Executive Remuneration in Crisis: A Critical Assessment of Reforms in Europe Guido Ferrarini Niamh...

Executive Executive Remuneration in Crisis: Remuneration in Crisis: A Critical Assessment A Critical Assessment of Reforms in Europeof Reforms in Europe

Guido FerrariniGuido FerrariniNiamh MoloneyNiamh Moloney

Maria Cristina UngureanuMaria Cristina UngureanuBolzano, November 27 2009Bolzano, November 27 2009

II The Incentive The Incentive ContractContract

A Tale of Two Crises – the Pathology of A Tale of Two Crises – the Pathology of Executive PayExecutive Pay Enron-era: perverse incentives to Enron-era: perverse incentives to

manipulate financial disclosuremanipulate financial disclosure Financial crisis: perverse incentives with Financial crisis: perverse incentives with

respect to risk-takingrespect to risk-taking Powerful incentive effects but malign Powerful incentive effects but malign

resultsresults Agency problem – Social problemAgency problem – Social problem How to harness incentive effects?How to harness incentive effects?


Dominant model for examining executive payDominant model for examining executive pay Incentive contract can reduce agency costs and Incentive contract can reduce agency costs and

support shareholder/manager incentive alignment support shareholder/manager incentive alignment in the dispersed ownership company (dominant line in the dispersed ownership company (dominant line of scholarship: Jensen and Murphy, 1990; Bebchuk of scholarship: Jensen and Murphy, 1990; Bebchuk and Fried, 2004)and Fried, 2004)

Minority shareholder protection in blockholding Minority shareholder protection in blockholding firmsfirms

High level of pay not troublesome as long as High level of pay not troublesome as long as performance link robust; risks if pay not linked to performance link robust; risks if pay not linked to performanceperformance

Being finessedBeing finessed Stakeholder interestsStakeholder interests Fairness dynamicFairness dynamic Agency remedy – social concernAgency remedy – social concern


Concerns over the Crisis: cross-sectorallyConcerns over the Crisis: cross-sectorally Main concern re the upper limit of pay – the Main concern re the upper limit of pay – the

‘outrage’ factor‘outrage’ factor Gap in remuneration – top management and Gap in remuneration – top management and

employeesemployees Weak links between pay contracts and firm strategyWeak links between pay contracts and firm strategy Pay contracts supporting ‘rewards for failure’Pay contracts supporting ‘rewards for failure’ UK 2009 AGM seasonUK 2009 AGM season Guardian Executive Pay Survey 2009 Guardian Executive Pay Survey 2009 Cheffins, 2009Cheffins, 2009


Concerns over the Crisis: Financial Concerns over the Crisis: Financial InstitutionsInstitutions An ancillary factor, but a scapegoat….An ancillary factor, but a scapegoat…. Excessive risk takingExcessive risk taking Bonuses based on illusory/mis-stated profitsBonuses based on illusory/mis-stated profits Short-termismShort-termism Undemanding performance targetsUndemanding performance targets No consideration for remuneration below board No consideration for remuneration below board

levellevel Lack of supervision in monitoring risks and Lack of supervision in monitoring risks and

assessing performanceassessing performance


Risks of the Incentive ModelRisks of the Incentive Model Manipulation of the performance linkManipulation of the performance link Rent seekingRent seeking Outrage constraint Outrage constraint

Does not address level of payDoes not address level of pay Over-reaction riskOver-reaction risk

Conflicts of interest in the pay-setting processConflicts of interest in the pay-setting process Board independence; external consultantsBoard independence; external consultants

Competence questions Competence questions Incompetence in establishing the performance link;Incompetence in establishing the performance link; Herding effectsHerding effects

Increased focus on shareholder value – Increased focus on shareholder value – stakeholder concerns and the incentive model?stakeholder concerns and the incentive model?


But need for clear conceptual basis for But need for clear conceptual basis for executive pay analysis given risks of crisis-executive pay analysis given risks of crisis-driven reformsdriven reforms Attractions of the incentive model – Attractions of the incentive model –

transparency/simplicity in a highly complex areatransparency/simplicity in a highly complex area Target for popular reformsTarget for popular reforms Appropriateness of regulatory interventionAppropriateness of regulatory intervention One size fits all?One size fits all? Impact on competitivenessImpact on competitiveness

FSA concernFSA concern ‘‘Remuneration Governance’ in support of Remuneration Governance’ in support of

Incentive AlignmentIncentive Alignment Buttress the ability of the board to align interests Buttress the ability of the board to align interests

effectivelyeffectively


Remuneration GovernanceRemuneration Governance Governance link to effective incentive Governance link to effective incentive

alignmentalignment Process not designProcess not design Supporting board decision-making; Supporting board decision-making;

independent directorsindependent directors DisclosureDisclosure Shareholder voiceShareholder voice Interlinked elementsInterlinked elements

Comprehensive disclosure – Stronger board Comprehensive disclosure – Stronger board monitoring – stimulating shareholder reaction monitoring – stimulating shareholder reaction


Board IndependenceBoard Independence The independent director as monitorThe independent director as monitor Closing information gap between shareholders and top Closing information gap between shareholders and top

management (dispersed ownership)management (dispersed ownership) Protecting minority shareholders in blockholding firmsProtecting minority shareholders in blockholding firms Independent monitors of pay processIndependent monitors of pay process Independent director may reduce need for intensive Independent director may reduce need for intensive

interventionintervention But conflicted and incompetent boardsBut conflicted and incompetent boards

Remuneration CommitteeRemuneration Committee Front line of effective remuneration governanceFront line of effective remuneration governance Proposals on remuneration to boardProposals on remuneration to board Monitoring remuneration disclosureMonitoring remuneration disclosure Performance reviewPerformance review External consultantsExternal consultants But competence and role of remuneration consultantsBut competence and role of remuneration consultants


Shareholder voiceShareholder voice Provide systemic shock to reset pay Provide systemic shock to reset pay

norms (Gordon)norms (Gordon)

DisclosureDisclosure Shareholder voice; signal good practice; Shareholder voice; signal good practice;

buttress the board; dilute unwarranted buttress the board; dilute unwarranted outrageoutrage

IIII The EU ContextThe EU Context Complexities of pay in the EU contextComplexities of pay in the EU context

The governance divideThe governance divide Cultural issuesCultural issues Transplantation risksTransplantation risks

What is the EU trying to achieve?What is the EU trying to achieve? Risks of harmonization so clear objective neededRisks of harmonization so clear objective needed Shareholder interest alignment? Cost reduction? Shareholder interest alignment? Cost reduction?

Company Law Action Plan and Anglo-American Company Law Action Plan and Anglo-American influenceinfluence

Is intervention justified?Is intervention justified? Disclosure drivenDisclosure driven 2009 reforms unclear – muddying of purpose2009 reforms unclear – muddying of purpose Is shareholder interest alignment valid?Is shareholder interest alignment valid?

II EU ContextII EU Context Our research questionOur research question

How the EU’s efforts to support incentive How the EU’s efforts to support incentive alignment have fared ‘in action’; effectiveness of alignment have fared ‘in action’; effectiveness of corporate governance codes/shareholder activismcorporate governance codes/shareholder activism

MS implementation of EU recommendationsMS implementation of EU recommendations Market application: FTSEEurofirst 300Market application: FTSEEurofirst 300

Best practice, particularly re disclosure, not Best practice, particularly re disclosure, not securely embedded across EU’s largest securely embedded across EU’s largest companiescompanies

Basic requirements – not the qualitative disclosure Basic requirements – not the qualitative disclosure necessary for effective monitoringnecessary for effective monitoring

Why?Why?

IIII The EU ContextThe EU Context

2004 Recommendation2004 Recommendation FlexibleFlexible Process basedProcess based Effective remuneration governance ‘in Effective remuneration governance ‘in

action’?action’? 2009 Recommendation2009 Recommendation

Illusion of reformIllusion of reform Wave of Corporate Governance Wave of Corporate Governance

Reforms – Related?Reforms – Related?

II EU ContextII EU Context 2005 Recommendation on Independent 2005 Recommendation on Independent

DirectorsDirectors ‘‘Sufficient’ numbers of INEDsSufficient’ numbers of INEDs Guidance on independenceGuidance on independence Remuneration committee: exclusively Non-Remuneration committee: exclusively Non-

Executive or Supervisory Ds, majority INEDsExecutive or Supervisory Ds, majority INEDs Functions of the RCFunctions of the RC

2004 Recommendation on Pay2004 Recommendation on Pay Disclosure of company pay policy (detailed Disclosure of company pay policy (detailed

recommendations)recommendations) Disclosure on individual payDisclosure on individual pay Shareholder vote Shareholder vote Prior approval of share-based schemePrior approval of share-based scheme

IIIIII MS Implementation: MS Implementation: Remuneration CommitteeRemuneration Committee

Corporate Governance Codes: comply or Corporate Governance Codes: comply or explainexplain

Well establishedWell established But divergences re ‘independence’But divergences re ‘independence’

Controlling shareholdersControlling shareholders How many independent directors?How many independent directors? Majority or sufficient?Majority or sufficient?

Divergences re format (joined/separate Divergences re format (joined/separate committees) committees)

RC ChairmanRC Chairman

IIIIII MS Implementation: MS Implementation: DisclosureDisclosure

Disclosure tends to be implemented through Disclosure tends to be implemented through binding rules; more detail in Codesbinding rules; more detail in Codes

(1) Separate Remuneration Report/Remuneration (1) Separate Remuneration Report/Remuneration PolicyPolicy EC Recommendation: Forward-looking; clarity on EC Recommendation: Forward-looking; clarity on

performance link; methods for performance evaluationperformance link; methods for performance evaluation Most MS do not require a separate remuneration Most MS do not require a separate remuneration

report; little standardization on format or contentreport; little standardization on format or content Patchy disclosure relating to remuneration policy – Patchy disclosure relating to remuneration policy –

undermines individual disclosureundermines individual disclosure UK regime still most detailedUK regime still most detailed Comply or explain leading to widely varying disclosure Comply or explain leading to widely varying disclosure

standards and practicesstandards and practices

IIIIII MS Implementation: MS Implementation: DisclosureDisclosure

(2) Individualized pay disclosure(2) Individualized pay disclosure EC RecommendationEC Recommendation

Executive and Non Executive DirectorsExecutive and Non Executive Directors Previous year; base salary and fees; variable pay; share Previous year; base salary and fees; variable pay; share

based incentive schemesbased incentive schemes Generally required by lawGenerally required by law Some MS only aggregate disclosure (Austria, Belgium Some MS only aggregate disclosure (Austria, Belgium

Greece) but often supported by more demanding Greece) but often supported by more demanding corporate governance codescorporate governance codes

Variations in content of individualized disclosureVariations in content of individualized disclosure (3) Share-based incentive schemes and (3) Share-based incentive schemes and

performance conditionsperformance conditions PatchyPatchy

IIIIII MS Implementation: Say MS Implementation: Say on Payon Pay

Limited implementationLimited implementation EC RecommendationEC Recommendation

Explicit item on AGM agendaExplicit item on AGM agenda Binding/advisoryBinding/advisory Approval for share schemesApproval for share schemes

UK (2002)UK (2002) Germany, Spain, Netherlands, SwedenGermany, Spain, Netherlands, Sweden Italy: banks onlyItaly: banks only Typically implicit approval of the annual Typically implicit approval of the annual

reportreport Disconnect between disclosure and voiceDisconnect between disclosure and voice

But generally shareholder vote required But generally shareholder vote required for share-based incentive schemesfor share-based incentive schemes

MS Implementation: MS Implementation: DesignDesign

Terms of Contracts and Termination Terms of Contracts and Termination PaymentsPayments Design not a feature of the 2004 Design not a feature of the 2004

RecommendationRecommendation Key element of the 2009 reformsKey element of the 2009 reforms

But disclosure on terms of contract, But disclosure on terms of contract, incentive pay designincentive pay design Essential for understanding performance linkEssential for understanding performance link Performance link to long term sustainabilityPerformance link to long term sustainability Avoiding rewards for failureAvoiding rewards for failure

IIIIII MS Implementation: MS Implementation: Design and Contract Design and Contract Terms/TerminationTerms/Termination

Limitations on notice periods – sporadic across Limitations on notice periods – sporadic across the MS: UK – one year or less; Italy – three years; the MS: UK – one year or less; Italy – three years; France – 4/6 years.France – 4/6 years.

Limits on termination payments?Limits on termination payments? Range of Corporate Governance CodesRange of Corporate Governance Codes UK, Netherlands, Belgium: 1 yearUK, Netherlands, Belgium: 1 year France, Germany: 2 yearsFrance, Germany: 2 years French law: most interventionistFrench law: most interventionist

Complete transparencyComplete transparency Conditional on performanceConditional on performance No rewards for failing executivesNo rewards for failing executives

Clawbacks?Clawbacks? Recent featureRecent feature

IIIIII MS Implementation: MS Implementation: Design of IncentivesDesign of Incentives

2004 Recommendation not prescriptive (2009 2004 Recommendation not prescriptive (2009 Recommendation more intrusive)Recommendation more intrusive)

Restraints on incentive pay?Restraints on incentive pay? ‘‘reasonable’; ‘proportionate’reasonable’; ‘proportionate’ Adjustments and clawbacks?Adjustments and clawbacks? But general support of incentive payBut general support of incentive pay UK Combined Code and design of incentive payUK Combined Code and design of incentive pay

Disclosure on performance criteria?Disclosure on performance criteria? Corporate Governance Code drivenCorporate Governance Code driven PoorPoor

IVIV Remuneration Remuneration Governance in action: FTSE Governance in action: FTSE

Eurofirst 300 Eurofirst 300 Effectiveness/relevance of corporate Effectiveness/relevance of corporate

governance codes governance codes Assessing disclosure and remuneration Assessing disclosure and remuneration

governance after the two Recommendationsgovernance after the two Recommendations FTSE Eurofirst 300 components; 16 EU FTSE Eurofirst 300 components; 16 EU

countriescountries Assessed 3 areas:Assessed 3 areas:

GovernanceGovernance Remuneration policyRemuneration policy Individual Disclosure Individual Disclosure

8 categories; 23 detailed criteria8 categories; 23 detailed criteria

IVIV Remuneration Remuneration Governance in action: FTSE Governance in action: FTSE

Eurofirst 300Eurofirst 300 Firms follow national regulation rather Firms follow national regulation rather

than Community best practicethan Community best practice Tendency to comply with legally binding rulesTendency to comply with legally binding rules Partial compliance with comply or explainPartial compliance with comply or explain

Lowest levels of complianceLowest levels of compliance Terms of contractsTerms of contracts Qualitative disclosure on performance linkQualitative disclosure on performance link

Highest levels of complianceHighest levels of compliance Presence of a remuneration committeePresence of a remuneration committee Existence of remuneration policyExistence of remuneration policy Individual pay disclosureIndividual pay disclosure

Highest: Individual disclosure; Remuneration Committee

Lowest: Disclosure terms of contracts for executive directors

Almost 83% established separate or joined RC60% have RC with majority independentUK, Netherlands: all independentGermany: no separate RC

58% overall complianceHigh: UK, Ireland, Netherlands Low: restNon-compliance:

- Disclosure of only non-executive or only executive directors

- Not all components of pay package are disclosed

•Continental Europe: elements of the remuneration policy are scattered throughout the AR •“A clear and comprehensive overview of the company’s remuneration”: not achieved

V Policy Issues and Reform V Policy Issues and Reform Process Process

MS have shown little enthusiasm for MS have shown little enthusiasm for legislating on remuneration governancelegislating on remuneration governance

Weaknesses in CG Codes as instruments for Weaknesses in CG Codes as instruments for delivering effective pan-EU remuneration delivering effective pan-EU remuneration governancegovernance

Considerable confusion concerning what Considerable confusion concerning what remuneration policy remuneration policy disclosuredisclosure should cover should cover Terms of contractsTerms of contracts Qualitative discussion of performance linkQualitative discussion of performance link

Divergences in independence requirements Divergences in independence requirements on on RCRC

Difficulties with Difficulties with ‘say on pay‘say on pay’ with respect to ’ with respect to further harmonizationfurther harmonization

V Policy Issues and Reform V Policy Issues and Reform ProposalsProposals

Is there a role for further Is there a role for further harmonization?harmonization?

What should its objective be?What should its objective be? Disclosure the most appropriate Disclosure the most appropriate

targettarget

V Policy Issues and the V Policy Issues and the Reform ProposalsReform Proposals

What approach has the EC adopted: What approach has the EC adopted: 2009 Recommendation2009 Recommendation

Uneasy mixture of more intervention Uneasy mixture of more intervention (design) but failure to address (design) but failure to address effectiveness (non-binding; basic effectiveness (non-binding; basic disclosure best practices not rolled out)disclosure best practices not rolled out)

Muddled purpose: shareholder incentive Muddled purpose: shareholder incentive alignment – public outrage – fairness – alignment – public outrage – fairness – spillover from banking sector? spillover from banking sector?


Focus on pay/performance link, Focus on pay/performance link, sustainability and on restricting sustainability and on restricting ‘excessive’ variable pay‘excessive’ variable pay

Disclosure on relationship between Disclosure on relationship between performance criteria and firm long-performance criteria and firm long-term interests and on termination term interests and on termination payments√ (but non-binding)payments√ (but non-binding)

Competence of RC√Competence of RC√ Clawbacks and termination payments√Clawbacks and termination payments√


But – intervention in design of But – intervention in design of remunerationremuneration ‘‘Limits’ on variable payLimits’ on variable pay ‘‘Proportionate’ remunerationProportionate’ remuneration Deferral of ‘major part’ of variable pay Deferral of ‘major part’ of variable pay

for a ‘minimum period’for a ‘minimum period’ Share-based pay: three year vesting Share-based pay: three year vesting

periodperiod


√√ Attempt to enhance quality of disclosureAttempt to enhance quality of disclosure Awareness of design issuesAwareness of design issues Focus on pay/performance linkFocus on pay/performance link

XX Core enforcement and consistency problems remainCore enforcement and consistency problems remain A policy distractionA policy distraction Reliance on a non-binding measureReliance on a non-binding measure Recommendations vagueRecommendations vague Spill over from financial institutionsSpill over from financial institutions Clarity of purpose?Clarity of purpose? Replacing board judgmentReplacing board judgment How does it address specific failure – impact assessment?How does it address specific failure – impact assessment?


The Way ForwardThe Way Forward Harmonization to enhance standardsHarmonization to enhance standards DisclosureDisclosure

Binding requirement for a separate Binding requirement for a separate remuneration reportremuneration report

Binding core standardsBinding core standards Standardization of disclosure format and Standardization of disclosure format and

key definitionskey definitions Rewards for FailureRewards for Failure

Mandatory limitsMandatory limits Disclosure of termination paymentsDisclosure of termination payments


BenefitsBenefits Reduce costsReduce costs Sharpen shareholder engagementSharpen shareholder engagement Facilitate comparative analysisFacilitate comparative analysis Closer focus on performance criteriaCloser focus on performance criteria Stronger legislative intervention risk-ladenStronger legislative intervention risk-laden

Complexities of designComplexities of design Dynamics of international competitionDynamics of international competition

Disclosure and governance reforms should Disclosure and governance reforms should remain the driver for harmonizationremain the driver for harmonization

Executive Remuneration in Crisis: A Critical Assessment of Reforms in Europe Guido Ferrarini Niamh...

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