22 June 2006
Executive pay and incentives in capital markets
On 20th June the Financial Times published a letter from David Haarmeyer which emphasised the role of activist shareholders with large stakes as an important constraint on executive pay. Whilst Mr Haarmeyer clearly has a point, the significance of the point is overstated. It is in fact completely unrealistic to assume that the incentives of the capital markets will ensure responsible practice on executive pay. I wrote to the Financial Times on this subject. The letter was not published, but is set out below.
(To see Mr Haarmeyer's letter or any of the relevant FT articles follow the links below. Level 1 subscription to FT.com may be required.)
My letter:
Sir, David Haarmeyer's letter ("Active investors are critical for controlling management"), 20th June) was too hasty to suggest that your article "What Price talent?" (Comment and Analysis, 16th June) was "high on moralistic indignation but less so on substance".
Mr Haarrmeyer quite rightly points out that independent directors are not in a position to properly hold management to account. His gives good reasons for this, the most crucial of which is the lack of proper incentives faced by the independent directors. Independent directors usually hold little or no equity stake.
However Mr Haarmeyer then rushes ahead to suggest that active investors with significant stakes do have proper incentives to control executive pay. If only it were that simple! Sadly however there are very important mismatches between the incentives faced by active investors and the behaviours which would be optimal for the underlying owners of the funds that they control.
Firstly, the hedge fund style active investor gets paid a big bonus in a year in which investments do well, but suffers no penalty in a year when investments do badly. As John Plender points out ("The games investors play", 18th June, ft.com) such investors therefore have a big incentive to provide the equivalent of catastrophe insurance.
Secondly, a person in the role of active investor has a disproportionate need to present strong recent performance because this is the basis on which that person is assessed, measured and given new opportunities. Long term performance is therefore compromised.
Thirdly, many large active fund managers are owned and controlled by FTSE 100 companies. This completely compromises their ability to comment critically on the corporate governance or executive pay of such companies.
Fourthly, and specifically on the subject of executive pay, activist fund managers are themselves notoriously well paid. In many cases, through their own pay they take far more from the underlying owners of their funds than company chief executives could ever justify. Activist fund managers are therefore in no position to critique the pay of chief executives. In fact their incentive is to support excessive executive pay to make their own position appear more credible.
For these four reasons it is not realistic to depend on the incentives of the capital markets to control executive pay. Rather we are quite right to demand that chief executives put the shareholder interest before their own, and provide evidence of this by exercising restraint on their own pay.
Yours faithfully, Patrick Gerard
(To see Mr Haarmeyer's letter or any of the relevant FT articles follow the links below. Level 1 subscription to FT.com may be required.)
My letter:
Sir, David Haarmeyer's letter ("Active investors are critical for controlling management"), 20th June) was too hasty to suggest that your article "What Price talent?" (Comment and Analysis, 16th June) was "high on moralistic indignation but less so on substance".
Mr Haarrmeyer quite rightly points out that independent directors are not in a position to properly hold management to account. His gives good reasons for this, the most crucial of which is the lack of proper incentives faced by the independent directors. Independent directors usually hold little or no equity stake.
However Mr Haarmeyer then rushes ahead to suggest that active investors with significant stakes do have proper incentives to control executive pay. If only it were that simple! Sadly however there are very important mismatches between the incentives faced by active investors and the behaviours which would be optimal for the underlying owners of the funds that they control.
Firstly, the hedge fund style active investor gets paid a big bonus in a year in which investments do well, but suffers no penalty in a year when investments do badly. As John Plender points out ("The games investors play", 18th June, ft.com) such investors therefore have a big incentive to provide the equivalent of catastrophe insurance.
Secondly, a person in the role of active investor has a disproportionate need to present strong recent performance because this is the basis on which that person is assessed, measured and given new opportunities. Long term performance is therefore compromised.
Thirdly, many large active fund managers are owned and controlled by FTSE 100 companies. This completely compromises their ability to comment critically on the corporate governance or executive pay of such companies.
Fourthly, and specifically on the subject of executive pay, activist fund managers are themselves notoriously well paid. In many cases, through their own pay they take far more from the underlying owners of their funds than company chief executives could ever justify. Activist fund managers are therefore in no position to critique the pay of chief executives. In fact their incentive is to support excessive executive pay to make their own position appear more credible.
For these four reasons it is not realistic to depend on the incentives of the capital markets to control executive pay. Rather we are quite right to demand that chief executives put the shareholder interest before their own, and provide evidence of this by exercising restraint on their own pay.
Yours faithfully, Patrick Gerard
16 June 2006
Executive compensation in crisis
The FT is full of executive compensation today (16th June 2006). On page 13 there is a full page of "Comment and Analysis" digesting the effects in the US of the options backdating scandal and the shareholder revolt over executive compensation at Home Depot. On page 16 the Lex column contemplates the inevitable feeling among investors that they have been taken for a ride by executive compensation arrangements.
I am grateful to the Lex column for its timely comments on executive compensation. Now is the time for a complete reconsideration of the way that executive pay is set.
As Lex points out, the traditional defense for high compensation is that this is what it takes to attract talent in a competitive market. If we take this argument seriously then we must question if the market is truly competitive. Lex also notes that executives appear to have very significant protection against real market pressures. Part of this arises because, as appointers of executive directors, company board members are dominant in their own market. Part of it arises from price distorting mechanisms, such as the near universal desire to pay executives at median level or above. These two issues ensure that the market in executive talent is far from truly competitive. It should be investigated by competition authorities. I seek to make the case for a competition law enquiry elsewhere in this blog.
The idea of recruitment in a competitive market can never provide a sound basis for setting executive pay. It implies that executives are selling themselves in a market to maximise their own personal return. This is completely in contradiction with the fiduciary responsibilities to act in the shareholders best interests. It introduces a fundamental conflict of interests in the board as both buyer and provider of executive talent. The executive director can only make sense as a role of service to shareholders. Executive pay has to reflect this and be set at a level which provides confidence in that attitude of service.
And where has this unhelpful idea about a competitive market in executive talent come from? I think we need to look at dynamics behind the remuneration consultancy business. Surely the best way of getting new consultancy business is to approach management with the message "You deserve more pay". Somehow the consultants have to justify that message.
This entry was originally written as a comment on the Lex Live page of ft.com. See:
http://forums.ft.com/2/OpenTopic?q=Y&a=tpc&s=646099322&f=813102159&m=923102159
I am grateful to the Lex column for its timely comments on executive compensation. Now is the time for a complete reconsideration of the way that executive pay is set.
As Lex points out, the traditional defense for high compensation is that this is what it takes to attract talent in a competitive market. If we take this argument seriously then we must question if the market is truly competitive. Lex also notes that executives appear to have very significant protection against real market pressures. Part of this arises because, as appointers of executive directors, company board members are dominant in their own market. Part of it arises from price distorting mechanisms, such as the near universal desire to pay executives at median level or above. These two issues ensure that the market in executive talent is far from truly competitive. It should be investigated by competition authorities. I seek to make the case for a competition law enquiry elsewhere in this blog.
The idea of recruitment in a competitive market can never provide a sound basis for setting executive pay. It implies that executives are selling themselves in a market to maximise their own personal return. This is completely in contradiction with the fiduciary responsibilities to act in the shareholders best interests. It introduces a fundamental conflict of interests in the board as both buyer and provider of executive talent. The executive director can only make sense as a role of service to shareholders. Executive pay has to reflect this and be set at a level which provides confidence in that attitude of service.
And where has this unhelpful idea about a competitive market in executive talent come from? I think we need to look at dynamics behind the remuneration consultancy business. Surely the best way of getting new consultancy business is to approach management with the message "You deserve more pay". Somehow the consultants have to justify that message.
This entry was originally written as a comment on the Lex Live page of ft.com. See:
http://forums.ft.com/2/OpenTopic?q=Y&a=tpc&s=646099322&f=813102159&m=923102159
