07 June 2016
Failure to curb excessive pay will lead to yet more unhelpful conflict and ill-conceived regulation
Shareholders’ rejection of BP’s remuneration report appears to have come as a surprise to everybody, including even the shareholders themselves. Although there had been evidence of objections to the chief executive’s remuneration package for 2015, most of the market had assumed that they were not sufficiently widely shared or strong enough to prompt outright majority rejection.
The media machine immediately cranked out a slew of articles suggesting the UK was again at a tipping point, and that the BP vote heralded a new and much tougher investor approach. This notion was welcomed subsequently by senior politicians, including the Chancellor of the Exchequer.
In fact we have been here before. In a previously unprecedented vote, shareholders in 2003 rejected the arrangements for Jean-Pierre Garnier, the then Chief Executive of GSK. In the period immediately after the financial crisis a wave of shareholder opposition to executive pay schemes – dubbed the Shareholder Spring by the media – caused heads to roll, including that of Andrew Moss, Chief Executive of Aviva.
On each of these occasions there has been an immediate period of restraint as companies reacted to the shock and sought to avoid putting themselves in the firing line. Gradually, however, as the alarm subsided, the market went back to business as usual and remuneration began to rise again.
Currently there does seem to be a tendency for executives to want to make up for ground lost during the aftermath of the financial crisis. This may explain the current restiveness. It is insensitive, however, because salaries for the rest of the workforce are still being squeezed.
The question after BP, which was followed within hours by a similar vote at Smith & Nephew – and subsequently by other significant shareholder revolts – is whether this time is different so that an opportunity for reform might be seized. There are perhaps some grounds for thinking the answer might be a very cautious ‘yes’.
Although the background to the BP vote was a sharp increase in CEO pay in a year of relatively poor corporate performance, there is starting to be a greater public and shareholder focus on the differentials between what top executives receive and the world at large.
The US presidential election campaign has heightened public awareness of inequality as a political issue, even among voters who would not normally describe themselves as radical. This has not only driven the Trump campaign in the US, but also inspired scepticism towards the establishment and protest politics in the UK and elsewhere in Europe.
For the first time, it appears as though shareholders are looking at absolute quantum just as much as at company performance. At the time of writing we do not yet know the voting results at some well performing companies, such as WPP, which boast very high absolute rates of pay. However, in early May, Reckitt Benckiser, which is much admired for its performance, faced a large vote against its remuneration report.
There are now mutterings in the shareholder community about whether the amounts on the table are simply too much for any one individual. Even for less ideologically driven shareholders, it seems, there is a reputational risk in being seen to support inequality in the present political climate.
If this takes root it will be a significant change. Hitherto shareholders have been nervous about addressing quantum, although the advisory vote introduced under the last Labour government clearly implied that they should do. Their preference has been to tailor remuneration to performance and leave the market to decide the appropriate quantum. Outsiders like shareholders simply cannot know the right going rate.
Now they may find it a bit harder to hide behind this argument, however reasonable it seems. The outcome may be a period of uncertainty. Judgements on quantum are highly subjective and heavily driven by press comment. This does not make for an easy period for either companies or shareholders. So how should the market respond?
There is growing acceptance of the case for radical reform. Privately, many involved in executive pay believe the system is too complicated and fails to produce a clear link with performance, which is needed to justify very high amounts.
Two basic principles should drive such reform. First, remuneration committees should be much clearer with themselves and others about the value of what is being handed over. Second, the time frame for remuneration needs to be lengthened to remove pressure for short-term decision making by chief executives.
The debate about the ‘single figure’ for executive remuneration, which companies are now obliged to publish, shows that no one can say with certainty what the single figure actually is. The new disclosure rules provide a clear picture of overall outcomes, but they still conflate rewards earned over a period of several years.
This is because they include figures for vesting of prior schemes and ignore the value of allocations of shares under long-term incentive schemes during the reporting year. Such allocations have a value, even though it is hard to determine.
The result is that remuneration committees are awarding remuneration with only a hazy idea of its value to executives, who are generally sceptical about the value they are receiving. Shareholders, who are even less able to determine what is going on, are asked to be the principal referees and validate the process through their vote.
One of the big problems with traditional schemes is that the outcomes are highly variable and uncertain. A strong stock market and moderately good performance by the company in comparison with its peers can yield high amounts. By contrast, a weak stock market and a sectoral crisis can severely reduce the worth of the scheme, even if the company has performed relatively well compared with its peers.
For executives this means there is all to play for over a three-year period and a strong incentive to ramp up profits over the short term. However, the reliance on metrics, such as relative total shareholder return, means that the outcome may be largely out of their control.
They will benefit if other companies in their comparator group happen to do badly as much as if they do well. A longer time frame and less reliance on leveraged share schemes would make the outcome less arbitrary.
Besides, if boards confined themselves to remuneration consisting of cash and shares bought in the market, it would be clear to see what was being handed over. Executives could be required to hold on to the shares for the long term, even if they left the company.
Subject to covenants on dividend cover, however, executives could receive dividends on their holding which would over time reduce, or even remove, the need for bonuses which fuel public opprobrium. The core incentive would be to produce a sustainable and growing cashflow. Complex performance conditions, which are all too frequently gamed, could be jettisoned. Remuneration reports, which are mostly dull and reek of self-obsession, could be slashed in length, creating room for some more useful discussion about strategy and prospects.
Whether we get to such radical reform is moot, however. Even some shareholders like the present complexity. It has created an industry within the corporate governance community on which many jobs depend. Sadly, the much-heralded review of executive remuneration by the Investment Association has turned out far less radical than expected.
Executives might reasonably point out that a requirement to hold on to the shares after they leave the company would expose them to risk over which they have no control. Yet, this could focus welcome attention on succession planning and put an end to situations in which iconic executives leave companies just when their fortunes are peaking.
Of course, there are often good reasons for hiring a new chief executive from outside the business. This is usually necessary when a board has decided that a change of strategy is required, and can be expensive because good executives may demand a generous package to lure them away from their existing role.
Yet outside hires often also reflect a failure of succession planning, and could easily become less frequent. That in turn would reduce some of the upward pressure on executive remuneration because there would be fewer ‘golden hellos’ and the new incumbent’s package could be better tailored to reflect experience – as was the case with National Grid’s appointment last year.
In short, the shock at the BP vote and the new political focus on inequality may just this time round yield some useful change. The forces defending the status quo are strong however, and without strong leadership by both the corporate and investor sectors, the opportunity could be fluffed.
The interim report on reform by the Investment Association acknowledges many of the problems but steers clear of recommending radical change.
Yet if the gap between top pay and that received by the average voter continues to widen, there will sooner or later be yet more pressure to rein in remuneration with more regular unhelpful public conflict between companies and shareholders and the prospect of yet more damaging and ill-conceived regulation.
Trust in business will also continue to weaken. One of the most vocal critics of executive remuneration has become the Institute of Directors, whose members are primarily small businessmen and women. Their frustration with executive remuneration reflects a deep-seated resentment towards large businesses which divides the political community.
There is little doubt that the insensitivity of large businesses to the reputational impact of their approach to pay, means the public is less willing to listen to business leaders on important issues like Brexit and more likely to push for other reforms, notably in the area of taxation.
Institute of Business Ethics (IBE) surveys consistently show concerns about executive remuneration at or near the top of the list of reasons for public mistrust of business. The cost of lavish rewards for a few individual executives may be affordable, but the price is high.