11 February 2010
Changing the mindset
On 7th February 2010 (on ft.com) the Lex Column of the Financial Times published a note on Executive Pay. This can be seen at:
http://www.ft.com/cms/s/3/28c6e0cc-1414-11df-8847-00144feab49a,s01=1.html
(Subscription may be required.)
I added the below comment:
Lex has precisely identified the problem with the “take one for the team”, “clubby remuneration committee” attitudes. The top people in business are now engaged in a game whereby they compete with each other to extract more and more value from the rest of the community. This is utterly wrong and completely unsustainable. A total change in mind set is needed. We need a global (or G20 wide) cap on pay from employments/directorships. This would promote and enforce the idea that an executive’s job is to work for the benefit of shareholders and wider stakeholders, not for his/her own benefit. This principle of fiduciary duty is fundamental to company organisation. Capitalism is doomed if we can’t get back to this principle.
More on a global pay cap at www.performanceandreward.blogspot.com
See links to "global cap on pay" and "Competition Law" in left hand column.
http://www.ft.com/cms/s/3/28c6e0cc-1414-11df-8847-00144feab49a,s01=1.html
(Subscription may be required.)
I added the below comment:
Lex has precisely identified the problem with the “take one for the team”, “clubby remuneration committee” attitudes. The top people in business are now engaged in a game whereby they compete with each other to extract more and more value from the rest of the community. This is utterly wrong and completely unsustainable. A total change in mind set is needed. We need a global (or G20 wide) cap on pay from employments/directorships. This would promote and enforce the idea that an executive’s job is to work for the benefit of shareholders and wider stakeholders, not for his/her own benefit. This principle of fiduciary duty is fundamental to company organisation. Capitalism is doomed if we can’t get back to this principle.
More on a global pay cap at www.performanceandreward.blogspot.com
See links to "global cap on pay" and "Competition Law" in left hand column.
Labels: club, competition, Fiduciary Duty, global cap
11 December 2009
Bankers’ pay and the financial crisis
The Ecumenical Council on Corporate Responsibility (ECCR- see http://www.eccr.org.uk/index.html) have published an article of mine on bankers' pay (the bulletin No 75 - December 2009). A near final draft of the article is included below.
One of the most disturbing aspects of the apparent recovery in world markets since March 2009, is that banking is still being conducted in much the same way as it was before the crisis. Certainly there is much more talk about regulation, and banks are working on reducing their leverage, but the banking business model has not changed. It seems extraordinary that the traumatic events of autumn 2008 have had so little impact on banking behaviours.
One reason for this is that normal market disciplines have not been applied. Had market discipline applied then most, if not all, of our financial institutions would have collapsed. The economic consequences of this would have been apocalyptic, so it was not allowed to happen; governments bailed the banks out. Banks now operate with their risks underwritten by government. Unfortunately this means that the banks have less incentive to behave responsibly than they had before the crisis.
Another reason is that it is taking a great deal of time to define new regulation for the banking sector. The best way to regulate the banks is not obvious and sophisticated lobbying to defend vested interests is causing confusion in the process. On top of this many of the new regulations will need to be agreed internationally, so new regulation will not be implemented quickly.
But it seems to me that there are profound cultural reasons why banking behaviours have not changed, and these cultural problems most typically arise from the way that bankers are paid.
Banking culture assumes that a banker’s objective is to maximise his or her personal pay. Banks seek to constructively harness the bankers’ desire for personal reward by linking their pay to the profit of the bank. The message to bankers is, “If you make more profit for the bank, then you will be paid more!” Although very widespread, this link between profit and pay has proved to be fundamentally flawed and can only lead to further disasters if it is not changed.
The first central flaw in the pay-for-profit paradigm is that it values profit higher than the safety of the banking institution. Bonuses are far more likely to be paid for generating profit (which is readily quantified), than for keeping banks safe (which is hard to quantify). But in banking there is always a clear link between risk and reward. The most direct route to increasing profit is to increase the risks that are taken. The banker who is powerfully motivated to increase profit is therefore driven to find new and creative ways of increasing risk. This is why, in the build up to the crisis, banks increased their leverage, created hidden risks off balance sheet, and devised complex financial instruments that had the effect of hiding risk.
This is a fundamental problem. Whatever new regulations are devised by governments and whatever new controls are put in place by institutions, individual bankers still have massive incentives to create risk, to hide risk and to place risk with people who do not really understand it. It is clear that during 2006 many bankers could see that the force feeding of mortgages into the market was not sustainable, but they continued to do it anyway. Why? Because that is what they were paid to do!
But there is an even more fundamental problem with the massive incentives that bankers have to generate profit. The incentive regime has generated a culture which is entirely driven by the supercharged desire of individuals to make money for themselves. The banks can only succeed as institutions if they can constructively harness this volatile (and morally dubious) aspiration of their employees. The big problem is that it has proved impossible to perfectly align the self-interest of individuals with the long term interests of banking institutions. Forms of remuneration that take incentive alignment seriously have to have a long term focus, and have to make bankers accountable for the risks that they take. Unfortunately such forms of remuneration are considered uncompetitive in the marketplace for hiring banking talent; bankers (like everyone else!) prefer their rewards to be immediate and secure from claw back.
The gap in incentive alignment means that bankers can often maximise their own rewards in ways that are damaging to the banking institutions, especially over the longer term. Individual bankers, under intense competitive pressure, inevitably exploit incentive alignment gaps to their own advantage even if this damages the financial institution. The self-interests of bankers have therefore prevailed over the interest of banks and their shareholders. The culture has evolved into the precise opposite of Fiduciary Duty, that extraordinarily high duty of care which a company director is legally obliged to show to the company.
Bankers’ pay has therefore created a culture in banking in which the rewards of individuals are prioritised above the health and security of the financial institution they work for. This culture is extremely dangerous to financial institutions and to the governments that underwrite them. A complete change of culture is essential, and this can only be brought about by very radical changes in the way that bankers are paid.
One of the most disturbing aspects of the apparent recovery in world markets since March 2009, is that banking is still being conducted in much the same way as it was before the crisis. Certainly there is much more talk about regulation, and banks are working on reducing their leverage, but the banking business model has not changed. It seems extraordinary that the traumatic events of autumn 2008 have had so little impact on banking behaviours.
One reason for this is that normal market disciplines have not been applied. Had market discipline applied then most, if not all, of our financial institutions would have collapsed. The economic consequences of this would have been apocalyptic, so it was not allowed to happen; governments bailed the banks out. Banks now operate with their risks underwritten by government. Unfortunately this means that the banks have less incentive to behave responsibly than they had before the crisis.
Another reason is that it is taking a great deal of time to define new regulation for the banking sector. The best way to regulate the banks is not obvious and sophisticated lobbying to defend vested interests is causing confusion in the process. On top of this many of the new regulations will need to be agreed internationally, so new regulation will not be implemented quickly.
But it seems to me that there are profound cultural reasons why banking behaviours have not changed, and these cultural problems most typically arise from the way that bankers are paid.
Banking culture assumes that a banker’s objective is to maximise his or her personal pay. Banks seek to constructively harness the bankers’ desire for personal reward by linking their pay to the profit of the bank. The message to bankers is, “If you make more profit for the bank, then you will be paid more!” Although very widespread, this link between profit and pay has proved to be fundamentally flawed and can only lead to further disasters if it is not changed.
The first central flaw in the pay-for-profit paradigm is that it values profit higher than the safety of the banking institution. Bonuses are far more likely to be paid for generating profit (which is readily quantified), than for keeping banks safe (which is hard to quantify). But in banking there is always a clear link between risk and reward. The most direct route to increasing profit is to increase the risks that are taken. The banker who is powerfully motivated to increase profit is therefore driven to find new and creative ways of increasing risk. This is why, in the build up to the crisis, banks increased their leverage, created hidden risks off balance sheet, and devised complex financial instruments that had the effect of hiding risk.
This is a fundamental problem. Whatever new regulations are devised by governments and whatever new controls are put in place by institutions, individual bankers still have massive incentives to create risk, to hide risk and to place risk with people who do not really understand it. It is clear that during 2006 many bankers could see that the force feeding of mortgages into the market was not sustainable, but they continued to do it anyway. Why? Because that is what they were paid to do!
But there is an even more fundamental problem with the massive incentives that bankers have to generate profit. The incentive regime has generated a culture which is entirely driven by the supercharged desire of individuals to make money for themselves. The banks can only succeed as institutions if they can constructively harness this volatile (and morally dubious) aspiration of their employees. The big problem is that it has proved impossible to perfectly align the self-interest of individuals with the long term interests of banking institutions. Forms of remuneration that take incentive alignment seriously have to have a long term focus, and have to make bankers accountable for the risks that they take. Unfortunately such forms of remuneration are considered uncompetitive in the marketplace for hiring banking talent; bankers (like everyone else!) prefer their rewards to be immediate and secure from claw back.
The gap in incentive alignment means that bankers can often maximise their own rewards in ways that are damaging to the banking institutions, especially over the longer term. Individual bankers, under intense competitive pressure, inevitably exploit incentive alignment gaps to their own advantage even if this damages the financial institution. The self-interests of bankers have therefore prevailed over the interest of banks and their shareholders. The culture has evolved into the precise opposite of Fiduciary Duty, that extraordinarily high duty of care which a company director is legally obliged to show to the company.
Bankers’ pay has therefore created a culture in banking in which the rewards of individuals are prioritised above the health and security of the financial institution they work for. This culture is extremely dangerous to financial institutions and to the governments that underwrite them. A complete change of culture is essential, and this can only be brought about by very radical changes in the way that bankers are paid.
Labels: Bankers, culture, Fiduciary Duty, incentives
18 October 2008
Regulation of Bankers Pay
On Wednesday 15th October the Financial Times published a very good article by Jamie Whyte about the diffiulties of regulating bankers pay. The article can be read (by subsribers?) at http://www.ft.com/cms/s/0/62601d32-9a51-11dd-bfe2-000077b07658.html . The article discusses the principle-agent problem (how does an owner get a manager to work for the owner's interests and not his own) and advocates inovation in devising new arrangements for performance related pay.
I responded by writing to the FT letters column. My letter was not published but is included below.
Dear Sir,
I appreciated Jamie Whyte’s excellent analysis in “Why regulating bankers’ pay is still a bad idea” (FT 15/10/08) even if his conclusions are not quite right.
Mr Whyte points out that if a business owner wants to get good performance from a greed free manager then the owner must rely on the manager’s desire to what is best for the owner. Mr Whyte then suggests that it is over optimistic for an owner to assume that he has found such a manager. Clearly to “assume” this is over optimistic, so the real challenge is to find ways of building trust between the owner and the manager such that, over time, the owner comes to know that the manager really is working for the owner’s best interests.
Trust and fiduciary duty are fundamental to success of capitalism because they are the only satisfactory solution to the “principle-agent problem”. It is hard work to sustain trust and fiduciary duty and as concepts they might be profoundly unfashionable, but we shall not escape the financial crisis until they have been re-established.
Mr Whyte prefers the alternative which is to devise remuneration schemes that align the interests of the managers with the interests of owner. In adopting this approach the owner is seeking to harness the managers’ greed to his own advantage. This drives the principle-agent relationship towards mutual exploitation and away from trust. The approach breaks down because the managers have a strong incentive (which remuneration consultants collude with) to move remuneration practice along to make it easier for managers to secure higher rewards. The moving along of remuneration practice is often presented as “innovation”, but the innovations that are easiest to agree and get implemented are the ones that work best for the managers.
Under the incentive model, owners should insist on stable long term incentives that align the managers interests with their own. One reason why they fail to do this is because owners are themselves really managers (fund managers) who are themselves seeking higher rewards from principles, so they find it convenient to collude. In reality remuneration schemes like the FILLIP, which are really serious about aligning owner and manager interests, are of little interest in the market place of remuneration ideas.
Mr Whyte’s criticisms of regulation have some validity, but regulation that imposed and kept stable real long term incentive alignment between management and owners might well be the lesser of many evils.
The real solution however is to build trust with talented and hard working managers who are willing to work for the ownership interest. How does the manager build trust? Well accepting a flat salary with no extras of, say, US$500,000 would be a very convincing start.
Yours faithfully,
Revd Patrick Gerard
I responded by writing to the FT letters column. My letter was not published but is included below.
Dear Sir,
I appreciated Jamie Whyte’s excellent analysis in “Why regulating bankers’ pay is still a bad idea” (FT 15/10/08) even if his conclusions are not quite right.
Mr Whyte points out that if a business owner wants to get good performance from a greed free manager then the owner must rely on the manager’s desire to what is best for the owner. Mr Whyte then suggests that it is over optimistic for an owner to assume that he has found such a manager. Clearly to “assume” this is over optimistic, so the real challenge is to find ways of building trust between the owner and the manager such that, over time, the owner comes to know that the manager really is working for the owner’s best interests.
Trust and fiduciary duty are fundamental to success of capitalism because they are the only satisfactory solution to the “principle-agent problem”. It is hard work to sustain trust and fiduciary duty and as concepts they might be profoundly unfashionable, but we shall not escape the financial crisis until they have been re-established.
Mr Whyte prefers the alternative which is to devise remuneration schemes that align the interests of the managers with the interests of owner. In adopting this approach the owner is seeking to harness the managers’ greed to his own advantage. This drives the principle-agent relationship towards mutual exploitation and away from trust. The approach breaks down because the managers have a strong incentive (which remuneration consultants collude with) to move remuneration practice along to make it easier for managers to secure higher rewards. The moving along of remuneration practice is often presented as “innovation”, but the innovations that are easiest to agree and get implemented are the ones that work best for the managers.
Under the incentive model, owners should insist on stable long term incentives that align the managers interests with their own. One reason why they fail to do this is because owners are themselves really managers (fund managers) who are themselves seeking higher rewards from principles, so they find it convenient to collude. In reality remuneration schemes like the FILLIP, which are really serious about aligning owner and manager interests, are of little interest in the market place of remuneration ideas.
Mr Whyte’s criticisms of regulation have some validity, but regulation that imposed and kept stable real long term incentive alignment between management and owners might well be the lesser of many evils.
The real solution however is to build trust with talented and hard working managers who are willing to work for the ownership interest. How does the manager build trust? Well accepting a flat salary with no extras of, say, US$500,000 would be a very convincing start.
Yours faithfully,
Revd Patrick Gerard
Labels: alignment, banking, Fiduciary Duty, incentive, Jamie Whyte, regulation, trust
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
