“Top managers are also good at destroying value, doing a poor job and hurting shareholders’ interests,” he continued, so it is equally important to be able to get rid of them and to be able to get rid of then whenever necessary. He observed that there was a general feeling, probably justified, that executive compensation had gone beyond what one would normally call sensible. “Are top managers today worth 30,40,50 times more than they were only 20 years ago?” he asked. “Is their role so much more important today that justifies such extraordinary inflation of executive packages?”

Some very distinguished researchers argue that there is no limit to executive compensation other than the so called ‘outrage factor’. As long as you can get by without too much outrage, go for it! This makes for an issue of enormous emotional content.

“We need to curb excesses. We need to restore shareholder sovereignty. We must make sure that managers do not take over governance and award themselves huge pay offs with shareholders’ money,” he continued, “but at the same time, we need to have motivated executives, confident in the knowledge that they are recognised and rewarded when they do a good job.”

Concluding his introductory remarks and introducing the remainder of the session, Mr Borges reminded the delegates that the ECGI does not take a position on these matters. Its primary role is to sponsor research, stimulate debate and disseminate best practice.

Colin Melvin described a Caucus Race as a race with ill-defined goals in which everybody wins – “a very good description of the current state of executive remuneration!”

For institutional investors, remuneration is the quintessential corporate governance issue, he opined. Corporate governance is about ownership and control - shareholders’ ownership of companies and the extent to which companies are controlled by the directors. Corporate governance addresses the gap between these interests, and properly structured, it can align the interests of managers and directors with those of shareholders. “It seems to us that in the majority of cases it fails to do so at the moment.” he added.

He set out some of the problems associated with executive remuneration problems. Large payments to directors who fail are clearly not in shareholders’ interests. Pay and remuneration are difficult enough but made more so by consultants to companies who produce complicated reports designed, he felt, to pull the wool over the eyes of shareholders.

Often schemes have performance targets which bear no relation to the prospects of the companies concerned. This is not only inappropriate but also a missed opportunity. These schemes are intended to motivate executives.

Excess is a problem; the quantum of remuneration has not been addressed. A lot of time is spent talking about performance but less about the amounts paid to directors. “Is it alright for Mr Aldinger of HSBC to get $50million in his first three years and not do anything to actually earn that beyond being there. He could be sacked tomorrow and still get the money. Shareholders are not taking a view on that at the moment and we think they should.”

If these are the problems, what is being done about them? In July 2002, the ICGN adopted the statement on executive remuneration incorporating best global practice guidance. It called on Remuneration Committees to do three things:

1. ensure that levels and structures of remuneration are appropriate and reasonable;
2. stop authorising certain types of payment and incentives; and
3. provide full and clear disclosure of remuneration philosophies and payments.

It also called on institutional investors to so something – namely to devote more resources to understanding remuneration issues and analysing remuneration proposals. This addresses a big problem in the investment industry. Whilst there are one or two institutions such as Hermes that are prepared to put serious resources into this area (Hermes has a team of 8 people dedicated to corporate governance and a further 34 people working in specialised focus funds, making its governance stewardship and engagement resource in total over 40), others with more assets have one or two people looking at this problem. There is no way they can do this properly and yet this is in an environment where governments, the investing public and the pension funds all expect governance and the stewardship of their investments to be taken seriously.

“This situation cannot continue,” he said. “This was recommended in the ICGN paper and there is a call upon institutions that are members of the ICGN to devote more resources to this. It will be interesting this year to see if they have done that. I suspect many have not.”

Colin Melvin commented on the factors which the ICGN recommended as best practice. These included:

- that Remuneration Committees should be composed of truly independent directors;
- Remuneration Committees should be responsible for the appointment of consultants. Far too often, remuneration consultants are appointed by executives rather than non-executives. Clearly the consultants see themselves beholden to those that appointed them to provide the maximum value for the minimum effort which we think happens quite a lot and that is not a very happy situation;
- all aspects of remuneration of key executives and directors should be disclosed to investors;
- substantial direct stock ownership is the best way to align management and investor interests;
- remuneration should be linked to appropriate short and long-term performance measures;
- short and long term incentive arrangements should not be disproportionate to performance. This is crucial. There cannot be payments for failure and for just following the market upwards;
- options should not be the sole long-term incentive. The gearing effect within share options is inappropriate as an incentivising measure. If one wants management to act as shareholders, they should be made shareholders. They should be given stock not options;
- the investing term should be at least 3 years and options should be granted at regular intervals which would go some way to mitigating the effect of the gearing;
- employment contracts should not be used as retention devices and should be no longer that 12 months;
- companies should not loan money to executives or pay bonuses purely on the completion of mergers and acquisitions. Transaction bonuses have been a big issue in the UK since Vodafone in particular tried to award £10million to Chris Gent for completing the takeover of Mannesmann. Hermes argued at that time that awarding a bonus for completing the transaction was inappropriate. Clearly, it is the consequences of the transaction that are demonstration of the value added and so there has to be some link to what happens afterwards;
- institutional investors should increase the resources devoted to corporate governance.

Colin Melvin felt these were very sensible points which reflected UK best practice as it currently stands. He thought it was reasonable to expect that other markets should attempt to emulate them. They didn’t, however, address quantum.

There is very little appetite at the moment for addressing this thorny problem of how much should be paid to directors. At Hermes, the view is that the best way to do this is somehow to allocate a portion of the excess return generated by executives to them. “In order to move away from the ratcheting up of awards, a certain amount of value generated, with an appropriate cap, should be allocated to executives. This seems to take us in the right direction and we will be taking these ideas forward,” he concluded.

“In this paper,” he said “we try to highlight first of all the theory of corporate governance as applied to executive remuneration. Then we examine the rules applicable in Europe for executive remuneration. We also did some statistical research, looking at remuneration reports and similar documents of FTSE Europtop 300 companies”

The problem is simple to conceptualise. That is not to say that the solution to the problem is at all easy. The great virtue of Professor Ferrarini’s paper is that he brought out very clearly what seem to be the four available legal strategies for dealing with this problem. We don’t have to plump for one of them – indeed any jurisdiction is likely to plump for some mixture of them but it’s pretty clear what they are.

One strategy is disclosure. You require more and more disclosure in more and more detail and in greater depth and certainly on the basis of individual directors and not the board as a whole. This is a sort of ‘naming and shaming’ strategy. The main question is ‘is naming and shaming a sufficient counter incentive to the high powered self-interest which can be displayed in the remuneration setting?’

A second legal strategy is to say ‘this isn’t a problem of director remuneration, it is a problem of executive director remuneration so let’s shift the decision-making about executive director remuneration into the hands of the non-executives’. In other words, let’s structure decision-making on the board in a particular way and that leads you to go down the road of independent directors, remuneration committees etc which we know well about. The main question is to what extent can one rely on the independence of the non-executive directors?

The third legal strategy is to do what common law did 200 years ago – which is to say if the board is in a conflicted position, then it should be disabled in taking the decision about which the conflict exists. Some other body has to take the decision other than the board. Let’s move the decision to the most obvious alternative body, namely the shareholders. The disadvantage of this is that is slows down enormously the process of contracting over executive pay and possibly shifts the decision into the hands of people who are less expert than the board. That is why companies in their constitutions uniformly wrote out the common law rule by restoring to the board the power to take decisions on executive remuneration. There are ways, and this is the thrust of the 2002 reforms in the UK, in which one can re-involve shareholders in decision-making on executive remuneration whilst avoiding the disadvantages of slowness and inexpertise which might arise. The proposed way of squaring the circle in the 2002 reforms in the UK is to require an advisory vote from the shareholders on the board’s remuneration policies so that no executive director’s contract is negated as a result of an adverse vote by the shareholders. But an adverse vote by shareholders certainly has a significant effect on future contract setting by the company and probably leads to voluntary renegotiation of existing contracts.

The fourth strategy is to impose mandatory limits on the sort of contracts that a company and its directors can enter into. That is obviously the toughest form of legal intervention, a form of intervention that is most likely to produce unexpected results. There is some evidence of the use of this technique, not so much in legislation but in ‘soft’ law, in combined codes and those sort of things. Here one finds limitations on things like notice periods which is a way of controlling payoffs at the termination stage. The British government is currently consulting on the question of whether such limitations should be embodied in the companies legislation.

He concluded “those are the four strategies which have been very clearly explained to us. I don’t think any one of them by itself is going to be effective. There’s some sort of combination of them all that we need and I think the interesting question is what should that combination be.”

If one looks at the median compensation in the US for the largest 100 firms last year, there is an increase of 14 percent on the median level. At the same time, shareholder returns dropped by 22 percent. You also see huge severance pay packages paid to failed executives. This indicates that it is very difficult to find pay-for-performance links.

What are the reasons for this? One reason is that executives are able to influence their own pay arrangements. There is evidence for this in many countries, in Europe also of course.

The second reason is that although ultimate pay decisions are made by the board, based on recommendations made by compensation committees, initial recommendations are made by company management advised by compensation consultants. These compensation consultants are part of the problem.

If compensation committee members are themselves executives in other firms, executive pay is positively related to their own pay. Many studies indicate this quite clearly. Furthermore many studies show that executive pay is higher if committees are comprised of insiders.

What are the solutions to improve the situation?

The first solution is that any attempt to reduce compensation or bring it into line with performance has led, at least if you look at US performance, to the perverse result of increases in pay. So if you take only two data points in 1992, the better disclosure of pay in the US led to higher pay. Because people saw how much everyone gets, they then tried to get even more themselves. The same argument applies in European countries.

In 1993, again in the US, Congress declared salaries over $1million to be tax-exempted. What was the outcome? Companies opted for huge stock option grants. What is the solution? Regulation is the spur to innovation!

The argument that pay has to be high to attract talented executives is flawed. The hypothesis that there is a shortage of talented CEO’s is simply a myth. Pay has less to do with the market’s invisible hand than with invisible handshakes. There are many examples of this in the newspapers every day.

If you look at Europe, European companies usually pay their executives a small fraction of their US counterparts make. Yet they don’t seem to have any problem recruiting and retaining talents. The shortage of talent is thus a myth.

The third solution is that as long as executives have the freedom to behave as if they owned the place, and the real owners are behaving as if they didn’t, nothing will, change.

“What conclusions can we draw from this?” he asked. “Executive pay has to put to shareholders’ vote. How do you do that? Disclosure of executive pay is essential. We have seen some progress on this in Europe but countries are different. In the case of Germany, we see some disclosure but not in the same way.”

“Pay structure has to be made transparent and simple to allow shareholders to understand pay-for-performance links. The pay structure we see now, especially in relation to stock option plans, is too complicated not only for shareholders to understand. I get the impression that even executives don’t understand their own stock option plans! Any pay-for-performance analysis has to part of the business report otherwise we won’t see change. In the UK, most companies already do this.”

On non-executive directors deciding pay, he agreed this was a good idea but as these people are on each others boards, there is, as Professor Schwalbach so graphically put it, a lot of invisible handshaking going on.

The consequences of an advisory vote like the one we have in the UK at the moment, are as yet uncertain. He said he was told that before the GlaxoSmithKline vote, one possible consequence might have been the entire board resigning if they had lost the vote on pay. “Now clearly that hadn’t happened in Glaxo’s case,” he said “but still it’s not entirely clear what a company is meant to do if it loses the vote. Glaxo, as it happens, has started an extensive series of consultations, the first meetings of which happened this week.”

On limitation on the length of notice periods, he said that the effect of that in the UK, a reduction to one year, has not really led to a reduction in the amount paid to directors. They seem to have managed to keep that pretty high by including bonuses and pension enhancements and such like so we have to be careful about placing too much emphasis on the structure and not so much on the consequences.

Lastly, on simplicity and transparency, he felt this was very important. Schemes should be simple and transparent. People being incentivised by these schemes need to understand what they need to do to get their hands on the incentives. “Recently in the UK,” he told the audience, “Kingfisher took a very bold step and decided not to employ a consultant to produce its new pay scheme but to think it up themselves. The Remuneration Committee got together and decided what they wanted to do which was a very basic annual bonus which produced an amount of shares which had to be held thereafter. Their approach which was simple and it seems it would work. We supported it on that basis. It’s a very good development.”

Professor Guido Ferrarini said he entirely shared Paul Davies’ view that this is after all a very simple problem. “I would like to emphasise that an element of complexity would be added if we take into account the fact that ownership structures differ in Europe,” he added. The discussion which is often conducted concerns mainly diffuse ownership companies. One should think of the same problems in respect of concentrated ownership companies. “If we ask what the combination of the four strategies that Paul Davies mentioned should be, taking into account ownership structure, then the solutions could also differ and the roles of the board and the shareholders meeting could be different. For the rest I entirely share the view that remuneration should be more transparent and simple.”

From the floor, Marco da Rin, an academic and a Research Associate of the ECGI, said that from the panel discussion, he was struck by the absence of reference to the role of stock exchanges. Professors Ferrarini and Davies made the very good point that the way to deal with corporate governance issues is in large part due legal regulations which are taken at the national or European level. However the instrument of disclosure is also very important as we have seen in the tables and in the data. And here, stock exchanges certainly have some leeway. They can do a lot. “My questions are ‘what is the contribution of stock exchanges in this respect and how does competition amongst stock exchanges affect their ability to influence corporate governance through disclosure?”

Paul Davies said one needs to distinguish the question of developing special rules for listed companies and the question of whether the development of those rules should be in the hands of stock exchanges.

From the floor, Kurt Ramin, Commercial Director at the IASB, said that there would appear to be consensus that disclosure and transparency are very important. “Professor Schwalbach made the cynical remark that sometimes even the executive often doesn’t know what his stock options are worth so expensing it would be quite a difficult task to,” he opined.

“Disclosure by sector is very important too,” he continued. “We have all kinds of indices by sector – automotive, airlines etc and if one focused on that it would give additional transparency.”

Colin Melvin answered the last point by saying that it would seem that certain types of company within certain sectors might require different remuneration structures. At the moment, structures are broadly similar across the market but clearly in some types of company and endeavour, greater entrepreneurship is required and that should be encouraged. In others, the director is more of a manager and it would seem that different pay structures would be appropriate for different situations. “We are still some way as shareholders from finding a solution to these problems but these are types of thing we are considering at the moment,” he concluded.

From the floor, Gregor Pozniak, Deputy Secretary General of FESE, said that there are different approaches disclosure requirements in Europe, it. It can be done on a European level through a Directive. It can be done on the basis of regulatory competition on the national level. It can be done in the form of competition in private law admission rules to trading by individual exchanges.

“From a purely European standpoint,” he said “certainly competition of market segments, competition of exchanges through disclosure levels in the admission rules is an option, but as in other areas of disclosure, be it quarterly or half yearly reports, be it executive remuneration, there is not only the European aspect to it, there is also a global aspect to it.”

If privately run and competing exchanges subscribe to an overall goal of making the European time zone competitive with others, aspects of global expectations, global competition etc must be drawn into the discussion. There can be liberty for all as well as market competition and all functioning competition between markets and market segments. If this opens the door towards driving the divide between European countries and European exchanges, this may play into the hands of other time zone’s regulators which will continue to look down on Europe

Colin Melvin said that there was an interesting issue about competition amongst exchanges and the exacting nature of corporate governance requirements. There had been a fear amongst those involved in this area that onerous governance requirements might drive companies towards exchanges with less exacting requirements in terms of disclosure. He felt the nature of competition is the other way around. “Companies can attract a lower cost of capital by migrating towards markets with greater regulation and transparency,” he concluded.

Sir Geoffrey Owen thanked the speakers and the members of the panel for their contributions and the audience for their questions and drew the proceedings to a close.