Comments from ACCA to the Department for Business, Innovation and Skills (BIS), 25 November 2011.
1. Would a binding vote on remuneration improve shareholders' ability to hold companies to account on pay and performance? If so, how could this work in practice?
Yes, at least in theory, although it could only be one step in holding companies properly to account.
We are uncertain, too, whether a binding vote would have the desired effect and there may be unintended consequences. It could for example encourage highly speculative funds to rent shares for voting purposes from long term passive investors. The votes of these rented shares could then be used to hold directors to ransom for a purpose other than to kerb excessive pay.
The fundamental problem to be solved is how to make shareholders in listed companies more engaged. In a family owned company or indeed any company where a shareholder, or group of them, has a significant and long term interest, excessive executive remuneration is rarely a problem. Such shareholders already have the means and the will to ensure that pay is appropriate.
There are probably too many links in the investment chain to expect institutional shareholders to exert effective influence on board remuneration. The growing gap between executive pay and employee average pay is easily explained by the entrenched structural remoteness of board members, institutional investors and their advisers from ordinary people. This is ironic as companies employ 'ordinary' people; those same people, if they have savings or have pension plans, indirectly provide much of the capital for companies. Remuneration committees generally comprise former senior executives from similar companies so there is a group tendency towards 'generous' levels of pay. This group tendency extends to fund managers and others in the investment chain who also enjoy high levels of pay relative to most people.
There are many reasons why shareholders in listed companies where the shares are widely held do not engage. Many shareholders have only a short term interest in their investment, do not regard themselves as owners of anything other than a share, and have no, and never will have, an interest in engaging in the way that a long term owner should.
A few institutional shareholders would like to engage but most do not; all shareholders stand to gain from engagement but the few that would like to engage are reluctant to do much as all the other shareholders would benefit too. In other words, apart from doing what is probably the right thing from a trust and moral perspective there is no material incentive to engage. The irony is that all long term investors would benefit by better engagement but there is no incentive for individual shareholders to act if others do not.
Further, institutional shareholders invest money belonging to their beneficiaries. The former have little direct interest in engaging. There is a fiduciary relationship but institutional investors have few binding obligations to their beneficiaries and the nature of the fiduciary relationship is nebulous: while, clearly, the beneficiaries are interested in long term value appreciation and low volatility, some institutional investors interpret their duty as being to maximise the value of their investment in the short term. This results in a focus on current share price and acts as a deterrent to companies which want to invest for the long term or to engage in socially or environmentally useful activities.
Such companies are effectively ownerless so that directors can do much as they please. We support moves, such as by Fair Pensions, to get more clarity about the fiduciary obligations. We hope that doing so will mean that boards become more accountable.
Finally, it seems that what is today widely regarded as excessive levels of pay in the UK is a problem confined to the largest listed companies. It is not made explicitly clear whether or not the questions being asked relate only to listed companies and our answers assume that the questions are only about pay in listed companies. If legislation was introduced to make shareholder votes on pay binding rather than advisory, we recommend that such a requirement should be introduced first, on a trial basis, for the largest UK listed companies eg the top say 25 of the FTSE100.
2. Are there any further measures that could be taken to prevent payments for failure?
The best way to prevent rewards for failure would be to eliminate the causes of short termism. Our response to the Kay Review addressed the causes and made recommendations.
In addition, rewards for failure could simply be prevented by ensuring that directors' service agreements do not allow them. It is usually easier to stop a problem from occurring that to deal with if after it happens.
In our response to the consultation document Rewards for Failure: Directors' Remuneration - Contracts for Performance and Severance published in June 2003 by the Department of Trade and Industry (DTI) we stressed the importance of getting service contracts right in the first place.
3. What would be the advantages and disadvantages of requiring companies to include shareholder representatives on nominations committees?
Having shareholder representatives would be a clumsy and poorly focussed approach to the problem. Directors, in law, are required to act in ways that they consider are likely to promote the success of their company. It is generally agreed that for practical purposes the actions required to promote the success of the company will be the same as what would be required to promote long term value for long term shareholders.
Shareholders appoint, or confirm the appointment of, directors and they all have a duty of trust to shareholders collectively. In UK company law we have unitary boards, in practice convention and the UK Corporate Governance Code imply that non-executive directors in particular should act to a greater extent as representatives of shareholders.
What is needed is a shift in the mind set of non-executive directors so that feel their duty in trust to shareholders more powerfully. All directors should regard their duty as being primarily to shareholders (as a whole) as their key stakeholder group.
We suggest that giving shareholders a more direct influence in the appointment of non-executive directors would help. Further, one non-executive director could be appointed with a specific brief to represent the interests of shareholders.
It is worth noting that executive directors' propensity for maximising their pay is unlikely to be the best way for promoting the success of the company and, indeed, could threaten its long term success. In organisations with a healthy working culture, higher pay for executives is very unlikely to boost company performance. Studies of motivation and most people's personal experience tell us that pay above a fairly low threshold does not motivate people. The pay of most executives will be well above the threshold. Therefore any pay beyond what is necessary directly reduces shareholder value.
4. Would there be benefits of having independent remuneration committee members with a more diverse range of professional backgrounds and what would be the risks and practical implications of any such measures?
ACCA advocates greater diversity on boards and it follows that there should also be greater diversity on remuneration committees. This would help to counter the group behaviour tendencies referred to in our answer to question 1.
We first recommended this in our response in 2003 to the consultation document Rewards for Failure: Directors' Remuneration - Contracts for Performance and Severance.
We do not encourage having remuneration committee members who are not also members of the board. We would make one exception to this, however, and can see potential benefit in having an employee representative on the remuneration committee (see our response to question 6).
5. Is there a need for stronger guidance on membership of remuneration committees, to prevent conflict of interest issues from arising?
Guidance on its own will achieve little if interests and incentives do not change. There should be fewer opportunities for promoting self interest or benefiting from conflicts of interest.
Excessive levels of pay attract people with excessive levels of desire for high pay. Unfortunately greater transparency in pay has only served to mean that everyone pays more attention to it. In a system where executive directors are effectively able to pay themselves what they like, such transparency serves to increase their desire for more pay and ability to get it.
6. Would there be benefits of requiring companies to include employee representatives on remuneration committees and what would be the risks and practical implications of any such measures?
We recommended including an employee representative on the remuneration committee in our response to the consultation document Rewards for Failure: Directors' Remuneration - Contracts for Performance and Severance.
In our view, the benefit of such a practice should be to reduce the remoteness between board members and employees. Having more contact could help promote better alignment of their mutual interests and greater success for the company and its shareholders in the long term. Further, if executives can satisfy their employees that their pay is reasonable compensation for the value they add, there should be less public or shareholder concern. For this to be successful, both parties must approach this positively rather than as adversaries.
7. What would be the costs and benefits of an employee vote on remuneration proposals?
For organisations where most staff have access to computers, voting would be a straight forward and almost costless matter.
An optimist would see benefits for employees who could they feel more involved and possibly valued, which could boost business performance. If employees approve remuneration proposals executives might also benefit and find they can work better with staff. All this would benefit shareholders irrespective of any direct savings to the company in the bill for executive remuneration and therefore boost to profitability.
On the other hand, a pessimist would argue that such a vote would serve to create conflict and ill feeling between employees and executives. Executives might 'buy' votes by increasing employee pay. This would benefit employees and executives but not shareholders.
Given that shareholders will not stop the trend of executive pay outpacing employee pay, even though it would be in their collective interest to do, we must look for other mechanisms. An advisory vote by employees would be an interesting idea.
8. Will an increase in transparency over the use of remuneration consultants help to prevent conflict of interest or is there a role for stronger guidance or regulation?
It is necessary to distinguish between consultants who advise executives and consultants who advise remuneration committees. There is an obvious conflict of interest if one firm advises both groups even if it does not advise both groups in the same company. There is also a potential conflict for a consultant who advises both the remuneration committee and provides other professional services to management.
Unfortunately an increase in transparency is likely to benefit the more established consultants and create barriers to entry for new ones as companies will want to show they use a well known name.
Given the unintended consequence of transparency in pay ratcheting up executive pay more transparency in use of consultants may not be a good idea.
Although it is common practice for executives to cause the company to pay remuneration consultants to work on their behalf, it is difficult to see how such practice can be said to in accord with directors' duty to promote the success of the company. The opposite is nearer the truth as any additional pay reduces the funds available to the company and its profitability.
An alternative would be to ban consultants from advising executives on the structure of their pay. This would reduce the conflict of interest and mean that executives do not use company money to work out how to maximise their pay.
9. Could the link between pay and performance be strengthened by moving away from TSR and EPS as the key measures of performance?
It is too easy for executives to structure things in such a way to boost short term profit at the expense of profits over the longer term. For example, they could just reduce maintenance beyond what is prudent. Such a practice destroys company value over the medium and longer term yet perversely doing so may boost share price in the short term. So shareholders may be pleased for a while and executives improve their pay. Unfortunately, the short term focus by investors provides a strong incentive for executives to do exactly this.
ACCA calls for investors and other stakeholders to pay more attention to a wider range of measures for how companies create value.
10. Should more companies be encouraged to adopt vesting periods of more than three years?
In the absence of any more fundamental reform, longer vesting periods seems desirable.
11. Should companies be encouraged to reduce the frequency with which long-term incentive plans and other elements of remuneration are reviewed? What would be the benefits and challenges of doing this?
It is time to question the assumption that it is necessary to have pay so closely related to performance - particularly when the measures used are crude and easily gamed.
Remuneration structures have become so complex that it can be very difficult for anyone to know what payments will ultimately be triggered over several years. The recent media reports of executive pay increasing by 49% is an example of both this complexity and the lack of understanding. The increased payments were in part based on performance of companies in previous years. By other measures, the year on increase in executive pay is nearer 13% - still significantly more than average pay and still difficult to justify.
12. Would radically simpler models of remuneration which rely on a directors' level of share ownership to incentivise them to boost shareholder value, more effectively align directors with the interests of shareholders?
Remuneration policies should be simplified. Our answer to 11 above gives one reason for simpler pay models.
Another reason is that there is plenty of evidence of how poorly executive pay correlates to performance. It still harder to proved a causal relationship ie it can not be proved that higher executive pay causes better performance by executives or better company performance. The opposite can be true - higher pay can lead executives to game the company to improve their bonuses or value of their shares. Sometimes this can destroy the company - Enron was a good example.
13. Are there other ways in which remuneration - including bonuses, LTIPs, share options and pensions - could be simplified?
Pay a basic salary only. If necessary this could be supported by a share scheme (not options).
Most employees work hard for the simple reason that they feel that is the right thing to do, that they gain satisfaction from a job well done and enjoy social contact with others. They do so without complex pay arrangements - normally they just have a simple wage or salary. An executive is in a far better position to gain satisfaction from doing a job well as they can see more directly the results of their labours and they have more control over what they do. Why is it that executives need more complex pay structures?
What is obvious is why executives want such complex structures, it is harder to see what is in it for shareholders.
14. Should all UK quoted companies be required to put in place claw-back mechanisms?
It depends what is meant by claw-back. If executives receive substantial payments or shares for performance which destroys value or for profits yet to be realised then a mechanism to recover payments might be appropriate provided it was workable and did not have unintended consequences. If pay structures were simpler and basic salary formed a high proportion of total pay a claw back mechanism would not be needed.
15. What is the best way of coordinating research on executive pay, highlighting emerging practice and maintaining a focus on the provision of accurate information on these issues?
The stakes are very high. Executives stand to gain considerable amounts of money from maintaining the status quo where their pay rises far faster than other people's. Many consultants and others depend on them for their livelihood. As a result, many other groups of people, including some professional advisers and journalists, have a powerful incentive not to upset executives by saying their pay is too high or calling for reform.
This can also make it harder to raise funds for independent research. People that pay for research often have their own agenda for what they want the research to reveal.
As a result it is difficult to have either objective and unbiased debate or research. Debate too often reflects entrenched points of view and obfuscation.