Executive Remuneration Part 2

Regulating Executive Remuneration: What Needs to be done? – Part 2

 

 

4.0  Literature Review

Since it was discovered that the 2008/2008 financial crisis and bank failures were contributed, among other factors, by a breakdown in corporate governance regimes and lack of market discipline, there has been a flurry of literature directed towards this area. The outcome of the intensive debate in this area has been that there is a need to introduce market-based remedies such as executive remuneration regulations and strict investor monitoring. Since this research is about the former remedy, it is only literature touching on executive remuneration that will be analysed, but the paper will not shy away from bringing other remedies if it is found that there is where they correlate with the main subject of the study.

Bebchuk and Fried have written a devastating critique of the way quoted companies pay their top executive, not only in the UK but across the globe. Their book, indeed, will shape debates on executive compensation and corporate governance in this period that there is a hot debate about the topic. The author regrets that top executive of companies continues to earn multi-million-dollar raises when their companies are underperforming and their share price are falling. The book attributes this trend to structural flaws in corporate governance that have produced widespread distortions in executive pay. The book notes that modern managers exert greater control over their own pay – a trend that has to change if firms are to be managed in the interest of shareholders. This is the reason that Avgouleas and Cullen observe that in the aftermath of the financial crises, a flurry of legislation and regulations have been enacted to try and exert control in remuneration policies. Avgouleas and Cullen agree with Bebchuk and Fried that the existing remuneration structures in banks “were strewn with perverse incentives which fostered short-terminism and excessive risk-taking and that, by implication, they were directly causative of the GFC and ensuing bank failures.”

Canyon discusses executive compensation and incentives in the U.S. Hill and McDonnell argue that the current law in the U.S. is not adequate enough to deal with the structural bias on executive remuneration. Such literature will be important for comparison. For purposes of comparison too, the research will also look at the regulatory framework in European Union. The EU has also published its green paper on corporate governance. According to Canyon, “the objective of a properly designed executive compensation package is to attract, retain, and motivate CEOs and senior management.” This objective is true in the U.S. as it is true in other countries across the globe. In the paper, Canyon discusses what has caused a sustained rise in executive pay. Among the attributes that Canyon cites are agency theory, shifts in firm strategy, changes in the managerial labour markets, and theories concerning managerial power. The importance of Canyon's paper in this research is that it explains the theories that explain how executive pay in organisation is decided such as the principal-agent model and the agency model. Hill and McDoonnell writes to say how the courts have intervened in executive remuneration. Bebchuk and Fried also discuss the managerial perspective on executive pay while Bertrand and Mullainathan discuss the skimming view of CEO pay. Core et al analyse executive pay from an economic contracting approach. The productive theory for instance explains CEOs' pay in terms of economic performance. According to this theory, the CEO's pay is simply a fair share of the corporate performance they deliver. All these theories are important in understanding how executive pay especially in quoted companies is decided. Grasping the theories will give the research a framework on which to build.

The relationship between executive pay and company performance in this debate has also come under sharp scrutiny. Gregg et al have examined how executive compensation is related to company performance for a sample of large UK companies with a bias toward the financial services industry.  Contrary to popular view, Gregg et al concluded that it was unlikely that hefty bonuses could have led to the financial crisis. Such literature and many more with a contrary opinions will be examined in the research in order to have a balanced view. At this juncture, it is important to look at what is considered to be the best practice in executive compensation. In an ideal situation, it is expected that executive compensation would be linked to company performance. However, as most of the literature notes, some of the companies do not have clear incentives. This leads to irresponsible behaviour and unrestrained greed. Trevor tries to analyse what could be the best practice when it comes to executive remuneration but cautions that arriving at an agreeable formula is a complicated business. The rule of thumb has been that companies should pay more to attract and retain top executives but ensure that the payment is aligned with the value drivers of the company. This is the reason why Trevor concludes that the best practice in executive compensation is “to attract and retain high-performing individuals that lead the company to success and create shareholder value.”

Most of the books and journals give a broader view of the topic. There are, however, government regulations and legislation that try to give a specific view of the subject. In 2002 the government enacted the Directors’ Remuneration Report Regulations which required that the executive remuneration policies of quoted companies be disclosed as well as the role of the board and remuneration committee. The disclosure had to show how the remuneration policy was related to performance. The regulation also required shareholders to approve the resolution on executive pay. However, the resolution was advisory in nature. A failure to implement the resolution attracted no penalty and therefore the regulations had no effect on the remuneration policy. The Companies Act 2006 sought to strengthen the 2002 regulation by setting out the format which could be used in reporting remuneration policy. According to the Act, ‘the directors of a quoted company must prepare directors remuneration report for each financial year of the company.” Failure to prepare this report is an offence as per this Act.

From the companies Act the UK has gone ahead to prepare different regulations in a bid to control top executive remuneration policy. In 2008, the government enacted the Companies (Summary Financial Statement) Regulations which required companies to prepare a Summary Financial Statement setting out the aggregate amount of directors’ emoluments. Shareholders are then given an opportunity to vote on the Summary Financial Statement. These rules only provided partial disclosure of companies’ remuneration policies. The rules remained loose until the aftermath of the financial crisis when the government felt that there was a need to tighten the rules governing remuneration policy. More emphasis, following this crisis was placed on reforming executive remuneration because it was felt that remuneration policy was at the heart of good corporate governance.

The UK government revised its Corporate Governance Code following the work of the Walker Review. The review noted that the “levels of remuneration should be sufficient to attract, retain and motivate directors of the quality required to run the company successfully, but a company should avoid paying more for this purpose.” Such a review will lay a good basis for this research. The review also gives recommendation on what needs to be done to regulate executive pay when it states that, “a significant proportion of executive directors’ remuneration should be structured so as to link rewards to corporate and individual performance.” The importance of such a review and the subsequent Corporate Governance Code in this research cannot be overstated. This research will commence from an assumption that a review of such stature commissioned by a government authority presents a balanced argument. As such, relying on such credible literature will help this research in coming up with a balanced and well-thought-out view on the topic. The UK Corporate Governance Code had clear intentions on how it expected to control executive pay, but it is surprising how it failed to do so seven years later. The Code provides a design of performance-related remuneration for executive directors whereby it states that “there should be a formal and transparent procedure for developing policy on executive remuneration and for fixing the remuneration packages of individual directors.” The caution of the code is that “no director should be involved in deciding his or her own remuneration”. The code goes further to provide the level and components of remuneration. The guiding principle, according to the code is that “executive directors’ remuneration should be designed to promote the long-term success of the company.” Those performance-related elements that are used to decide the executive remuneration should be “transparent, stretching and rigorously applied”. Such restriction on executive remuneration can be seen as a follow-up on the Companies Act 2006 as well as a response to the 2008 financial crisis.

The misgiving, however, on this government regulation despite this paper treating them as the bedrock of the research is that the government has enacted one resolution after the other without managing to address the issue of executive remuneration. The 2010 Corporate Governance Code has been reviewed several times, including 2012 and 2014. It will be therefore the work of this research to look at all these regulations critically with a bid of filling the gaps. As Bebchuk and Fried observe, the regulations are a set of soft laws that approach corporate governance from a “comply or explain’ perspective. The regulations give the board of directors the leeway to explain their action that is not consistent with the regulations. The judiciary, on the other side, as Tomasic and Avgouleas, and Cullen observe, exercises restraint in the view that “executive compensation decisions are business judgements vested in the board of directors that will rarely be second-guessed” without proving that the board of directors acted in bad faith. The Financial Reporting Council, nonetheless praise the “comply or explain’ approach arguing that it remains an effective alternative to a rule-based system. Although the Financial Reporting Council has praised the existing regulation as “the trademark of the corporate governance in the UK” due to its flexibility, it is important to analyse whether the set framework is adequate to check the spiralling executive compensations. This leads the research into comparing the ‘comply or explain’ approach with the rule-based system that is likely to be part of the proposed outcome of the research. The research will also look at the different opinions that tend to argue that regulating executive remuneration is not the solution. According to Kay, executive pay is self-regulating.

The recent attempt by the government to control executive remuneration has come in form of a green paper on corporate governance reform. The green paper focuses on three areas for parliamentary debate – the key of them being executive pay. In the preamble of the green paper, the government extols the UK as a world leader in corporate governance due to its high standards but flexible regulations. It is with this background that the green paper invites solutions on critical areas such as executive pay. While introducing the paper, the prime minister remarked that ‘for people to retain faith in capitalism and free markets, big business must earn and keep the trust and confidence of their customers, employees, and the wider public.”  The prime minister noted that “where this social contract breaks down and individual business decides to play by their own rules, faith in the business community as a whole diminishes.” This is why the government while introducing the green paper believes that something has to change. Basically, what the green paper envisions in regard to executive pay is that there will be a binding vote on all or some elements of the executive pay package. This is as far as shareholders' voting and other rights are concerned. Another option that the green papers look at is shareholder engagement on pay where there will be mandatory disclosure of fund managers’ voting records at AGMs and the extent to which they have made use of proxy voting. In addition, the green paper invites debates on the role of the remuneration committee, transparency in executive pay, and long-term executive pay incentives. On the remuneration committee, for instance, the green paper advocates for a consultative process that involves the shareholders and the wider workforce in preparing its pay policy. This research will look at all these options and analyse their objectivity in regard to regulating executive compensation.

Various responses have emerged in response to the green paper. The Financial Reporting Council (FRC) has cautioned that any changes to the UK Corporate Governance need to build on its existing strength such as the ‘comply or explain the approach.’ According to FRC, “the role and remit of the remuneration committee should be extended to cover pay policies throughout the organisation.” Other organisations that have responded to the green paper include the PWC, PLSA, SSGA, and Hermes Investment Management. Most of these organisations support the move to introduce transparency and accountability as far as executive pay is concerned. However, Hermes Investment Management believes that “care should be taken to not unintentionally usurp the role and responsibility of directors.” Similarly, the law society while welcoming the reforms cautions that there is the risk of the “measures being unduly prescriptive.” According to the Law Society, “a single approach to a highly diverse corporate environment is likely to be unworkable and counter-productive.” All these different responses will be relied on to build on the research.

5.0  Ethical Considerations

This research does not involve significant ethical risks. However, there are a number of concerns that this research will look at in order to maintain high ethical standards. Some of these concerns include the privacy of various executives who might be mentioned in the research, the confidentiality of company materials, respect to copyright laws, cultural sensitivity, disclosure of finding,s and objectivity.

Each individual has a fundamental right to privacy. According to the Human Rights Act 1998, all citizens, irrespective of their status in society, have a fundamental right to private and family life. Though inquiring about top executive pay is not a violation of this law, some of the employees may treat their salary as personal secrets. Inquiry into their pay may thus be treated as an intrusion into their privacy. As such, this research is likely to encounter the intricacies of the Data Protection Act 1998. For the purpose of this Act, salaries and remuneration are treated as personal data.

However, this does not mean that it is illegal to publish salaries and bonuses information; what it means is that every researcher has to be considerate of how that information is published. With the current trend towards transparency, salaries, and bonuses are seizing to be personal data, but it is important to be concerned. The reason for this concern is that salary relates to an individual’s financial circumstances. To those executives who are introverted, they may wish this information to remain private. More importantly, disclosure may prejudice an employee’s interest in an ongoing salary and remuneration negotiation. To circumvent this ethical concern and still retain the high standard of research, the paper will be more general with the salary information rather than being specific to particular CEOs. However, it is important to note that a considerable number of CEOs' pay is already in the public domain. In addition, employees’ personal data seizes to be much more sensitive with seniority.  The right to privacy does not only stop with employees. Companies also have a right to confidential information. Such information could one that may affect a company’s competitiveness. As a result, this research will be concerned with how it publishes sensitive employee and company information. In summary, the research will comply with the law in regard to access to information. In addition, the research will observe confidentiality where it applies.

The other ethical concern is objectivity. Executive remuneration is a topic that has attracted hot debate in the recent past.  In such a climate, there is the ethical risk of falling to either side. To avoid such a risk, the research will be guided by the ethical principle of objectivity. In order to attain this, the researchers will carry out wide research and evaluate all the proposals and concerns in order to arrive at a balanced conclusion.

Another concern likely to face this research is the issue of copyright. This topic has been studied before and also legislated on. Some of the ideas that will be advanced in the paper might be borrowed from previous research. The paper will have a chapter on literature review. Some of the information may be pulled from the company’s website. To respect copyright, any idea that will not originate from the research will be acknowledged. The authors or initiators of particular ideas will be duly acknowledged.

6.0  Proposed Research Timetable and Chapter Heading

 

Proposed Chapters

Chapter 1: Introduction

Chapter 2: Literature Review

Chapter 3: Methodology

Chapter 4: Executive Compensation and Corporate governance

Chapter 5: Is regulating executive compensation a realistic objective?

Chapter 6: Best Practices in executive Remuneration

Chapter 7: Conclusion and Recommendation

 

 

 

 

Bibliography

Avgouleas E and J Cullen, ‘Market Discipline and EU Corporate Governance Reform in the Banking Sector: Merits, Fallacies, and Cognitive Boundaries’, [2014] 41 Journal of Law and Society 1, pp.28-50, at p.33

Bebchuk L and J Fried, ‘Pay without performance: The Unfulfilled promise of executive Compensation,’ (Harvard Business press, 2006).

Bertrand M and S Mullainathan, ‘Agents without principals’, [2000] 90 American Economic Review, pp.203-208

Canyon M, ‘Executive Compensation and Incentives’, (Academy of Management perspectives, 2006) at p. 24

CIPD, ‘What employees think of their CEO’s pay packet’, (CIPD, 2015)

Core J et al, ‘Corporate governance, chief executive officer compensation and firm performance,’ [1999] 51 Journal of Financial Economics, pp. 371-406

Department for Business, Energy & Industrial Strategy, ‘Corporate governance reform: green paper,’ BEIS/16/56, at pp. 23-31

Financial Reporting Council, ‘FRC Response to BEIS Green Paper consultation on corporate governance reforms’, [Feb 2017]

Financial Reporting Council, ‘The UK Corporate Governance Code’, (FRC, June 2010)

Gregg P, ‘Executive Pay and Performance: Did Bankers’ Bonuses Cause the Crisis? (University of Bath, 2011) at p.2

Hermes Investment Management, ‘Corporate Governance Reform Green Paper’, [Feb 2017]

Hill C and B McDonnell, ‘Executive Compensation and the Optimal penumbra of Delaware Corporation Law’, [2009] 4 V. L. & BUS. REV 2, pp.333-374

Kay I, ‘Regulating CEO Pay is not the Answer’,  (Harvard Business Review, June 2009)

Norris K and R Kelly, ‘Economics of Australian Labour Markets,’ (Pearson Education, 2005) at p.103

The Law Society, ‘Law Society Response to the BEIS Green Paper on Corporate Governance Reform’, (The Law Society, Feb. 2017) at p.1

Tomasic R, ‘Company Law Modernisation and Corporate Governance in the UK- Some Recent Issues and Debates,” [2011] 1 Victoria Law School Journal, pp 43-61, at p.58

 

Statutes and Case laws

Companies (Summary Financial Statement) Regulations, 2008

Data Protection Act 1998

Directors’ Remuneration Report Regulations, 2002

Freedman v Adams, 58 A.3d 414 (Del.2013)

Green Paper-The EU corporate governance framework

Human Rights Act 1998

The Freedom of Information Act 2000

The UK Corporate Governance Code (September 2010)

The UK Corporate Governance Code (September 2012)

The UK Corporate Governance Code (September 2014)