Corporate governance debate should focus on getting company strategy and executive performance pay right, experts say

Out-Law News | 01 Dec 2016 | 5:34 pm | 6 min. read

If a much-anticipated review of the UK's corporate governance framework is to properly serve the public, it must address more than just capping, rather than improving, executive pay, or party squabbles about potential  U-turns, an expert has said.

Executive remuneration expert Graeme Standen of Pinsent Masons, the law firm behind Out-Law.com, was commenting as the government published a 'green paper' seeking views on executive pay; strengthening employee, customer and other stakeholder 'voices' on the boards of listed companies; enhanced corporate governance requirements for large private companies; and any other proposals that respondents might have.

"Theresa May always claimed that making business 'work for everyone' would be the guiding principle of her proposed reforms," he said. "Hopefully, the debate and policy-forming process that her government has now kicked off will encompass more than just capping, rather than reforming, the rapidly growing pay of those at the top of quoted companies: doing that might be justifiable and satisfy the public mood, but on its own it wouldn't serve the public well in the longer term. Investors and companies have been trying to get executive performance pay 'right' for years, and it would be a real triumph if this latest round of debate and reform can find a way to better align executive reward with performance of the kind that the UK needs."

"The consultation document seems genuinely open and broad-ranging, which is a good start, given the complexity of the subject and the desirability of business engaging with policy makers at an early stage. Some have been disappointed, or scornful, that the document does not simply advocate proposals that Mrs May had already made, or at least was understood to have made; such as workers on boards and annual binding shareholder votes on pay. But company law, reporting and corporate governance are complex areas, in which even good ideas might only work if implemented in a certain way, or might be best implemented by companies choosing the most appropriate of several options for themselves," he said.

In particular, the regulation of executive pay was "an area in which hasty state intervention without full consultation would have a high risk of unintended consequences", Standen said.

"Many are convinced, for example, that the reforms to UK directors' remuneration reporting in 2002 played a large part in driving up executive pay after that, even with the benefits of consultation," he said. "Sunlight may well be 'the best disinfectant', but transparency also facilitates bidding-up pay."

The section of the document addressing executive pay seeks feedback on a range of possible reforms.

"That the majority of the Green Paper is devoted to the thorny topic of 'executive pay' comes as no surprise," said Lynette Jacobs, incentives expert at Pinsent Masons. "Equally, the points raised in relation to executive pay are well rehearsed, many having been cited - and acknowledged as such in the green paper - by the Investment Association's Executive Remuneration Working Group in its final report published in July."

"The potential development of the Working Group’s, and others', suggestion that an 'escalation process' be applied, requiring a binding vote for companies which encounter significant minority opposition to pay awards in the previous one or two years, may be a pragmatic solution, setting a clear marker for companies and their remuneration committees. The jury is out on what that percentage level should be – the green paper suggests a figure in the range of 20% to 33%," she said.

The suggestion in the green paper that executives be required to retain any share awards until they built up a shareholding equivalent of double their gross total salary in order to "help further encourage a focus on long-term value creation at the companies they lead" seemed slightly strange, "given that this level of shareholding, or higher, is a current requirement at many listed companies", Jacobs said.

"The green paper also does not refer to the proposed requirement to continue to hold shares after leaving, included in remuneration guidance issued by Legal & General Investment Management and Hermes, and referred to in the recently updated Investment Association Remuneration Principles. That was a missed trick, perhaps, as the proposal could discourage decisions by directors in their final stint at a company which would flatter the share price in the short term, but undermine performance in the longer term," she said.

Among the suggestions included in the paper is a discussion of mandatory reporting of the ratio of the chief executive's pay to that of the median worker, Standen said. To an extent, the green paper was "catching up with a sudden enthusiasm for this idea", he said. This requirement is due to be introduced for listed companies in the US, and UK institutional investors have already recommended that companies should report this figure on a voluntary basis.

"In effect, this would be the latest and most intense incarnation of a long-running, and so far rather unsuccessful, policy aimed at 'shaming' companies and executives into moderating high pay by compulsory transparency," he said.

"While a pay ratio, and any change in it from year to year, could expose the gap between CEO and average pay in a brutally clear way, it is not obvious that in itself it must work, especially when previous phases of the same policy have not. A lot will depend on the details of the computation, and its consistency of application and any accompanying narrative. The green paper itself makes the sensible point that the greatest benefits from pay ratio disclosure might flow from the explanations and analysis that companies would want to add to the bare figure," he said.

Corporate governance reform has been central to UK prime minister Theresa May's plans for government since the early days of her campaign for leadership of the Conservative Party. Early speeches set out her support for policies including pay ratios, annual binding shareholder votes on pay policy and the inclusion of employee and consumer representatives on company boards.

As indicated in a recent speech by the prime minister to the CBI, the government does not propose requiring companies to appoint employee representatives to their boards. Instead, it is seeking views on the types of company that need to "strengthen stakeholder voices" and sets out a number of ways in which this could be done, for example through a stakeholder advisory panel, dedicated board-level representatives and giving an existing non-executive director responsibility for ensuring that these interests are being heard by the board.

"The consideration of stakeholder 'voice' in the boardroom is more interesting and potentially important than one might think, in terms of company law and corporate governance," Standen said. "There was long deliberation and broad consultation over updating and codifying directors' duties under company law, during the major reform project that culminated in the Companies Act 2006. Section 172 of that Act now sets out a careful formulation that boards, in general, should take decisions in the 'enlightened' best interests of the shareholders of the company as a whole - that is, taking into account in appropriate ways the interests of employees, customers, suppliers and other stakeholders as well."

"Many argue that this is increasingly necessary, as the beneficial ownership of shares in the often enormous, multi-national companies listed on stock exchanges such as London's is now very diffuse and intermediated; for example, held in pension funds that provide for thousands of individual employees and savers. At the same time, many are disappointed that the reforms attempted by way of section 172 seem to have made little difference to corporate behaviour, and that stock market performance now seems far less impressive than in earlier decades. For these reasons, there may be vigorous debate about this section of the green paper," he said. 

The paper also seeks views on ways to strengthen the corporate governance framework for large, privately-held companies, to ensure that "big businesses all play by the same rules". This could be done by extending a version of the UK Corporate Governance Code to these companies, by developing a separate 'comply or explain'-style code of conduct or by applying non-financial reporting requirements, such as on diversity or environmental issues, more consistently.

Commenting on the timing of the report, Graeme Standen of Pinsent Masons said that the earliest date on which any reforms might take effect would be around October 2017, with October 2018 perhaps more likely, given the open and wide ranging nature of the consultation.

"In the last round of corporate governance and reporting reform, which led to legislation taking effect on 1 October 2013, the initial discussion paper was published in September 2011," he said. "The latest consultation also seems likely to take some time to produce legislation, even if the government manages to do so in rather less than two years this time."

"The 2016/17 FTSE AGM season has already begun, and will see a three-year peak in companies renewing their binding remuneration policies, first introduced in 2013. If legislation takes effect before 1 October 2017, the changes could miss companies with early AGMs entirely, and be very difficult to manage for a significant number of companies with imminent AGMs," he said.

The consultation closes on 17 February 2017.