Written evidence from Professor Grzegorz Trojanowski (University of Exeter Business School, Exeter, UK) (CGV0055)

 

Executive summary

The author and reason for submission

Professor Grzegorz Trojanowski is a Professor of Finance and the Director of Xfi Centre for Finance and Investment at University of Exeter Business School. Beginning with his doctoral research in the field of corporate governance, the author continues researching various aspects of corporate governance in the UK. The submission below draws on the results of my research project examining executive compensation practices, which was funded by the Economic and Social Research Council grant (“Executive compensation, incentives, and corporate debt”, ESRC First Grant Scheme, ref. no. RES-061-25-0416). In particular, it focuses on the conclusions of the survey of chairs of the boards (who typically also serve as chairs of remuneration committees) of UK listed firms, that I conducted as part of the aforementioned project. It sheds some light on the determinants of executive pay and thus fits within the remit of the current inquiry. While the questionnaire was distributed to all the UK-listed companies, the findings are based on almost 80 anonymised responses. Thus while the findings may not be fully generalizable to the universe of public firms, they do provide an illustration of the trends in a substantial sample of listed companies in UK.

Submission

  1. Importantly, while it is the level of executive pay that has drawn quite a lot of attention recently (incl. the remit of this Select Committee inquiry), it is widely acknowledged that the behaviour of top executives is crucially influenced by the structure of managerial incentives and compensation packages, which is likely to have important implications for long-term performance and even survival of companies. Over the last couple of years, inappropriate design of executive pay packages was highlighted by the Bank of England and the FSA as one of the factors that caused the recent financial turmoil. Still, the focus of both academics and policy makers until very recently seemed limited to promoting the alignment of managerial incentives with the interests of a single category of stakeholders, namely shareholders. This was also reflected by the UK Corporate Governance Code stipulating that "performance-related elements of remuneration should form a significant proportion of the total remuneration package of executive directors and should be designed to align their interests with those of shareholders." However, the unintended consequence of such an approach was the implicit conflict of interest between shareholders and other categories of stakeholders including creditors who usually prefer safer strategy choices relative to those favoured by shareholders. Too strong an alignment of incentives of managers with the shareholders' value may and, as the financial crisis has shown, does encourage executives to take excessive risks (The Walker Review, 2009). This in turn can harm the interests of creditors and of other stakeholders. The recently revised wording of the corresponding section of the Corporate Governance Code appears to avoid this pitfall by stipulating that “[t]he remuneration committee should determine an appropriate balance between fixed and performance-related, immediate and deferred remuneration. Performance conditions, including non-financial metrics where appropriate, should be relevant, stretching and designed to promote the long-term success of the company. Remuneration incentives should be compatible with risk policies and systems.” While this is a welcome shift in the regulatory position, the recurring calls for increasing the power of only one category of stakeholders (i.e. shareholders) in the pay-setting process may be misguided and further exacerbate the problems discussed earlier.
  2. The results of the survey I conducted reveal that three (declared to be almost equally relevant) factors stand out as the most important ones considered by the remuneration committees proposing compensation packages to CEOs and other top executives, namely: motivating the executives to work in the interest of firms’ shareholders, providing executives with appropriately-powered incentives, and being able to retain the CEO and other executives. In particular, while this perceived competitiveness of the market for executive talent is cited as an important or a very important factor by 83% of the companies surveyed, comparability with executive compensation in peer companies in the UK or worldwide is not deemed so crucial (only 41% and 13% of respondents, respectively, consider it important or very important), which raises some doubts about the validity of the retention arguments.
  3. Interestingly, while remuneration committees acknowledge the importance of providing appropriate incentives to managers (87% of respondents deem it important or very important); and 72% of companies want to reward the executives for their recent performance and contribution, only 38% and 41% of responding chairs of boards consider performance/ financial position of their companies to be very important and important factors, respectively, in determining executive pay. These numbers appear somewhat lower than what could be expected given the governance recommendations stressing the importance of tying compensation to (long-term) firm performance.
  4. A substantial proportion of UK executives (although smaller than in the US) receive some of their pay in the form of options and stocks. Moreover, many of these grants in the UK have a form of Long-Term Incentive Plans (LTIPs), deferred for a number of years and paid only upon meeting particular performance criteria, which should encourage longer-term orientation in managerial decision-making. Still, relatively few UK executives receive debt-like instruments as parts of their remuneration package, irrespectively of the capital structure of companies they manage. Hardly any CEOs receive compensation in the form of cash LTIPs. Meanwhile, bonuses (at best tied to short-term results) are prevalent. Overall, while the evidence confirms some alignment of managerial incentives with shareholders’ preferences in the UK (possibly weaker though than in the US), it does not appear that these incentives are congruent with those of other stakeholders (incl. creditors in particular). Hence, it is not clear that the current compensation practices “promote the long-term success of the company” as advocated by the recommendations of the Corporate Governance Code.
  5. The survey results also offer a cautionary tale about the companies’ response to external pressures, be it from shareholders, regulators, or other stakeholders. Only 28% of the responding companies consider the pressure from their shareholders to be an important factor influencing the remuneration committee recommendations on executive pay. This number, although low, is still much higher than the proportion of companies that deem the pressure from other stakeholder to be important in this context: the corresponding numbers are only 13% for the pressure from regulators and government; 7% for the pressure from the general public, media, and NGOs; 5% for the pressure from creditors; and 9% for the pressure with other stakeholders. Last but not least, only 37% of the companies consider the likelihood of the executive compensation proposals being accepted by the shareholders at the annual general meeting to be an important consideration in designing the recommendation packages.
  6. Taken together, this body of evidence suggests limited effectiveness of the current framework for controlling executive compensation in public companies: in this context,  firms do not appear to pay much heed either to governance recommendations or to a more direct pressure from stakeholders in general (and shareholders in particular, even when it comes to say-on-pay). While it is beyond the scope of the study I have conducted, further research should examine to what extent the limited role that shareholders seem to play in the executive pay-setting process stems from the passivity of companies’ shareholders (in particular, institutional investors) and their reluctance to challenge the companies’ proposals.
  7. Interestingly, my other research findings (as discussed in my other submission to this inquiry, focusing on board of directors) also reveal that compensation seems to be the aspect of corporate governance to which management pays particular attention. Among the firms where compliance with the board-related recommendations of the Corporate Governance Code decreases (which also happen to be companies where managerial power is high), the independence of remuneration committees is the provision most likely to be sacrificed. This suggests that managers do try to capture the pay-setting process and protect their remuneration packages.

 

26 October 2016

 

Reference

Walker, D. (2009). A Review of Corporate Governance in UK Banks and Other Financial Industry Entities. Financial Reporting Council, available at http://www.frc.org.uk/corporate/reviewCombined.cfm.