Our contribution to the BIS select committee’s ongoing enquiry into corporate governance reform
Written evidence submitted by the High Pay Centre to the Business, Innovation and Skills select committee, October 2016
• Section 172 of the Companies Act 2006 is good as far as it goes. But it is open to misinterpretation and is not effectively “policed” (enforced). A new, properly resourced regulator is needed. Business should not have a “comply or explain” relationship with the law.
• A cultural and legislative shift is needed to make shareholders play a more active part in holding directors to account for their decisions, especially on the question of pay. It is unclear whether all shareholders are willing or able to act like responsible owners.
• Executive pay is out of control and action is needed. Important first steps would be making the publication of pay ratios mandatory, including employee representatives on remuneration committees, and making shareholder votes mandatory and binding. But these would be the precursors to necessary cultural change, which is the key to lasting improvement.
• Boards are not diverse enough. There are not enough women in executive roles, and not enough people from ethnic minorities. Directors are drawn from too narrow a social circle.
• We need employee representatives on remuneration committees (and probably on full boards as well). The “shopfloor” perspective in the pay discussion would bring a much-needed reality check.
1. About the High Pay Centre
The High Pay Centre (HPC) is an independent, non-party think tank focused on pay at the top of the income scale. The HPC was formed following the findings of the High Pay Commission. The High Pay Commission was an independent inquiry into high pay and boardroom pay across the public and private sectors in the UK, launched in 2009. On publication of the Commission’s final report in 2010, a permanent body (HPC) was founded in 2011.
2. We are grateful for the opportunity to make this submission. The HPC has played a prominent role in the continuing debate over executive pay, and has been involved in wide-ranging discussions on corporate governance and the purpose of business. While our main focus is on pay, we can offer relevant views on other questions being posed in this inquiry.
3. Section 172 of the Companies Act 2006 sets out some clear objectives – duties – for company directors. No distinction is made between executive and non-executive directors, as they have a similar standing in law. This makes sense as a unitary board should share a common purpose. The “duty to promote the success of the company” is often interpreted narrowly, and inaccurately, as though the phrase essentially refers to the share price. Thus takeovers are agreed on the basis of price and justified according to some notional (and fallacious) “fiduciary duty”.
4. The word “success” is clearly open to a number of interpretations. Companies do not always last forever; success could mean coming to the end of a useful life, or giving up independence to be part of a larger organisation. But generally “success” ought to mean continuing to trade and prosper sustainably, selling valuable goods and services, employing people and buying from suppliers, and being a responsible corporate citizen. Section 172 is only enforceable if shareholders or others wish to pursue legal action against a company for failing to observe the law: an extremely rare occurrence.
5. Section 172 requires companies to have regard for other stakeholders, while preserving shareholder primacy. Successful businesses tend to take a balanced approach to serving all stakeholders. As the writer John Kay has observed, on the trading floor at the US investment bank Bear Stearns there was a sign which said: “We make nothing here but money.” The bank was bought by JP Morgan in 2008 for a small fraction of its former value.
6. Shareholders should engage more energetically with the companies they invest in. This means scrutinising board decisions, voting on them, and maintaining a dialogue. There should be “challenge” in the boardroom already, from independent directors.
7. Fees paid to advisors should be disclosed. And there should be clarity on what has been paid for which specific services ie if a “big four” accountancy firm is providing management consultancy and/or pay consultancy these separate fees should be itemised. Advice from consultants may well be needed, but it is rarely cheap and these costs should be visible to investors. This transparency would provide helpful discipline.
8. The letter of Cadbury (1992) has been observed. But in practice the spirit of Cadbury has not always been held to so completely. Higgs (2003) sought to embed “challenge”, via independent directors, in his contribution to corporate governance reform. This too made some chairmen and boards uncomfortable. There will always be a tension between the desire for collegiality in the boardroom and the need for constructive criticism. Shareholders should insist that chairmen (and senior independent directors) are working hard to get the balance right, even if perfection in these matters is often unachievable.
9. The FRC has done a good job creating and overseeing the Combined Code, but it is not set up to “police” boards in their behaviour. To do so it would have to be reconfigured – probably replaced or reinvented altogether – and enlarged to carry out that role, and given new powers. (It should be noted there is quite deep scepticism about the FRC’s relationship with the accountancy profession.) The “comply or explain” mechanism is good in theory. In practice many boards complain that they feel obliged simply to comply with the code. (An alternative description of the mechanism is “comply or perform” – ie when a company is doing well shareholders are less exercised about the code. Of course, business should not be in a “comply or explain” relationship with the Companies Act: it is the law.) Others suggest that boards are protesting too much, and that investors are ready to listen to non-compliant explanations. It seems there has been a long-standing gap in understanding and engagement here, explored in the past by Tomorrow’s Company (eg http://tomorrowscompany.com/publication/tomorrows-corporate-governance-bridging-the-uk-engagement-gap-through-swedish-style-nomination-committees/ ). Has “comply or explain” come to the end of its usefulness as a mechanism? It feels as though something like systemic failure is occurring. This is exemplified most strikingly in the question of executive pay.
10. Something extraordinary has happened to executive pay over the past 20 years or so. The gap between top pay and that received by the average worker in the business has roughly tripled, from around 50x in the late 1990s to around 150x today. None of the explanations offered for this rise – globalisation, technological change, the so-called “war for talent”, the growth in the size of companies or in the alleged complexity/difficulty in having a top job – is at all convincing. Simply, the system does not work. People have been asking for more, and getting it. No effective countervailing forces have been deployed to stop this. CEOs are not necessarily entrepreneurial or “wealth-creators”; rather they are administrators of vast bureaucracies. Sir Philip Hampton, now the chair of GlaxoSmithKline but previously of Sainsbury’s and the Royal Bank of Scotland, told us recently that the larger a business was, arguably the less credit a CEO deserved: there is so much corporate infrastructure in place, with all sorts of crucial decisions being taken by others far from the CEO’s office.https://highpaycentre.org/files/FINAL_MADE_TO_MEASURE.pdf
11. The long-term performance of companies is measured not only in share price movements but in a range of other factors: product innovation, number of employees, reputation, market share, environmental impact, profitability, investment. It follows that tying executive pay to an at times arbitrary and unpredictable share price is not sensible. Share prices move for a variety of reasons beyond the control of an executive. And any credit reflected in the share price is down to the work of hundreds or thousands of people, not a single person. We have criticised the use of complex structures such as LTIPS in the past, calling for their abolition https://highpaycentre.org/files/No_Routine_Riches_FINAL.pdf . We understand that the Institute for Business Ethics (IBE) suggests that no pay package which cannot be clearly valued should be awarded, and we agree. We also share their view that cash is the best and simplest form of payment: good enough for the rest of the organisation, why not good enough for the boss? Remuneration committees should use their judgment and discretion when awarding (bonus) pay to executives, and be ready to explain their decisions to shareholders. (Another idea of the IBE’s worth pursuing is their suggestion that a statement on how the demands of Section 172 of the Companies Act are being met should be published. This would help shareholders assess how good a job the board is doing.)
12. Publishing pay ratios – which reveal the gap between top pay and that of the average worker in the business – is not a “silver bullet”. And there will of course be variation between different business sectors. But publishing these ratios will bring discipline and pressure to bear on companies. They will have to explain why they sit where they do in their sector. This also offers an opportunity: companies could argue that a tighter pay ratio relative to those of competitors indicates that there is greater cohesion and sense of common purpose in their business than elsewhere. This is a cost-free exercise as the data exist and are easily retrievable. Last November the HPC published a paper on this issue – “Pay Ratios: just do it” (link here: https://highpaycentre.org/pubs/pay-ratios-just-do-it ). It is noticeable that what was considered controversial only a year ago seems to have become unthreatening today, with leading investors such as LGIM and Hermes supporting the introduction of mandatory pay ratio publication.
13. Chief executives have not got three times better at their jobs in the past two decades. Companies have not been vastly more successful. Indeed, there have been two serious downturns in that time. The current gaps between top pay and the rest of the workforce are unprecedented in recent history. In the last century notable business figures such as the banker JP Morgan and the writer Peter Drucker both argued that a business leader did not need to be paid more than 20 times the pay of even the lowest paid worker, let alone the average figure. So current levels of top pay are very hard to justify. The CIPD carried out research last December which indicated that workers find the excessive pay of their bosses demotivating (link herehttp://www.cipd.co.uk/pm/peoplemanagement/b/weblog/archive/2015/12/18/dramatic-rethink-needed-on-demotivating-ceo-pay-levels-warns-cipd.aspx ). The government should make the publication of pay ratios (top to middle) mandatory, and investigate the possibility of requiring top to bottom ratios to be published as well. We note ShareSoc’s suggestion that a ten year data set on ratios would be useful. Publishing other internal ratios could be considered eg top to second highest paid. Country by country reporting, including data on workforce numbers, would also reveal more useful information on pay ratios. Crucially, “employee voice” is missing from the current discussion. Employee representatives should have seats on remuneration committees (see paragraph 17 below).
14. Recent negative shareholder votes on executive pay packages were a sign that asset managers have recognised things have gone too far. However, this so-called “shareholder spring” followed another one that took place four years earlier. And as with the “Arab spring”, the consequences of a burst of action are uncertain. The 2013 reforms have made it possible to assess the so-called “big figure” ie total remuneration for a CEO. But shareholder activism has been intermittent and unpredictable. Shareholder votes should be made mandatory and binding.
Composition of Boards
15. One obvious danger, alluded to by Theresa May in her speech of July 11 this year, is that boards are drawn from too narrow a social circle. There are risks of groupthink on non-diverse boards. For there to be effective challenge there has to be a better range of voices in the room.
16. The former EU justice commissioner, Viviane Reding, said: “I don’t like quotas but I like what they do.” The threat of legislation behind Lord Davies’ target of having 25% of board positions held by women provoked action (albeit overwhelmingly in creating non-executive director posts). It follows that quotas (or the threat of them) work. It may not be sensible to set targets for several minority groups. But measuring representation on the board will reveal the extent to which diversity has been achieved or not. It is also important to note that diversity of outlook and experience is also vital. Directors may look different, and there may be a good gender balance, but this does not mean that there is intellectual diversity on the board.
17. The HPC’s “locus” is pay. Our particular concern is the remuneration committee, a sub-committee of the full board. And here the ordinary employee perspective is clearly missing. RemCos could make better decisions on executive pay, and avoid a lot of bad PR, by moderating pay awards with the help of the “shopfloor” perspective. It would simply be harder to wave through excessive pay packages with employees in the room. Employees could elect representatives to the RemCo. There would have to be more than one rep, and they would have to be properly resourced/supported to allow them to make a full contribution. These reps could be (but need not be) union members. Our view is that electing employee reps to the full board may well be a good idea also. The RemCo remains our principal focus.
18. If we want to have more women in executive roles a quota or target will have to be set for that too. The precedent set by the Lord Davies target proves it. Targets or quotas get senior management’s attention, and provoke action. If you give people a target they will try to hit it.