The weakest link in capitalism as practiced today in the US, UK and other but not all countries, is that the interest of the individual top managers is no longer the same as the company or the shareholder interest. Thus, managements can and do increase their incomes and wealth whilst their companies’ and shareholders’ income and wealth declines. Reading this statement you may be saying, so what’s new, we know that; have known it for some time.
The point is that capitalism cannot function with this misalignment of interests. Crisis must periodically follow crisis until capitalism has its cockpit rewelded to its fuselage. Corporate aeroplanes are falling out of the sky, to be caught just short of the ground, patched together by governments and returned to the air. But the weakness remains. The cockpit behaves as if it is independent of the fuselage, engines, fuel supply, ground support and aeroplane owners. Its behaviour is reinforced in its own mind by the disproportionate and increasingly large rewards it receives. If you earnt that much money, you would start to believe you could walk on the corporate water.
Capitalism has worked because the interests and objectives of shareholders, companies, and managements are the same. It works even better if the staff and workforce feel they have common interests with the company and management. Thus, Victorian capitalism, based on the exploitation of workers, was transformed into considerate capitalism, which is now the norm in much of the developed world and is expected of the modern visible corporate.
At the company level, the method by which capitalism produces wealth is broadly this: the shareholders invest their money in a company, to earn a return in the form of dividends and/or capital appreciation. The company itself is established in law with a duty and accountability to its shareholders. A board of directors at the head of a company has in law a sole duty to its shareholders and, in practice, this duty is to maximise shareholder returns. The board then employs some senior management to run the company to deliver this return, and the management employs the staff and workers to make the products/provide the services which produce the profits that provide the return. Each person is paid his/her market rate. If talent is scarce and in demand then the market rate will go up, and vice versa. Top managers in football clubs have seen their market worth go up enormously in recent years as the money in football has inflated plus the impact of a top manager on the team’s results has been appreciated. You may not like it, but it is a market rate.
But, step-by-step, first in one company, then in another, managements found they could ratchet up their take beyond their market worth. Year after year, managements persuaded their boards to increase their pay disproportionately, using the increased pay of managements in other companies (up to the same game), as justification for their own increases. In theory, remuneration committees are there to control top pay and to hard wire it to company performance and thus shareholder returns, a critical link in the capitalist system.
In practice, the relationship between the non-executives on a board and the senior managements is an odd one. They need to act in unison and work as something of a team. They are trying to do the same thing – run a company successfully. But the senior management are also accountable to the board for their performance, and therefore to have their performance measured, their contribution appraised and their pay set. The senior management are full -time and have access to all management information. The non-execs are part-time, often as little as a day per month, and their access to information is through the senior management. Knowledge and presence are power.
As with most people at the top of an organisation, the egos are large and the personal need for control and power is high. Chief execs don’t like their power being limited, nor being checked or corrected. To add to the dynamic, the chief executive often has the role to find non-execs, the non-execs are up for reappointment every three years usually, and if the chief exec does not then want you, you may well be out. It’s sort of like the prisoners voting on and off the prison guards every three years. It doesn’t really work. It takes a strong and experienced chairman to hold the right balance in this arena of challenge and cooperation, friendship and firing, the psychological need for power and the shareholder and legal need for accountability and transparency.
In recent times, the first attempt to improve corporate governance was in the wake of the BCCI and Maxwell failures and the controversy over directors’ pay. The Cadbury review, reporting in 1992, made particular progress with establishing audit committees. These had impact. It also recommended remuneration committees to set directors pay, with a majority of non-execs. Subsequent corporate governance reviews have flowed thick and fast as more failures followed and Cadbury, for all its good work and intent, was found to be insufficient for dishonest, greedy, gullible or semi-competent managements. Greenbury (1995), Hampel (1998), Turnbull (1999), the Combined Code (2000), Higgs (2002) and Smith (2003) followed in the UK alone. Seven reports and a whole series of actions were followed by last year’s banking fiasco and this year’s bonus outrage. Broken Britain indeed. For all the qualities of their chairs and members, the number of committees has proved proportional to the rise in pay at the top, not the intended converse. To suggest that the current model of corporate governance does not work seems almost tautological. But the working assumption of regulation and regulators is that it does. Key decisions in companies are not actually made according to the paper theory.
Remuneration committees are as effective as a damp toilet roll. Typically managements propose their pay package plus all the share and pension bells and whistles. This is accompanied by justification of the proposals by the pay of people in similar roles in other companies (who simultaneously are doing the same in their own companies). This is supported by a remuneration consultants report (the consultant being hired and paid by the management, using comparative data to rationalise their inflationary role). In reviewing these proposals, the non-execs want to keep the management happy and rejecting their pay proposals is a bit like a vote of no confidence; the last thing non-execs want is a board room crisis with public dissent or resignations/sackings which is both bad for the share price and very time-consuming; and often it is seen as the height of bad manners to reject these pay proposals. I have seen it. It is the gentlemen’s club effect. Further, some of the non-execs are full-time executives at their own companies, subject to just the same pay process and with a strong vested interest in a process that has hyper inflated their own pay. There are a very very few top managers who, for good reason, could go on the market today and secure the same rate as their current remuneration. Such visionaries and leaders are few and far between. A 50%+ drop in pay would restore some rationale. Most directors can aspire to being good, and to turn the corporate wheels satisfactorily. This does not justify an entrepreneurial heroes pay. Far more people could do these jobs well than are ever given the chance.
In this environment, it is hardly surprising that pay has been ratcheted up and up to the point where, with the banks, there is no relationship between top pay and shareholder interests and returns. At the same time as this critical linkage has been broken, another flaw in the system has allowed ultra high-risk behaviour with no regard for shareholders at all. Many years ago, the original point of the law establishing companies limited by guarantee was to allow entrepreneurs and managers to take risks to build businesses and provide new products and services. This has been a foundation of economic growth. Taking risks is crucial. If the individual is liable for each market risk, little innovation and growth would occur. However, this laudable aim has allowed bankers to do anything, without consequence. Thus, highly complicated financial instruments are developed and sold to the gullible without any regard to the risk involved, whilst the remuneration systems are used to massively reward themselves.
Bingo! Managements’ interests are no longer the shareholders. The individual can make a small fortune in a very short time and escape with it intact when the company goes down. Until the individual’s interests are restored to being those of the shareholder and company, we can anticipate continuing fatal behaviour. At the same time, regulation is founded on the corporate governance architecture developed in those seven reports. But as described above, this is not how critical decisions are taken at the top of companies. The regulators must fail.
There will be more to it than this, but step one is to remove blanket immunity from personal liability. Entrepreneurial risk is crucial. Reckless risk needs personal consequences if it is to be stopped. In the partnerships of accounting and legal professionals, although some recent changes in the law have in theory limited the personal risk, the culture remains of the entire assets of the individual being at stake for failures by the partnership. Thus an audit failure, for example from Enron to Maxwell, could result in the firm paying the claimed damages which would go way beyond any insurance cover and mean seizing the house, possessions and investments of the individual. I can assure you this focuses the mind in every business decision, and quite rightly. Exactly the same regime should apply to all bankers at any level (and not just to the directors) who are taking risks with the company’s, shareholders’ and investors’ money. Under this regime, we would now see bankers and traders at all levels being rightly sued for their personal assets for the losses. That would concentrate their minds. As in the partnerships, it would not stifle appropriate risk, but it would stem reckless risk.
Step two: Shareholders clearly need much greater control over remuneration. Remuneration committees have to be composed of the truly independent. Some of this is process. The monetary policy committee has shown the way in its process for producing the best available outcomes. Thus, its decisions are all public, its proceedings minuted, and the votes of each member recorded and published. Transparency produces learning through media and specialist discussion. The individual cannot hide under a cloud of club behaviour. In terms of membership, no one who could in anyway benefit from the ratchet effect on pay should be a member, thus barring all company executives. The information base for pay should be published and come from the office for national statistics or a similarly independent organisation. If you think all this is too draconian and will drive away all this global management talent, remember the comment of an American colleague on a board I served, which was that the senior management would do it for a third of what they were asking as they all wanted the power so much.
At some point, someone with clout in government and without an interest in the status quo will clock that seven committees followed by the biggest crash in history must add up to doing something very different. The longer these corporate outlaws are allowed to continue (for in any capitalist system that is what they are), the more company failures there will be, the more outrageous pay packets, and the more bills for us to pick up. It’s obvious isn’t it? Fundamental reform is needed, not an idle debate as to the hemline of the FSA.
Progress Magazine Website 08 December 2009
