This purchase shares at a pre-agreed price, so directors

This essay aims to critically analyze the UK government’s proposals in dealing with the problems of rising executive pay. In doing this, the essay will briefly discuss the idea of director’s remunerations/executive pay. It will then look at the idea of agency problem it creates and the effectiveness of the current remunerations committees. Furthermore, majority of the analysis will stem from the UK government’s proposal1 in tackling the issues of increasing executive pay by analysing their effectiveness in practice. Overall, it will conclude that the reform places too much emphasis on non-legislative measures which might not be a reliable method in discouraging excessive pay and pay without performance.

 

Executive pay is a broad term for the financial compensation awarded to a public company’s executives. Companies want to attract managers who can make good use of its resources to generate the most value from those resources. Once they are in the job the aim of the remuneration is to incentivize the said executives who have a significant impact on company strategy and decision-making.2

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There is a need for a performance related pay which helps in aligning managers and shareholder’s interests such as bonuses on hitting set targets, the concern with performance-based incentives is that whilst a manager should be compensated for the increase in company value created by their efforts they should not be compensated for any increase in company value that has nothing to do with said efforts. An example of this type of remunerations are Executive Share Options (‘stock options’) – it will enable directors to purchase shares at a pre-agreed price, so directors hope that by driving the company profit share prices will increase. This type of remuneration is said to be paid with no correlation to performance, the perspective of the company is that they want to attract and retain the best people performing and making the best decisions, as such pay is an important factor in doing this.  

  

However, such incentives may encourage irresponsible levels of risk-taking, paying by way of performance can encourage entrepreneurial risk-taking in that top executives will take the risks they would not usually take which may present a long-term problem for the company.  3

  

Another concern with the idea of remunerations arise from the ‘agency problem’, which is the relationship between the shareholders and the managers. It arises from the delegation of authority or level of autonomy granted by the shareholders to the directors in which their interest may not be aligned and as such there may be conflicts of interest. 4

 

The constitutional contract (s 33 CA 2006)(REF) – delegation of power to the board was a way to remedy this problem.  The board appoints senior management and as a part, that process will enter into a service contract with managers which will include an agreed remuneration package. There is no automatic right to payment for being a director, but articles (e.g. the Model Articles for PLCs(REF)) usually provide that directors are entitled to such remuneration as the directors determine: this is where the conflict of interest arises. To remedy this, we have a remuneration committee who aren’t employed by the company so their career progression is not at stake. The overarching aim is to make sure no director is able to determine how much they should be paid for their services to the company. The board of directors determines the pay of senior executives who sit on the board – this can also pose a potential for conflict as the executive directors wield considerable power. If the executive directors have a significant amount of power on the board and the board is responsible for awarding their remunerations, it follows that they wield significant influences in the setting of their own pay and benefits. As a result, they are likely to act in their own financial interests and pay themselves more than the market rate. Additionally, there is an issue regarding the level of expertise required on remuneration committees, if they lack expertise this may result in them being too dependent on remuneration consultants who may well have close relationships with the company management.  

This problem becomes particularly acute when executive pay is increasing rapidly. Over the last few years, there has been reported rapid increase in executive pay. In fact, over the last 17 years, the average pay of a CEO of an FTSE100 company has risen by 400%. Importantly the ratio of a CEO pay to an average employee pay has risen from 47:1 to 128:1 in the same period5, so there is this genuine concern that executive pay is spiralling out of control in the UK.   

  

The reason executive pay is said to be high in the UK is that our equity capital market secure the highest level FTSE100 level. For instance, they are broadly defined by what is known as a ”dispersed ownership system’ so effectively, our listed companies are usually owned by a large number of shareholders that own small number of equity in the company so each individual shareholder is not motivated or incentivised to monitor management. Therefore, management is not particularly well monitored in terms of how they run the company and in theory this could mean managers are able to prioritise their own agenda over the best interest of the company leading to what is known as the agency cost for shareholders.   

In response to those concerns, the government has set out a number of proposals; the first proposal in respect of director’s pay, is to require quoted companies to publish their director’s remuneration and report the ratio of their CEO’s pay to the average pay of their UK employees. An advantage of this is that it serves as an effective means of checks and balances so as to ensure directors aren’t getting excessive pay. This proposal could also go a long way in aligning the levels of remuneration a company offers its executives, as current trends have no doubt generated adverse publicity for some companies and in some instance, some shareholders have shown discontent with the payment arrangement for executives. 

Conversely, this could lead the board tasked with determining the pay for top executives to be reluctant to offer what could be deemed as an acceptable level of pay in fear of public outcry when such report is published. 

 

However, it is unlikely that executive pay will fall significantly in such a short term as the white paper doesn’t really address the main cause of high pay which is that most shareholders seem to be happy with the status quo as there has been limited effort to curb/control executives’ pay. Perhaps a way to limit this is to impose a pay cap, but the problem with this is that it would be seen as an intervention and restriction on the company’s freedom.

 

 

The proposal of publishing the names of listed companies that receive greater than 20% shareholder opposition to executive pay packages would increase transparency, and scrutiny of listed companies by shareholders, media and the wider public. Data published recently shows that ”22% of companies listed on the FTSE All Share index such as Morrisons and WPP were among the firms that saw more than 20% shareholders oppose their remuneration reports this year – with revolts ranging from 21% at ad group WPP to 48% at supermarket Morrisons”.6

 

 

Association CEO Chris cummings also commented that ”a significant number of companies need to seriously start listening to shareholder views and acting on them.”7 this could also benefit the company in ways such as enhanced public perception and engagement.  

However, one of the main reasons there is rapid rise in executive pay is lack of shareholder’s exercising their rights under section 172 of the companies act 2006{ref}. Shareholder decision-making can only be made by way of meetings for public companies, and are viewed as an important arena for members to voice concerns. Historically, they were often well attended with vigorous debate and meaningful voting. Now, as Hannigan states it is a ‘weak and ineffectual method of control’ as it is poorly attended and shareholders are ill-informed. {ref} 

Moreover, those that attend do so in small numbers and are unrepresentative of all shareholders and this has resulted to an increase in shareholder passivity.  Perhaps a less controversial alternative rather than imposing a pay cap is to encourage voting by individuals as opposed to institutional shareholders, as these individuals are more likely to share the general public’s concerns about the high executive pay. However, as individuals now hold such a small portion of the shares in listed companies, any rise in their levels of engagement would be unlikely to result in a fall of director’s pay.  {ref}

 

The other main proposal was to introduce an employee advisory council or have an employee representative on the board itself, the aim of this is for the board to consider stakeholders interest. The idea here is that companies will be required or encouraged to constitute committees of stakeholders, rather than sole representation from only employees, consumers or shareholders as individual groups. These committees will be tasked with advising and consulting with the board in relation to policy and strategy. Although this would be a very good way for pertinent issues to be discussed from various stakeholder groups but in terms of having a real influence on the way policy and strategy of a company is formulated, it is unlikely to have significant effect.

With that said, if the advisory stakeholder committees were able to publicly publish their concerns and perhaps even details of their discussion with boards, this may have more of an effect considering the public fall out and potential damage to public relations should material concerns be readily available to scrutiny by the general public such that directors may be embarrassed into changing their strategy and policy. For example, the recent case of Bath university chancellor which led to her resignation after her excessive salary and bonuses were published8

 

Although this will definitely give increased prominence to stakeholder’s views and it will also ensure that directors listen to the voice of employees, the effectiveness of this reform in changing the board’s behaviour in terms of their actual decision is uncertain. A company that is well run should already have in place some sort of mechanisms for ensuring that stakeholder’s interests are taken into account,9 which could therefore render this reform unnecessary, however their attention will certainly be drawn to this key component of their obligation under the statutory statement of director’s duties.

 

 

perhaps some directors will benefit from having their attention drawn to this key component of their obligation under the statutory statement of director’s duties.  

 

Importantly, the proposal for designated non-executive directors potentially could be a good way forward for UK listed companies to have a board constituted of executive and non-executive directors. The concept here will be to designate a particular non-executive director as a liaison effectively to particular stakeholder groups. This approach could really give stakeholders including employees direct line of influence into the way policy is formulated.  For example, if the non-executive director designated to liaise with employees was also required to serve in the remuneration committee, if employees have concerns about the divergences between pay of executives and that of employees, the non-executive director could take those concerns directly into the forum of either the remuneration committee that they consult with or to the board whilst also providing input into policies on executive remuneration. Hence, the proposal to designate non-executive director to the board could be a potential solution to maintain control on the spiralling top executives pay in line with those of company’s average employees.

 

In conclusion, the current approach could be said to consist of a mixture of legislation and ”soft law” – the corporate governance code. The combination of both can be said to be a good way to balance company’s autonomy and shareholders and stakeholders  interests, however too much emphasis is placed on the non-legislative measures

 

 

Perhaps, what this new reform proposed by the UK government should have taken into consideration is as shareholder’s interests are being ignored, section 172 should be turned into a pluralist duty that ranks equally with shareholder’s interests.

 

Although using this method may seem radical, but in reality, companies as a whole are under increasing pressure to change their behaviour.  For example, as stated in the white paper the government will monitor the effectiveness of this reform and if its progress is insufficient they will consider further actions10 which begs the question as to why the government didn’t legislate accordingly in some areas in which they are convinced that there is a right and wrong way to behave.

  

Overall, the proposal does present a really interesting set of policies clearly targeted at a perceived disconnect between big businesses and society in general and with the climate of populous movement throughout the world this is going to become a political priority. It will be fascinating to see whether the implementation of this new legislation will keep a check on the rapidly increasing executive pay and pay that bears no correlation to performance.