and not necessarily making them any safer.
The focus on the Board as the source of good governance has other risks. Chief Executives have two basic functions in life. One is to steward pre-existing entrepreneurial ideas: to implement, to scale, to make more efficient a company’s existing activities. The other is the genuinely innovative entrepreneurial function: to identify the new ideas which represent profitable opportunities, or to discover a new area of competitive advantage.
Many Chief Executives have the skills to manage the first function; few have the flair to take the real risks required to create a differential growth business. Most Chief Executives of large listed companies are actually managing the inevitable decline of their businesses. The corporate world is Darwinism in practice. Taking the FTSE 100 index today, and comparing it with the top 100 companies a century ago, there are only 8 which have made the journey through time. Ten per cent of the S&P 500 companies in the US leave the index each year.
Because entrepreneurial skill is so scarce, it is almost inevitable that a Chief Executive with vision will find himself in a minority on a Board. Great innovations are often regarded at the time as moments of madness. Without the ability to ignore scepticism and opposition, such break-throughs could become fewer, and good Chief Executives could waste significant amounts of time dealing with the politics of too powerful a Board.
The very people who make it to the top of an organisation, or who are attracted to the role of Chief Executive of public companies, may change. Many, like the late JK Galbraith, claim that large companies already reward those who are best at living within their structures and procedures – the ‘greasy pole-climbers’ – rather than the unusual and heterodox entrepreneurs. Those who get to the top are already more apparatchiks than money-makers. That possibility could easily be exacerbated by a focus on the procedural niceties of corporate governance.
Overall, there is a serious possibility that corporate governance reforms could unwittingly make companies much more risk averse than hitherto. It may mean that some of the egregious losses which occur from stupid decisions may be avoided. But it may also mean that some of the spectacular profits which occur from heterodox decisions are also foregone. In short, it may reduce the upside for shareholders.
The shareholders must take ultimate responsibility for the restoration of faith in corporate management. They have in the past abrogated their rights, or even been denied them in the US, by not voting and by failing to engage directly with executive management and the Board. In the past unhappy shareholders simply sold their shares, depressing the share price and creating an opportunity for other corporates and private equity firms in the takeover market. Responsibility for sorting out deficiencies was effectively outsourced to other agents.
Shareholder short-termism has been a key part of the problem. Institutional shareholders have in the past done a credible job on paper of defending themselves against the charge of short-termism (Marsh, 1991). I believe – after 15 years in the investment industry – that short-termism is systemic.
Pension fund trustees, and retail investors, are intolerant of poor results for anything but the shortest time periods; investment consultants set constraints around indices which left fund managers with no incentive to invest, only the option of speculating on market psychology; and forcing them to own the shares of far too many companies, even ones they do not like, by virtue of their size.
Companies played along too, desperate to beat analysts’ annual or even quarterly earnings forecasts. Chief Executives feel they need to deliver crowd-pleasing short-term members: if not because they are incentivised to do so by stock options, then because their expected tenure in the job is now down to 3 years.
Institutional investors in the past have seen their job as buying shares rather than buying stakes in a company. So they failed to develop relationships with the management of companies. They do not spend sufficient time together; they do not have substantive discussions about strategic issues; and they do not have frank exchanges of views about future courses of action. What passes for a relationship consists in possibly two hour-long meetings each year. From the outset there is little sense of commitment, since shareholders ask not to be made insiders, which would prevent them from ‘voting with their feet’ and selling stock. When management are contemplating sizeable deals, they solicit views indirectly from corporate brokers, who purport to represent the considered opinions of shareholders, but rarely do (another conflict of interest). The relationship between shareholders and the management is like a one-night stand: mutually convenient, but brief. (Blair, M., 1995)
When shareholders have engaged with management, it has more often than not been in conflict. Corporate governance for some investors means finding poorly managed companies, buying a stake in those companies, and then intervening to enforce change. There is, of course, a place for such activism; but it is easy to see why executives regard shareholders either as absent and quiescent, or as a threatening menace.
The Anglo-Saxon model has been described as one of dispersed ownership, and contrasted with the European model of concentrated ownership. Only 16% of the top 100 companies in the UK have shareholders who represent more than 25% of the equity; whilst in France and Germany the equivalent figure is 80%. This fragmentation of ownership has hindered the development of closer relationships between shareholders and corporates: it leads to barriers of cost and effort to requisite co-operation, and to the disincentive of the free rider effect: the prospect of bearing all the costs, but benefiting all the shareholders equally, regardless of whether they have contributed. It has led to absentee capitalism.
This model is not, however, immutable. Markets are a series of legislative and social conventions, and both can, and have, changed over time (Kay, J., 2003). Free and flexible secondary markets are an important tool, but within that system there is no reason why the behaviour of shareholders cannot change significantly to allow them to take ultimate responsibility for governance. I think that there are five steps to reassuming responsibility.
Firstly, investors should genuinely invest and buy more meaningful stakes in companies they like, as well as those they are seeking to reform. This means running more concentrated portfolios without slavish concern for the index; and it means reduced trading, which will indicate to management that they intend to be long-term partners.
Secondly, they should put much more effort into developing a close relationship with the management. This requires time and effort to engage in regular dialogue about strategic issues and ad hoc discussions on the immediate choices which companies face. Management should then feel more supported in their ventures than they currently do, and may be more willing to take entrepreneurial risk. It should free up their time to do so, rather than spending it wandering around the City or Wall Street talking –or pitching- to quite so many disinterested investors.
Next, shareholders should be willing to be made insiders on price-sensitive issues in many more circumstances than today. If holdings are larger and longer-term this should not concern shareholders. Instead, it allows them to lobby to prevent poor decisions from being taken.
Fourthly, they should be willing to intervene directly in a company’s affairs if the company is failing to follow the agreed strategy, or management is failing to implement intelligently. Bigger stakes do not eliminate the free rider effects of close involvement and intervention; but they certainly lessen them, and make it more likely that enough of the benefit can be internalised to justify the costs involved.
Finally, shareholders should recognise the importance of non-executives as their internal agents. This means three things. First- it means interacting with them so that the non-execs can understand what shareholders’ interests actually are. Second, it means becoming involved in the choice of non-executives – if not directly in certain cases, then at least monitoring the quality and breadth of Board appointments. This will strengthen non-executive independence, with a feeling that their legitimacy is derived directly from the shareholders. Thirdly, the major shareholders should be consulted on the details of proposed compensation schemes which are vital to improved governance
This prescription represents a considerable change from the hands-off operation of the UK financial system today. However, it is an evolution of an existing system rather than the radical imposition of some overseas system currently identified as superior. There is no attempt to import a Continental model of corporate governance. There is no prescription for greater involvement of the banks, for example; though, as Mayer (1997) points out, the involvement of banks has been much more limited than is generally supposed. In the dominant system of concentrated ownership in France, Germany and elsewhere, the controlling shareholder is often another corporate. That is not what is being suggested here. I am merely proposing less dispersion and much greater responsibility. To many Continentals, the interventions of institutional shareholders will still appear to be an ‘attack by locusts’.
Onto the third definition of corporate governance. For many of the public, and politicians, and sections of the media, corporate governance is synonymous with the issue of pay. Indeed, for many Boards, this has become their preoccupation too.
Only at the beginning of the 1990s, prominent financial economists were urging shareholders to be more accepting of large pay packages that would provide high-powered incentives for management. They were supported by early empirical work which suggested a link between executive share ownership and shareholder value.
Now that pay has quadrupled, and become 500 times larger than the average employee’s package, there is a concern that we now have excessive pay; and that the incentives which have been created are not necessarily in shareholders’ interests.
There are still many who would deny that there is excessive pay, not least the bodies representing executive management. The official theory of executive compensation places the Board at the centre of the process, acting as guardian of shareholder interests. The Board is assumed to bargain at arm’s length with executives over their pay, solely with the interests of the corporation and its shareholders in mind. In theory, the compensation arrangements produced by such arm’s length bargaining will provide enough to induce the executive to join or stay, but not so much that it reduces the pie for shareholders. It is not just the size of the pay packet which matters. Economists have long seen compensation as an important mechanism for reducing so-called agency costs: limiting the potential mismatch between the desires of the management and the interests of the shareholders by linking pay to performance. It is understood by shareholders that, given natural human risk aversion, it will be necessary to offer greater upside when variable pay is adopted in preference to fixed pay. Everything else being equal, it takes more performance-based pay than fixed to entice an executive to join.
Why all the concern over excessive pay, then? Intuition certainly leads us to think that there might be a problem. We cannot observe the transfer price for executives- the minimum amount necessary to prevent them from going off and doing something else. But when we ask ourselves the question, ‘Would Chief Executives still work as Chief Executives if pay were lower?’ the answer is surely Yes. Of course they need to be paid more for their differential skills and the stresses involved – but quite as much more?
There are, fortunately, much more objective reasons to believe that pay is now excessive in many cases. There is now a substantial body of research which suggests that shareholders are often overpaying, and doing so in a way which decouples pay from performance and damages their own interests. (Beebchuk, L., and Fried, J., 2004)
Take the multiple forms of gratuitous payment which are now commonplace. When Chief Executives are fired, they are often paid much more than the amount to which they are entitled under their severance arrangements. Why do that? That is a straight reduction in shareholder wealth with no possibility of the executive positively affecting results – they have been fired. It may be normal for a board to want the departing Chief Executive to be a friend, not an adversary- but that is not the concern of shareholders. When corporations are acquired, the executives are often paid cash sums for having been acquired, either by the shareholders of the acquired company, or by the new owners. Why do that? In fact it suggests that the Chief Executive needs to be bribed to recommend an offer for his company. If the offer is in the interests of shareholders, the Board should recommend it regardless of the Chief Executive; but Chief Executives exercise power over the very people who are supposed to restrain his power. There are numerous cases of gratuitous payments to retiring Chief Executives as well. Jack Welch of GE was paid share options worth $20 million. Why? What can a retired CEO do to make the shareholders of GE better off? It represents a direct and unnecessary reduction in shareholder wealth.
Take the post-retirement deals which are struck while existing management is still in office. They not only camouflage executive pay, often being opaque to shareholders, but they also remove any linkage between pay and performance. There are multiple examples of massive pension deals not available to ordinary members of staff; there are deferred compensation schemes which offer guaranteed above-market rates of return on monies invested for the executives; and there are ongoing perks like access to apartments, private jets, offices, assistants, chauffeur-driven cars, club memberships, and post-retirement consulting contracts.
When it comes to cash-based pay and bonuses, empirical work has failed to find any strong, persistent correlation between cash received and the company’s performance. Bonus design commonly provides executives with value even when their relative performance is not good. The criteria often chosen – like accounting profits and earnings per share – are only loosely related to shareholder value: shareholder value must take account of the amount of capital management use to deliver those earnings; and the earnings are often more influenced by the general economy rather than the company-specific contribution of the executives. As if to underline the disconnect between pay and performance, Boards have often lowered the goal posts when it appears that CEOs are unlikely to achieve their designated targets, or have already missed them.
Shareholders and Boards have increasingly looked to equity-based compensation schemes to strengthen the link between pay and performance. Share prices do at least take into account the real generation of wealth, the use of capital, and the growth prospects which a business may have created. Sadly, the design of schemes has turned out to be expensive for shareholders, and has not served their interests well.
Share prices also reflect the general growth in the economy, general financial confidence, and prevailing interest rates. Only 30% of share price movements reflects corporate performance: the remaining 70% is driven by general market conditions. There has been no indexing of stock options, other than a few exploratory attempts in Australia and New Zealand. So management get rewarded for the general rise in the market rather than their own performance. And when markets have fallen, the options have often been re-priced downwards by Boards. Tails you win, heads the shareholders lose.
In addition, the design of schemes often allows management to exercise and sell options simultaneously, delivering them large cash rewards, without any underlying exposure to the company’s future, The result: they have managed for short term gain around option vesting, sold everything, and then pointed out that they have no incentivisation in place and asked the Board for more – meaning a load of new options. An expensive merry-go-round for the shareholders.
So it’s not just intuition: observation and academic studies confirm that pay has been excessive: more than shareholders should have paid. No wonder Warren Buffett has said that ‘….in judging whether corporate America is serious about reforming itself, CEO pay remains the acid test.’
How has this arisen in the first place? Two reasons.
Firstly, there is a market failure at work. There is not an efficient transparent market for Chief Executives. There are, instead, a series of bilateral exchanges characterised by information asymmetries about the quality of candidates, and about the firm-specific issues which invalidate simple comparisons. Boards of Directors imperfectly benchmark Chief Executives against global peers. They are naturally reluctant to concede that their choice is lagging behind the pack, so they all want to pay better than median. In Garrison Keillor’s fictional town Lake Wobegon, all the children are above average. It’s the same in the corporate world. The consequence is a continual racheting up in pay levels. What may appear rational for an individual company becomes a global absurdity for shareholders as a class.
Secondly, it is a reflection of the power of executives over their Boards. The arm’s length model of negotiation in the textbook is not the practical reality. A number of factors impede arm’s length bargaining. Executives have in the past been very influential in the appointment of non-executives, which makes those non-execs both grateful and careful once appointed not to upset the executives and be dropped from the Board. Even with greater independence of nomination committees, it is possible that a troublesome non-exec disliked by the management will be dropped to prevent boardroom ‘infighting’. Executives have also been able to reward compliant non-executives, via their own pay, and business contracts given to related companies.
Nor should we forget the purely social and psychological factors at play. Human beings enjoy the sense of collegiality and team spirit of a compliant board. They respond to the authority of a Chief Executive, and may be driven by motivations of friendship and loyalty. If they themselves have been in executive roles in the past, they are unlikely to drop beliefs about pay which were consistent with their self-interest. Those still in executive roles elsewhere may find themselves on a remuneration committee determining the pay of executives against which they will later be compared. In the UK this is a particular problem, since lazy headhunters in the past sought non-executives from existing boardroom line-ups, leading to a self-serving plutocracy.
Non-executives rarely have sizeable stakes in the business, and so there is little personal cost to them of squandering shareholder money. And it is not just their financial stake which matters. They rarely give the time to be able to hold the management to account. Even if they did, they do not have the information to be able to take an objective stance, relying instead on HR departments. Often they do not even understand the complexity of compensation schemes which they are asked to approve.
For these reasons then – market failure, and inherent weaknesses in Boards – executives are able to exercise considerable power over their own pay. Excess pay is the monetary reflection of power without sufficient responsibility.
Who should be responsible for improving this failure in corporate governance? This time the list of contenders is: government: the Board; and the shareholders.
Certainly, politicians have regarded corporate pay as being within their scope of influence, if not control. Their attention seems to have been mainly about assuaging our sensitivities regarding social justice and fairness. That is what the tax system is for. The trouble is that tax is a very blunt-edged tool, and would hit those who deserve their pay just as much as those who do not. So far, governments on both sides of the Atlantic have encouraged ex ante control at the corporate level. Corporations are being urged to exercise self-control before de jure controls are applied. Even greater reason to do something about it before they are inclined to act.
The issue of pay is really the responsibility of the Board and shareholders jointly. They have failed to exercise that responsibility; and they have only themselves to blame for being fleeced by executives. The levels of pay now represent a collective market failure, but that is itself the result of individual Board failures to provide directional incentives of the right kind, which genuinely align the interests of shareholders and management.
It is astonishing that Boards have been allowed to give away shareholders’ money without being held to account by those shareholders. More independent and better quality Boards will help, particularly if they feel allegiance to the shareholders as I have proposed. Greater transparency of pay for executives will focus attention on the behaviour of the Board. Shareholders must vote against the re-election of Boards who have paid for failure. The solution is relatively simple one: it is about seizing responsibility which is already there. There are tentative signs of change, but only that. Pay levels in the US peaked five years ago. But there is much more to do.
The final definition of corporate governance is corporate governance as ethical, social and environmental responsibility.
Some commentators, politicians and activists have seen in the corporate governance debate the opportunity to ask a broader question about the appropriate functions of corporations – to re-examine what corporations are actually for. They wish to encourage companies to accept objectives other than purely financial: to impose on management and shareholders obligations which appease their moral sensitivities. In this meaning of corporate governance, companies are expected to target environmental effects; to improve the balance of men and women in the workplace; to redress years of under-representation of ethnic groups; to champion the interests of those with specific religious beliefs or sexual orientations. Interest groups can now focus on corporations as before targeting our legislators.
This concept of ‘corporate social responsibility’ takes corporate governance into an even more subjective realm. It imposes on corporations objectives which would be alien to an economist, but which are entirely natural for Social and Christian Democrats, recognising the importance of the community context within which corporations operate. For businessmen and economists in liberal laissez-faire economies, the raison d’être of companies is to make money for shareholders. Environmental impact and social engineering are seen as constraints on that objective; or they may be a means to that end, via the social kudos which is derived. But they have never been the ultimate objective of a corporation, ranking on a par with the profit motive. (Henderson, D., 2004)
Economic theory has moved on over the last thirty years, and it does recognise that shareholders are not the only risk-bearers in an organisation. To the extent that human beings build up firm-specific skills whilst working for a corporation, they too bear some of the risks of the success or failure of a business. Since human capital is required just as much as physical or financial capital, the workers’ interests need to be represented in the governance of the organisation too. This economic stakeholder theory has also been hijacked, more often exposited as a political position, into an attempt to reconcile the competing claims of economic efficiency and social justice.
This development, this new understanding of corporate governance, adds new layers of responsibilities for companies. In the past they were responsible to the law, to gatekeepers, to shareholders, to Boards, and (of course) to customers. Now they are responsible to the wider public, to interest groups, and to posturing politicians.
This is potentially dangerous territory. Unless there is a complete consensus in society, corporations cannot easily satisfy all constituencies. They end up being help responsible to the loudest and best organised groups in society. It represents the usurpation of ownership.
Corporations may just be paying lip-service to these constituencies, as an economist would advise them too. With record levels of profitability they can currently afford to appear magnanimous. They have adopted enough of the social agenda to keep their critics at bay, and without imposing apparently excessive costs. Perhaps a reasonable equilibrium has been reached.
Corporate governance is a protean term. It is about the restoration of trust; or the strengthening of faith; or the control of excessive pay; or the pursuit of political aims.
Insufficient responsibility has been exercised by shareholders, gatekeepers and Boards; too much is sought by political groupings. The ultimate responsibility must lie with the owners of these businesses: the shareholders. Until shareholders act as owners, they will continue to receive the corporate governance they deserve. There is a feeling among many shareholders that corporate governance is imposed on them by demanding clients and media pressure. They must remember that if they are successful in improving governance, they will benefit too: the ultimate test is, after all, improved shareholder returns.
It is perhaps ironic that I have given this lecture in Oxford, where corporate governance debates just a few years ago were extremely divisive. Those in favour of emulating the practices of the corporate world were perhaps uncritical of reality. In fact, the corporate world has little to teach Oxford about governance. Oxford can remind shareholders about the virtues of acting as owners – and remind executive management of the advantages of a sense of ownership, accountability and responsibility in motivating staff.
References & Bibliography
Bauer and Guenster, ‘Good Corporate Governance Pays Off’, IFMA paper, 2003
Beebchuk, L. and Fried, J., ’Pay without Performance’, Harvard University Press 2004
Blair, M., ‘Ownership and Control: Rethinking Corporate Governance for the Twenty-First Century’, Brookings Institution, 1995
Coffee, J., ‘The Gatekeepers: The Professions and Corporate Governance’ OUP 2006
Coombes and Watson, McKinsey Quarterly, 2000 Number 4
Franks, Mayer, Renneboog, ‘Who disciplines management in poorly performing companies?’, Journal of Financial Intermediation, 2001
Henderson, D., The Role of Business in the Modern World, Institute of Economic Affairs, 2004
Kay, J., The Truth About Markets, Penguin 2003
Marsh, P., ‘Short-Termism on Trial’, IFMA, 1991
Mayer,C., ‘Corporate Governance in the UK’, Hume Papers on Public Policy, Vol 8:1, 2000
Mayer,C. ‘The City and Corporate Performance: Condemned or Exonerated?’, Cambridge Journal of Economics, Vol 21, 1997
Mayer, C., Economic Growth and Government Policy, HM Treasury, 2001
Myners Review, HM Treasury, 2000
O’Sullivan, M., ‘The innovative enterprise and corporate governance’, Cambridge Journal of Economics, Vol 24, 2000