21 November 2007
A Christian Perspective on Corporate Governance and Executive Pay
I was invited to write a Christian perspective on Corporate Governance and Executive Pay for Faith in Business Quarterly. My article is below. It was published in volume 11.2, November 2007. Find out more about Faith in Business Quarterly at www.fibq.org .
Executive Pay and Corporate Governance
Executive pay is a subject of growing importance. This is mainly because the amount that we pay to senior executives started to grow significantly in the mid 1980s and has continued to grow either rapidly or significantly ever since. Statistics from HM Revenue and Customs suggest that the total income paid to top earners in the UK has increased five fold in real terms between 1987 and 2004[1].
It is important to realise that this is part of a trend that stretches across the whole western world. Executive salaries in America have set the pace with the UK, France and Germany following close behind. Twenty years ago it was hard to become extremely rich through being employed, but now it is much more possible.
The trend is most spectacular when the distribution of newly created wealth is considered. Between 1997 and 2001, the top 10 per cent of US earners received 49 per cent of the growth in aggregate real wages, while the top 1 per cent received 24 per cent! Meanwhile, the bottom 50 per cent received less than 13 per cent.[2] In other words the benefit of new wealth creation in the US economy accrues substantially to the people who need it least. Ronald Regan used to argue that allowing the rich to get richer would cause the whole economy to grow and the benefits would trickle down to the poor. It would appear that the rich have become so effective in capturing their share of new wealth that trickle down hardly occurs. The social justification for economic growth becomes rather thin if the benefits of growth are shared so unevenly.
There has been a significant political outcry against excessive pay in most of the world’s big economies. Politicians, quite rightly, have wanted to know how these generous pay awards have come about, and whether they are really necessary. This has led to an increased focus on Corporate Governance.
A company’s corporate governance is the set of systems and procedures by which, at the highest level, the company is governed and controlled. In the US and the UK companies are usually headed up by a board of directors, so corporate governance is mainly concerned with the way that the board functions and makes it decisions. Of course, one of the key questions is how a company board determines how much it will pay its directors. The board of directors has a rather obvious conflict of interests on this question; increasing the directors pay is good for the directors, but may not be good for the company itself, which has to foot the bill.
Political interest in corporate governance, and executive pay in particular, has lead to the development of codes of best practice. In the UK the pre-eminent such code is known as The Combined Code on Corporate Governance[3] and is administered by the Financial Reporting Council.
The Combined Code requires large listed companies to have a remuneration committee that is responsible for setting the pay of the executive directors and other senior executives in the company. The remuneration committee is a sub-committee of the main company board. The members of the remuneration committee are non-executive directors, and so have no immediate or direct interest in the pay that they are controlling.[4] In remuneration reports, remuneration committees typically state that it is their policy to set pay so as to recruit, retain and motivate the best possible executives, in order to generate the maximum possible value for shareholders. This is more or less what the Combined Code tells them to say.[5]
Lying behind these statements is an assumption that the executive is selling his or her services in a competitive market for executive talent. Many companies are seeking to buy the services of the executive and the executive will work for the company that makes the most attractive offer. The executive will change company if a better offer is received from elsewhere. The company must therefore make an offer that is good enough to recruit, retain and motivate the executive in the competitive market.
This central assumption is widely accepted amongst the people with a direct influence on the levels of executive pay. However it should be noticed that many such people have a personal vested interest in high executive pay.[6] The picture that is painted by independent commentators is very different. The book Performance and Reward analyses in detail the incentives that arise from performance related pay in the UK. It concludes that the typical structure of executive pay in the UK cannot be explained by a desire to increase shareholder value in the long term, but rather owes more to presentational considerations, comparative pay positioning and the business model of remuneration consultants.[7] Also, although there is undoubtedly lots of competition to secure the top jobs in big companies, the market for executive talent is heavily distorted by the practice of comparative pay positioning, and by the significant control that executives in post can exert over the supply of future executives. The market therefore is highly problematic under competition law.[8]
The book Pay without Performance [9] argues convincingly that levels of executive pay in the US are ultimately driven far more by the power of the directors who serve on company boards than by a genuine arms length negotiation intended to maximise shareholder interests.
Pay without Performance presents the problem of directors paying themselves too much as a classic symptom of a wider “Agency Problem”:
The separation of ownership and control creates what financial economists call
an “agency relationship”: a company’s managers act as agents of its shareholders. The principals (the shareholders) cannot directly ensure that the agents (the managers) will always act in the principals best interests. As a result, the manger-agents, whose interests do not fully overlap those of the shareholder-principals, may deviate from the best course of action for shareholders. This is called the “Agency Problem”.[10]
The “Agency Problem” is the problem that you face if you employ people to look after something that you own. How do you make sure that they take care of it in a way that suits your interests, rather than in a way that suits their own interests? Shareholders face the agency problem in respect of the company directors that they elect. The general public face the agency problem in respect of the politicians and managers who they appoint to run public services.
Jesus comments on the agency problem extensively in his parables. Firstly there is the parable of the faithful and unfaithful servant (Matt 24:45-51, Luke 12:42-46). The servant is put in charge of the house while the master is away. If the master returns and finds the house in good order he responds by putting the servant in charge of all his possessions. This is “promotion”. Alternately if the master returns and finds the servant mistreating others and eating and drinking himself, then the servant will be cut to pieces. The parable emphasises the building of trust over time, with greater responsibility given to the servant with the good track record.
Luke’s account of the parable is followed by an analysis of the guilt of the unfaithful servant. There are higher expectations of those who have been entrusted with more. In terms of modern corporate governance, this suggests that the personal priority given to the shareholders should become higher, the more senior a manager is in a business organisation.
In the parable of the talents (Matt 25:14-30) the master asks no questions about the behaviour of the servants, but judges them solely on the financial return they have made. As the master has been away a long time, we can perhaps assume that any faults in the servants’ behaviours have had time to show through in the financial results. The same theme of trust being built on previous track record is emphasised when the successful servants are rewarded with greater responsibilities. This is further reinforced by the uneven initial distribution of the talents; the more able servants being given more, and by the master reallocating the unused talent to the most trusted servant, despite the fact that he already has the most. Luke’s account of a similar parable (Luke 19:11-27) echoes many of these themes.
Then there are two parables where the agency relationship is completely abused by the managers. The dishonest manager (Luke 16:1-13) knows he is to lose his job, so uses his master’s money to buy himself friends (though the master does find aspects of his behaviour to commend). In the parable of the wicked vineyard tenants (Matt 21:33-46, Mark 12:1-12, Luke 20:9-19) the tenants seem keen to forget that they are in any kind of agency relationship at all.
To scratch through these parables for insights on executive pay is probably seeking more from them than Jesus was ever intending to give! However it is interesting to see the assumptions that Jesus makes about the agency relationship and the agency problem. Jesus appears to see the agency problem as a metaphor for the difficulty that God has in getting human beings to behave properly. In the parables the master only ever seeks to manage the agency problem through trust. There appear to be no other mechanisms of audit or control. The managers are free to honour the master’s trust, or to abuse it. The consequence of honouring the trust is the building of greater trust and increased responsibility. The consequence of abusing the trust is dismissal or worse. There is a consistent theme of responsibilities and opportunities being handed over to the most trusted servants.
It is interesting to compare these assumptions of Jesus with the way that corporate governance works today. The 2006 version of the Combined Code uses the word “trust” only once in its 25 pages, and that is in the preamble. The word “honest” does not appear at all. The word “integrity” appears twice, but it applies to financial information rather than to people. In contrast the key words in the Combined Code are “transparency”, “control”, “independence” and “effective”.
Present day corporate governance is reluctant to ask shareholders to trust executives. Instead it emphasises the importance of aligning the interests of shareholders and directors. Alignment of interests is typically achieved through the way that directors are paid, and through performance related pay in particular. The idea is that executives get paid well if and only if the company performs well for its shareholders.[11]
And yet it is important to notice that this way of thinking about executives and company directors is a very recent development. Before the 1992 Cadbury Report there was no code of practice on corporate governance. In law the key concept was (and still is!) the fiduciary duty that a company director owes to the company, and in particular to the members of the company: its shareholders.
A fiduciary duty is the highest standard of care imposed at either equity or law. A fiduciary is expected to be extremely loyal to the person to whom they owe the duty (the "principal"): they must not put their personal interests before the duty, and must not profit from their position as a fiduciary, unless the principal consents. The fiduciary relationship is highlighted by good faith, loyalty and trust, and the word itself originally comes from the Latin fides, meaning faith and fiducia. [12]
The legal concept of fiduciary duty is clearly much more rooted in Christian thinking than the Combined Code. It depends on care, loyalty, good faith and trust. It also sits very uncomfortably with the current corporate governance practices described above. In particular loyalty does not fit with the executive changing companies in response to a better offer. Trust is reduced to trusting that the executive will do what is best for the executive, and company remuneration schemes must align incentives so that this is also best for the company. It is also widely assumed that the executive is using the company to progress his or her own interests, rather than seeking to serve the interests of the company. David Haarmeyer sees this as important:
…expecting managers to subvert their interests to shareholders is not realistic and indeed likely to lead to bad outcomes. This was the same idea that the Soviet state was model under -- that human nature is malleable. This is after all the point of corporate governance -- to use internal and external forces to align management's interests with those of shareholders.[13]
It is likely that David Haarmeyer is articulating the underlying assumptions of many people currently working in the field of corporate governance and executive pay. However, from a Christian perspective there are very serious problems with this position.
The first problem is that it presents an extremely pessimistic view of human nature. The human being (even those human beings at the very top end of our society) are unable to look beyond their own interests. This is much more pessimistic than mainstream business thinking which, when considering motivation, often refers to Maslow’s triangle of needs and the “self-actualizing” needs of top people.
A second problem is that it interprets good corporate governance as a balance point between the different vested interest groups which creates incentives for managers to deliver good outcomes for those vested interest groups.[14] This implicitly accepts that corporate governance is a power struggle in which executives, investors and investors’ representatives seek to optimise their own position. In reality the Combined Code does appear to be more the outcome of a power struggle between institutional investors and directors than a principle driven exercise to optimise outcomes for the underlying investors.[15] In this power struggle trust and co-operation are replaced by red-tape, regulations and controls.
But the biggest problem here is that individuals and institutions are expected to use their talents and powers solely to further their own agendas. This generally means maximising their own power and their own proportion of the wealth created by business activity. This creates a tension in which power and money are pulled towards those people who already have the most power and money, and away from those who are least able to defend themselves. This explains the increasing differentials in income, observed at the start of this article. It also resonates with the “war of the powerful against the weak”[16] perceived by Pope John Paul II.
Christians in business face the challenge of responding to these problems! The difficulty of finding responses that are both authentic and constructive should not be underestimated. Attempts to constrain executive pay when this is not what the company board really wants, tend to have undesirable consequences.[17] Effective change therefore requires a change in the hearts and mind of board members. One approach is to promote, by word and example, the positive values implicit in any Business Principles or Core Values that are published by the company. Sadly such publications are often not as constructive as the Principles for Those in Business[18] which emphasise values of service (principles 1 and 19) and trust (principle 7).[19]
Real success in corporate governance requires the directors to have an attitude of service towards the shareholders (and other stakeholders) showing that they respect the agency relationship and take their fiduciary duty seriously. The outward visible sign of this attitude is self-imposed restraint on executive pay. As Warren Buffet, America’s most successful investor, pointed out, executive pay is the “acid test”[20] of corporate governance.
Notes:
[1] Income statistics are taken from Table 3.6 (employment income only) available for tax year 2004/5, at http://www.hmrc.gov.uk/stats/income_distribution/table3-6.pdf . Table 3.6 for 1987/8 was supplied by HMRC following e-mail enquiries to the contact e-mail address provided in the website. The five fold increase compares the £6,780 million total earned by the 120,000 people earning more than £50,000 in 1987/8 with the £54,340 million earned by the 328,000 people earning over £100,000 in tax year 2004/5. Aggregate Inflation over this 17 year period was 83% [Based on Headline Rate of Inflation (RPI table RP02) from the table supplied at http://www.statistics.gov.uk/statbase/product.asp?vlnk=9412 ].
[2] Martin Wolf, “A new gilded age” in the Financial Times, London 25/04/06.
[3] Available from http://www.frc.org.uk/corporate/combinedcode.cfm .
[4] This does not mean that they are free of conflicts on interest. See Patrick Gerard A Response to the Consultation by the Financial Reporting Council October 2005, page 11, available from http://performanceandreward.blogspot.com/2006/04/combined-code.html .
[5] Combined Code, Main Principle B.1
[6] Patrick Gerard, Performance and Reward (Matador, Leicester) 2006, pages 178-182, 187-189
[7] Performance and Reward, pages 142-157
[8] http://performanceandreward.blogspot.com/2006/04/competition-law.html
[9] Lucian Bebchuk & Jesse Fried, Pay without Performance (Harvard University Press, MA) 2004
[10] Pay without Performance pages 15-16
[11] Performance and Reward argues that the credibility of this incentive alignment is seriously undermined by the structure of performance related pay typically used in the UK. Often the incentives faced by the executives have a short term and individualistic focus whereas the underlying shareholders benefit only from growth in shareholder value that is sustained in the long term.
[12] From http://en.wikipedia.org/wiki/Fiduciary, accessed 19/09/07
[13] David Haarmeyer, comment on blog entry at http://performanceandreward.blogspot.com/2006_06_01_archive.html added 04/08/2006.
[14] Compare definition in A Response to the Consultation by the Financial Reporting Council page 36
[15] A Response to the Consultation by the Financial Reporting Council pages 2-3,32-34
[16] Pope John Paul II, Evangelium Vitae, 25/03/95, paragraph 12.
[17] For example, according to the Financial Times Lex column 17/07/07, it was US Congress’ block on tax deductions for salaries in excess of $1million that lead to the explosion of executive stock options in 1993.
[18] See http://www.principlesforbusiness.com/
[19] For example Cadbury Schweppes describes “Aggressiveness” as one of the three key behaviours which should guide everyone in the company. See “our business principles” page 9 downloaded from http://www.cadburyschweppes.com/EN/AboutUs/PurposeValues/our_bus_principles.htm on 26/09/07.
[20] Berkshire Hathaway Chairman’s letter to shareholders 2003
Executive Pay and Corporate Governance
Executive pay is a subject of growing importance. This is mainly because the amount that we pay to senior executives started to grow significantly in the mid 1980s and has continued to grow either rapidly or significantly ever since. Statistics from HM Revenue and Customs suggest that the total income paid to top earners in the UK has increased five fold in real terms between 1987 and 2004[1].
It is important to realise that this is part of a trend that stretches across the whole western world. Executive salaries in America have set the pace with the UK, France and Germany following close behind. Twenty years ago it was hard to become extremely rich through being employed, but now it is much more possible.
The trend is most spectacular when the distribution of newly created wealth is considered. Between 1997 and 2001, the top 10 per cent of US earners received 49 per cent of the growth in aggregate real wages, while the top 1 per cent received 24 per cent! Meanwhile, the bottom 50 per cent received less than 13 per cent.[2] In other words the benefit of new wealth creation in the US economy accrues substantially to the people who need it least. Ronald Regan used to argue that allowing the rich to get richer would cause the whole economy to grow and the benefits would trickle down to the poor. It would appear that the rich have become so effective in capturing their share of new wealth that trickle down hardly occurs. The social justification for economic growth becomes rather thin if the benefits of growth are shared so unevenly.
There has been a significant political outcry against excessive pay in most of the world’s big economies. Politicians, quite rightly, have wanted to know how these generous pay awards have come about, and whether they are really necessary. This has led to an increased focus on Corporate Governance.
A company’s corporate governance is the set of systems and procedures by which, at the highest level, the company is governed and controlled. In the US and the UK companies are usually headed up by a board of directors, so corporate governance is mainly concerned with the way that the board functions and makes it decisions. Of course, one of the key questions is how a company board determines how much it will pay its directors. The board of directors has a rather obvious conflict of interests on this question; increasing the directors pay is good for the directors, but may not be good for the company itself, which has to foot the bill.
Political interest in corporate governance, and executive pay in particular, has lead to the development of codes of best practice. In the UK the pre-eminent such code is known as The Combined Code on Corporate Governance[3] and is administered by the Financial Reporting Council.
The Combined Code requires large listed companies to have a remuneration committee that is responsible for setting the pay of the executive directors and other senior executives in the company. The remuneration committee is a sub-committee of the main company board. The members of the remuneration committee are non-executive directors, and so have no immediate or direct interest in the pay that they are controlling.[4] In remuneration reports, remuneration committees typically state that it is their policy to set pay so as to recruit, retain and motivate the best possible executives, in order to generate the maximum possible value for shareholders. This is more or less what the Combined Code tells them to say.[5]
Lying behind these statements is an assumption that the executive is selling his or her services in a competitive market for executive talent. Many companies are seeking to buy the services of the executive and the executive will work for the company that makes the most attractive offer. The executive will change company if a better offer is received from elsewhere. The company must therefore make an offer that is good enough to recruit, retain and motivate the executive in the competitive market.
This central assumption is widely accepted amongst the people with a direct influence on the levels of executive pay. However it should be noticed that many such people have a personal vested interest in high executive pay.[6] The picture that is painted by independent commentators is very different. The book Performance and Reward analyses in detail the incentives that arise from performance related pay in the UK. It concludes that the typical structure of executive pay in the UK cannot be explained by a desire to increase shareholder value in the long term, but rather owes more to presentational considerations, comparative pay positioning and the business model of remuneration consultants.[7] Also, although there is undoubtedly lots of competition to secure the top jobs in big companies, the market for executive talent is heavily distorted by the practice of comparative pay positioning, and by the significant control that executives in post can exert over the supply of future executives. The market therefore is highly problematic under competition law.[8]
The book Pay without Performance [9] argues convincingly that levels of executive pay in the US are ultimately driven far more by the power of the directors who serve on company boards than by a genuine arms length negotiation intended to maximise shareholder interests.
Pay without Performance presents the problem of directors paying themselves too much as a classic symptom of a wider “Agency Problem”:
The separation of ownership and control creates what financial economists call
an “agency relationship”: a company’s managers act as agents of its shareholders. The principals (the shareholders) cannot directly ensure that the agents (the managers) will always act in the principals best interests. As a result, the manger-agents, whose interests do not fully overlap those of the shareholder-principals, may deviate from the best course of action for shareholders. This is called the “Agency Problem”.[10]
The “Agency Problem” is the problem that you face if you employ people to look after something that you own. How do you make sure that they take care of it in a way that suits your interests, rather than in a way that suits their own interests? Shareholders face the agency problem in respect of the company directors that they elect. The general public face the agency problem in respect of the politicians and managers who they appoint to run public services.
Jesus comments on the agency problem extensively in his parables. Firstly there is the parable of the faithful and unfaithful servant (Matt 24:45-51, Luke 12:42-46). The servant is put in charge of the house while the master is away. If the master returns and finds the house in good order he responds by putting the servant in charge of all his possessions. This is “promotion”. Alternately if the master returns and finds the servant mistreating others and eating and drinking himself, then the servant will be cut to pieces. The parable emphasises the building of trust over time, with greater responsibility given to the servant with the good track record.
Luke’s account of the parable is followed by an analysis of the guilt of the unfaithful servant. There are higher expectations of those who have been entrusted with more. In terms of modern corporate governance, this suggests that the personal priority given to the shareholders should become higher, the more senior a manager is in a business organisation.
In the parable of the talents (Matt 25:14-30) the master asks no questions about the behaviour of the servants, but judges them solely on the financial return they have made. As the master has been away a long time, we can perhaps assume that any faults in the servants’ behaviours have had time to show through in the financial results. The same theme of trust being built on previous track record is emphasised when the successful servants are rewarded with greater responsibilities. This is further reinforced by the uneven initial distribution of the talents; the more able servants being given more, and by the master reallocating the unused talent to the most trusted servant, despite the fact that he already has the most. Luke’s account of a similar parable (Luke 19:11-27) echoes many of these themes.
Then there are two parables where the agency relationship is completely abused by the managers. The dishonest manager (Luke 16:1-13) knows he is to lose his job, so uses his master’s money to buy himself friends (though the master does find aspects of his behaviour to commend). In the parable of the wicked vineyard tenants (Matt 21:33-46, Mark 12:1-12, Luke 20:9-19) the tenants seem keen to forget that they are in any kind of agency relationship at all.
To scratch through these parables for insights on executive pay is probably seeking more from them than Jesus was ever intending to give! However it is interesting to see the assumptions that Jesus makes about the agency relationship and the agency problem. Jesus appears to see the agency problem as a metaphor for the difficulty that God has in getting human beings to behave properly. In the parables the master only ever seeks to manage the agency problem through trust. There appear to be no other mechanisms of audit or control. The managers are free to honour the master’s trust, or to abuse it. The consequence of honouring the trust is the building of greater trust and increased responsibility. The consequence of abusing the trust is dismissal or worse. There is a consistent theme of responsibilities and opportunities being handed over to the most trusted servants.
It is interesting to compare these assumptions of Jesus with the way that corporate governance works today. The 2006 version of the Combined Code uses the word “trust” only once in its 25 pages, and that is in the preamble. The word “honest” does not appear at all. The word “integrity” appears twice, but it applies to financial information rather than to people. In contrast the key words in the Combined Code are “transparency”, “control”, “independence” and “effective”.
Present day corporate governance is reluctant to ask shareholders to trust executives. Instead it emphasises the importance of aligning the interests of shareholders and directors. Alignment of interests is typically achieved through the way that directors are paid, and through performance related pay in particular. The idea is that executives get paid well if and only if the company performs well for its shareholders.[11]
And yet it is important to notice that this way of thinking about executives and company directors is a very recent development. Before the 1992 Cadbury Report there was no code of practice on corporate governance. In law the key concept was (and still is!) the fiduciary duty that a company director owes to the company, and in particular to the members of the company: its shareholders.
A fiduciary duty is the highest standard of care imposed at either equity or law. A fiduciary is expected to be extremely loyal to the person to whom they owe the duty (the "principal"): they must not put their personal interests before the duty, and must not profit from their position as a fiduciary, unless the principal consents. The fiduciary relationship is highlighted by good faith, loyalty and trust, and the word itself originally comes from the Latin fides, meaning faith and fiducia. [12]
The legal concept of fiduciary duty is clearly much more rooted in Christian thinking than the Combined Code. It depends on care, loyalty, good faith and trust. It also sits very uncomfortably with the current corporate governance practices described above. In particular loyalty does not fit with the executive changing companies in response to a better offer. Trust is reduced to trusting that the executive will do what is best for the executive, and company remuneration schemes must align incentives so that this is also best for the company. It is also widely assumed that the executive is using the company to progress his or her own interests, rather than seeking to serve the interests of the company. David Haarmeyer sees this as important:
…expecting managers to subvert their interests to shareholders is not realistic and indeed likely to lead to bad outcomes. This was the same idea that the Soviet state was model under -- that human nature is malleable. This is after all the point of corporate governance -- to use internal and external forces to align management's interests with those of shareholders.[13]
It is likely that David Haarmeyer is articulating the underlying assumptions of many people currently working in the field of corporate governance and executive pay. However, from a Christian perspective there are very serious problems with this position.
The first problem is that it presents an extremely pessimistic view of human nature. The human being (even those human beings at the very top end of our society) are unable to look beyond their own interests. This is much more pessimistic than mainstream business thinking which, when considering motivation, often refers to Maslow’s triangle of needs and the “self-actualizing” needs of top people.
A second problem is that it interprets good corporate governance as a balance point between the different vested interest groups which creates incentives for managers to deliver good outcomes for those vested interest groups.[14] This implicitly accepts that corporate governance is a power struggle in which executives, investors and investors’ representatives seek to optimise their own position. In reality the Combined Code does appear to be more the outcome of a power struggle between institutional investors and directors than a principle driven exercise to optimise outcomes for the underlying investors.[15] In this power struggle trust and co-operation are replaced by red-tape, regulations and controls.
But the biggest problem here is that individuals and institutions are expected to use their talents and powers solely to further their own agendas. This generally means maximising their own power and their own proportion of the wealth created by business activity. This creates a tension in which power and money are pulled towards those people who already have the most power and money, and away from those who are least able to defend themselves. This explains the increasing differentials in income, observed at the start of this article. It also resonates with the “war of the powerful against the weak”[16] perceived by Pope John Paul II.
Christians in business face the challenge of responding to these problems! The difficulty of finding responses that are both authentic and constructive should not be underestimated. Attempts to constrain executive pay when this is not what the company board really wants, tend to have undesirable consequences.[17] Effective change therefore requires a change in the hearts and mind of board members. One approach is to promote, by word and example, the positive values implicit in any Business Principles or Core Values that are published by the company. Sadly such publications are often not as constructive as the Principles for Those in Business[18] which emphasise values of service (principles 1 and 19) and trust (principle 7).[19]
Real success in corporate governance requires the directors to have an attitude of service towards the shareholders (and other stakeholders) showing that they respect the agency relationship and take their fiduciary duty seriously. The outward visible sign of this attitude is self-imposed restraint on executive pay. As Warren Buffet, America’s most successful investor, pointed out, executive pay is the “acid test”[20] of corporate governance.
Notes:
[1] Income statistics are taken from Table 3.6 (employment income only) available for tax year 2004/5, at http://www.hmrc.gov.uk/stats/income_distribution/table3-6.pdf . Table 3.6 for 1987/8 was supplied by HMRC following e-mail enquiries to the contact e-mail address provided in the website. The five fold increase compares the £6,780 million total earned by the 120,000 people earning more than £50,000 in 1987/8 with the £54,340 million earned by the 328,000 people earning over £100,000 in tax year 2004/5. Aggregate Inflation over this 17 year period was 83% [Based on Headline Rate of Inflation (RPI table RP02) from the table supplied at http://www.statistics.gov.uk/statbase/product.asp?vlnk=9412 ].
[2] Martin Wolf, “A new gilded age” in the Financial Times, London 25/04/06.
[3] Available from http://www.frc.org.uk/corporate/combinedcode.cfm .
[4] This does not mean that they are free of conflicts on interest. See Patrick Gerard A Response to the Consultation by the Financial Reporting Council October 2005, page 11, available from http://performanceandreward.blogspot.com/2006/04/combined-code.html .
[5] Combined Code, Main Principle B.1
[6] Patrick Gerard, Performance and Reward (Matador, Leicester) 2006, pages 178-182, 187-189
[7] Performance and Reward, pages 142-157
[8] http://performanceandreward.blogspot.com/2006/04/competition-law.html
[9] Lucian Bebchuk & Jesse Fried, Pay without Performance (Harvard University Press, MA) 2004
[10] Pay without Performance pages 15-16
[11] Performance and Reward argues that the credibility of this incentive alignment is seriously undermined by the structure of performance related pay typically used in the UK. Often the incentives faced by the executives have a short term and individualistic focus whereas the underlying shareholders benefit only from growth in shareholder value that is sustained in the long term.
[12] From http://en.wikipedia.org/wiki/Fiduciary, accessed 19/09/07
[13] David Haarmeyer, comment on blog entry at http://performanceandreward.blogspot.com/2006_06_01_archive.html added 04/08/2006.
[14] Compare definition in A Response to the Consultation by the Financial Reporting Council page 36
[15] A Response to the Consultation by the Financial Reporting Council pages 2-3,32-34
[16] Pope John Paul II, Evangelium Vitae, 25/03/95, paragraph 12.
[17] For example, according to the Financial Times Lex column 17/07/07, it was US Congress’ block on tax deductions for salaries in excess of $1million that lead to the explosion of executive stock options in 1993.
[18] See http://www.principlesforbusiness.com/
[19] For example Cadbury Schweppes describes “Aggressiveness” as one of the three key behaviours which should guide everyone in the company. See “our business principles” page 9 downloaded from http://www.cadburyschweppes.com/EN/AboutUs/PurposeValues/our_bus_principles.htm on 26/09/07.
[20] Berkshire Hathaway Chairman’s letter to shareholders 2003
Labels: Agency Problem, Christian, Combined Code, FiBQ, Fiduciary Duty
14 November 2007
Regulation of contracts for differences (CFDs)
The Financial Times today (14th November 2007) published a letter of mine about the regulation of Contracts for Differences (CFDs). The letter was a rehash of the letter posted on this blog on 8th October 2007. The letter makes the additional point that holders of a CFD should have no influence over the business of a company, just as people who bet on a cricket match should not be able to affect the outcome of the match. Any such influence dilutes the proper influence of the real shareholders on the share register. The full text can be read at:
http://www.ft.com/cms/s/0/fa07bfe8-9253-11dc-8981-0000779fd2ac.html (subscription may be required.)
http://www.ft.com/cms/s/0/fa07bfe8-9253-11dc-8981-0000779fd2ac.html (subscription may be required.)
Labels: activism, CFD, share register
12 November 2007
Moral hazard, bank incentives and the credit crisis
In August, Mervyn King, Governor of the Bank of of England, made an important point about "Moral Hazard" which has not been taken nearly seriously enough. His point was that if the Bank of England helps banks that have taken imprudent risks then it encourages banks to take such risks in the future. Banks (perhaps imprudent banks?) complained that his stance was out of line with Europe and America and impractical. But now that the Bank of England has pragmatically made credit available there is a danger than Mervyn King's important point is forgotten about and lost.
The moral hazard problem on bank's behaviour stems from an even more important moral hazard problem in the way that bankers are paid. It is far too easy for bankers to get extremely rich on annual bonuses and other short term rewards, before the risks that they have taken properly come home to roost. When the risks finally do come home it is someone else (the banks shareholders, or public financial regulators) who carry the cost. Bonuses are not retrospectively deducted.
The problem is further exacerbated by the way that bankers are appointed or dismissed. Promotion decisions are influenced far more by personal performance in the last 18 months (before the risks taken have come to maturity) than on long term performance. Then when the risks go wrong the top man might lose his job, but he is paid handsomely for it! The message to potential future executives is clear - short termism pays both on the way up and on the way down.
To avoid moral hazard we need to take long term performance far more seriously than short term performance. In this context I was delighted to read Patrick Hosking's article in The Times, (10th November 2007, page 61, "Time to reform the way bankers are paid").
He is absolutely spot on to say that the way that pay works in the big investment banks is at the very heart of the current credit crisis. The incentives for senior bankers work over a time frame that is far too short.
As Patrick Hosking quite rightly says, shareholders should be demanding better practice on pay. But this is so obvious that I think we have to ask why it has not already happened.
I believe one reason is that shareholders are represented by fund managers and institutional shareholders who typically have exactly the same incentive problem in their own pay. They receive big incentives based on one year cycles, which are not aligned with the interests of the underlying owners of the funds. This is most clear in the case of hedge funds. A hedge fund typically charges very high fees for a good year of investment performance, but does not pay money back if the value of the fund falls. A investment strategy that makes good returns four years out of five, but which is occasionally disastrous, therefore works very well for the hedge fund manager, but not for the underlying owner of the fund.
We should be just as concerned about the way that fund managers are paid.
The book "Performance and Reward" (see link "View the book" in left hand column) suggests solutions to these problems. First of all, it sets out a form of executive pay called a FILLIP. A FILLIP depends on a far more rigorous alignment of pay with shareholders interests, such that performance for top executives is only about long term growth in shareholder value. It also, as Patrick Hosking's article suggests, holds performance related pay in a manner similar to an escrow account for, say, five years. This ensures that value lost latter in the risk cycle is properly reflected in the performance pay.
The moral hazard problem on bank's behaviour stems from an even more important moral hazard problem in the way that bankers are paid. It is far too easy for bankers to get extremely rich on annual bonuses and other short term rewards, before the risks that they have taken properly come home to roost. When the risks finally do come home it is someone else (the banks shareholders, or public financial regulators) who carry the cost. Bonuses are not retrospectively deducted.
The problem is further exacerbated by the way that bankers are appointed or dismissed. Promotion decisions are influenced far more by personal performance in the last 18 months (before the risks taken have come to maturity) than on long term performance. Then when the risks go wrong the top man might lose his job, but he is paid handsomely for it! The message to potential future executives is clear - short termism pays both on the way up and on the way down.
To avoid moral hazard we need to take long term performance far more seriously than short term performance. In this context I was delighted to read Patrick Hosking's article in The Times, (10th November 2007, page 61, "Time to reform the way bankers are paid").
He is absolutely spot on to say that the way that pay works in the big investment banks is at the very heart of the current credit crisis. The incentives for senior bankers work over a time frame that is far too short.
As Patrick Hosking quite rightly says, shareholders should be demanding better practice on pay. But this is so obvious that I think we have to ask why it has not already happened.
I believe one reason is that shareholders are represented by fund managers and institutional shareholders who typically have exactly the same incentive problem in their own pay. They receive big incentives based on one year cycles, which are not aligned with the interests of the underlying owners of the funds. This is most clear in the case of hedge funds. A hedge fund typically charges very high fees for a good year of investment performance, but does not pay money back if the value of the fund falls. A investment strategy that makes good returns four years out of five, but which is occasionally disastrous, therefore works very well for the hedge fund manager, but not for the underlying owner of the fund.
We should be just as concerned about the way that fund managers are paid.
The book "Performance and Reward" (see link "View the book" in left hand column) suggests solutions to these problems. First of all, it sets out a form of executive pay called a FILLIP. A FILLIP depends on a far more rigorous alignment of pay with shareholders interests, such that performance for top executives is only about long term growth in shareholder value. It also, as Patrick Hosking's article suggests, holds performance related pay in a manner similar to an escrow account for, say, five years. This ensures that value lost latter in the risk cycle is properly reflected in the performance pay.
Labels: Bank of England, long term, Mervyn King, moral hazard, Patrick Hosking, short term
