Performance and Reward

2010-06-19T14:36:00.003Z

Today I wrote to the Financial Times.

Dear Sir,
I enjoyed Gillian Tett's article Ideas on curbing bankers appetite for risk (15/6/2010 on ft.com) about finding the best incentives for top bankers. I was also interested in Dr Steve Webb's letter (18/06/10) suggesting bonuses be paid in the bank's own long term debt, and requiring that this be held to maturity. My own proposals on executive rewards (Performance and Reward, Troubador 2006) was that payment be made in long term equity, which should be even more sensitive to excessive risks than long term debt.
However since writing that book, I have, like the New York Federal Reserve, come to realise that there are fundamental problems with linking bankers' rewards to profit or returns. The profound links between profit and risk mean that an incentive to increase profit is in fact an incentive to increase risk. Increasingly, because risk is subject to regulation, the incentive is actually to create hidden or understated risk, and this is even more dangerous in the longer term. The great complexity of the area means that there will always be clever people who can make a lot of money for themselves by circumventing or perverting the system. They have made their fortunes long before the world properly understands the dangers involved in what they have done.
This is why I now advocate a brutally simple global cap on bankers' pay. It is the only realistic way of curbing the risk appetite. Such a cap is not against enterprise or investment; rather it is to protect entrepreneurs, business owners and investors from the greed of their agents.
Yours faithfully
The Revd Patrick Gerard

Click here for the original article about a global cap on pay.
Click here for more on the problems of linking pay to profit.

Saving the financial system

2010-04-21T20:10:00.002Z

I today left the following comment on ft.com, in response to an article by Martin Wolf, "Halting the Financial Doomsday Machine"

As you so pertinently point out, the incentives of those who run the system are the engine room of the doomsday machine. It is on the incentives that the really radical change is required. A global cap on executive pay (say US$500,000 per annum) would remove the incentive for top earners to prioritise personal gain. This would give more constructive motivations (such as saving the financial system) a real chance of being heard in the boardroom. Voters might well like to see a cap on pay, and it would free up lots of cash for the banks, allowing them to recapitalise.
And why not? The whole point of competition is to drive out costs and increase efficiency, but this has totally and completely failed in the case of the market for executive talent.

For more on the Global Cap on Pay follow the link in the left hand column of this blog.

Changing the mindset

2010-02-11T10:26:00.003Z

On 7th February 2010 (on ft.com) the Lex Column of the Financial Times published a note on Executive Pay. This can be seen at:
http://www.ft.com/cms/s/3/28c6e0cc-1414-11df-8847-00144feab49a,s01=1.html
(Subscription may be required.)
I added the below comment:

Lex has precisely identified the problem with the “take one for the team”, “clubby remuneration committee” attitudes. The top people in business are now engaged in a game whereby they compete with each other to extract more and more value from the rest of the community. This is utterly wrong and completely unsustainable. A total change in mind set is needed. We need a global (or G20 wide) cap on pay from employments/directorships. This would promote and enforce the idea that an executive’s job is to work for the benefit of shareholders and wider stakeholders, not for his/her own benefit. This principle of fiduciary duty is fundamental to company organisation. Capitalism is doomed if we can’t get back to this principle.
More on a global pay cap at www.performanceandreward.blogspot.com

See links to "global cap on pay" and "Competition Law" in left hand column.

Q&As on the Global Pay Cap - 1

2010-01-04T10:08:00.010Z

Click here for the original article about a global cap on pay.
Click here for the global-cap-on-pay letter published by the FT, 12/12/2009.

Agreeing a global cap on pay and making it stick would be really tough - look how difficult international leaders have found it to agree anything on climate change. Is it feasible?
I agree that agreeing a global cap and making it stick is a tough challenge. However I can't help feeling that any less radical reform would not really get to the heart of the problem. Also, compared to climate change, a global pay cap has three big things going for it.
1) It is a simple concept.
2) It would be popular with voters.
3) It offers a cheap way of recapitalising banks
Like climate change there would be powerful vested interests working against it, but it is much easier to see it gaining rapid political momentum.
[Incidentally, if the pay of oil chiefs was capped and not affected by oil profits, then I suspect that oil chiefs would be far more ready to work constructively on the climate change agenda.]
Also we have to recognise that as the world gets more and more interconnected then there will be more and more need for global agreements. Truely international issues such as climate change and financial regulation really require international agreements. World leaders are going to have to get much better at delivering them!

To what parts of banking should the cap apply?
I agree that there are issues about where the cap should apply, but in the first instance it is very simple. Money made from someone investing his/her own money or growing his/her own business is not captured. Money made from other people's money or businesses is. All company directors and employees are working for a company and not for themselves so all wages and salaries, whatever form they are paid in, are all captured. All banking activities are clearly captured.
Where it potentially gets more difficult is with people like lawyers, accountants and consultants who are partners in a firm or have a company limited by guarantee, so they do make money from growing their own businesses. However it seems to me that this money should still be captured under the cap because they do not act as "Principals" but rather as "Agents" of their clients. They are therefore working for their clients and owe their clients a Fiduciary Duty.

The really fundamental issue that the cap is trying to address is making sure that "Agents" really do act as "Agents" and properly respect the interests of their "Principals". If agents are highly paid, or on performance related pay, then it suggests that they are working for their own benefit, not for the benefit of the Principal. This agency problem is a really deep problem. See http://en.wikipedia.org/wiki/Principal-agent_problem . It is also an ancient problem. Note that Jesus discusses the agency problem in his parables (e.g. Luke 16: 1-8). Alan Greenspan's comments on the cause of the credit crunch are very important. He says that in 60 years dealing with American business he had always assumed that companies worked to maximise the company interest, and especially to avoid their own destruction. However the risks taken in the build up to the credit crunch show that this assumption was no longer valid. Managers made the decisions that worked for managers, more than for the companies they managed. Part of the reason for this was the intensity of the competitive pressures than managers were facing.

Could not more be done to boost competition in the banking sector which is riddled with cartels and other practices aimed at artificially pushing up profits, and hence bonuses, at the expense of the customer?
I agree that there is a lack of economically effective competition in many sectors of banking. In the left hand column of this blog there is a link "Competition Law" which documents my efforts to get the Office of Fair Trading excited about the competition problems in the market for executive talent. Having said that, I no longer believe that more effective competition could ever solve the problems. The top people in society need to collaborate before they can compete. If they only compete then they pull society apart. Competition is certainly a big factor in the falling apart of the financial sector.

Are you aware of Stephen Green, Chairman of HSBC, and his work on banking ethics?
I am aware of Stephen Green through a Church Times article, but I don't know much about him really. I am interested in his book "Good Value"(although I am hopeless at reading!) HSBC is a good example of a bank that did not allow competitive pressures to distroy it. In the year before the crisis HSBC was under intense pressure from the activist investor Knight Vinke who thought HSBC should use its balance sheet more agreesively to improve "performance". I think HSBC was able to see through this because of its strong comporate culture and its emphasis on long term returns in the pay of top people.

Why investors cannot be expected to control pay

2009-12-30T15:33:00.002Z

The below was pasted onto the ft.com website as a comment on the leading article for 30/12/2009(?). The article can be viewed (subscription may be required) at:
http://www.ft.com/cms/s/0/d256c8ca-f4af-11de-9cba-00144feab49a.html

Sadly it is now abundantly clear that action on executive pay must come from governments not from investors. Investors have been struggling to have an impact on this issue for more than 20 years and have failed completely.

One of the main reasons for this is that most shares with voting powers are controlled some kind of professional fund manager. There are many reasons why fund managers can never be effective in controlling executive pay:

- Fund managers are themselves usually very well paid and they benefit from the high pay culture.
- It is easy for a management team under pressure from about executive pay to retaliate, for example by suggesting that the earnings of all fund managers should be made more transparent.
- Investing energy in improving the performance of a company for the benefit of all shareholders does not help an individual fund manager compete with his/her competitors
- Sorting out executive pay is “short term pain for long term gain”. If a fund manager’s performance is measured quarterly then the short term pain shows through straight away, and the manager is unlikely to stay in post long enough to see the long term gain.
- A fund manager making a stand on this issue is likely to lose all his friends and contacts.
- A fund manager taking a stance on executive pay is going to find it far harder to sell his/her services to high paid clients than a fund manager who colludes on pay.
- A management team whose pay is constrained by investors is likely to wriggle! For example they might seek to play off the interests of one set of investors against another. In practice it is impossible for investors to commit the long term persistence necessary. The fact that each only controls a very small shareholding so that co-ordination is required also makes this impossible.
- Professional fund managers often sit in management structures which are headed up by banking executives, insurance executives or other senior executives, often in listed companies. For the fund managers to seek to limit the pay of their own bosses is an obviously bad career move! They are not stupid!

Another problem that investors face is that the standard guidance on this issue of executive pay (The Combined Code on Corporate Governance) was written by highly paid people in order to preserve the interests of highly paid people. From an executive pay perspective it is extremely counter productive. See http://www.freewebs.com/hgerard/FRCCombinedCodeSubmission.pdf .

It is quite clear that the investor route to controlling executive pay has been tried, persevered with, and persevered with again, but can never work. A complete culture change is required. Just as “non smoking pubs” were socially highly desirable, but required a culture change that could not be delivered by the market, so lower executive pay is extremely socially desirable but can only be delivered by carefully co-ordinated government action. It would be all to easy for an individual government to tinker and get it wrong, but a globally agreed (or at least a G20 agreed) cap on pay could provide the culture change required. See http://performanceandreward.blogspot.com/2009/12/case-for-global-cap-on-pay.html .

The role of politicans in banking

2009-12-23T22:22:00.003Z

I was encouraged by an excellent article by philip Stephens in the FT 21/12/09. This can be seen at http://www.ft.com/cms/s/0/222e7a5e-ee6c-11de-944c-00144feab49a.html (subscription may be required).
Philip argues powerfully that politicans need to be involved in banks. I posted the following comment (on 23/12/09):

I did appreciate this article which was brave enough to confront the key issues. I was particularly glad to see talk of a long term cap on remuneration. (What does long-term mean in this context?) Remuneration caps are all-important if the incentive problems are to be solved. (See my letter in FT 12/12/09 and my blog www.performanceandreward.blogspot.com.)
The incentive problem is illustrated by "Young NY Banker" note to self below. All the concerns mentioned concern his/her own personal situation and prospects. None of it concerns the public good or the way in which we all need to help one another if we are to get along sensibly as a society. The incentive regime has utterly eliminated such "altruistic" concerns from present day banking, but now that the banks are supported by public money these questions must be put centre stage once again. Making sure that finance properly benefits the whole of society has to be the top priority. Politicians are the people to whom we entrust such decisions and they have to be centre stage.
We used to turn a blind eye to selfish practices in banking because banks created wealth in which we all shared in, at least to some extent. The crisis however has revealed that much of the wealth created was less real than it seemed. Current profits in banking are very heavily dependent on artificially cheap money, so it is still far from clear that banks are creating real wealth. Politicians have got to get involved big time.

The case for a global cap on pay

2009-12-11T13:56:00.004Z

Why a global cap on pay makes sense now
The argument for high pay is that businesses have to compete to secure the best talent. This is a real problem but it would disappear if all top business people worldwide were paid no more than say US$500,000.
Economists usually support competitive markets because competition forces out costs and increases efficiency. However competition has manifestly failed in the market for executive talent. Costs have spiralled, but the performance of the FTSE100 has been dismal since Dec 1999. In my opinion the failure of competition in the market for executive talent is caused by distortions in the market. The executives have considerable market power and there are concerted practices coordinated through remuneration consultancies. I have raised these concerns with the Office of Fair Trading (OFT). My dialogue with the OFT can be viewed by clicking on the link “Competition Law” in the left hand column.
Actually it seems to me that a truly competitive market in executive talent could never lead to efficient outcomes in appointing people to top posts. It is more likely to ensure that we appoint the most ruthless people to top jobs. We need to develop a culture in which top people are motivated by (or at least mindful of) their responsibilities to the rest of society. Money fuelled competition between top people inevitably pulls society apart in a destructive way. This has been seen most clearly in the financial sector, but it can also be seen in all sectors of society where pay has been used aggressively to motivate top people.

The purpose of the pay cap
The cap is not to get vengeance on bankers, although it might be politically popular for this reason.

The cap is not to raise revenue, although it will free up a lot of revenue in the banks, helping them to recapitalise.

The purpose of the cap is to solve structural problems in executive incentives. It addresses problems in executive motivation.

My recent blog post “bankers’ pay and the financial crisis” shows how performance related pay is profoundly flawed for top bankers because it colludes with a culture which assumes that the banker’s top priority is his/her own personal well-being, most tangibly his/her pay. In other words it encourages the top executive to put his/her own interests ahead of the interests of the company he/she manages. This is a recipe for disaster. Alan Greenspan could not believe that American Banks behaved in ways that were so destructive to themselves. The reason they did this was because the top executives were paid to look out for themselves. I have written a book on performance related pay for top executives (see link “View the book” on the left) but increasingly it seems to me that the goal of alignment between shareholder and executive interests is not realistic because it colludes with selfish desires on the part of managers and does not build a culture in which managers put the company interest first. It undermines the Fiduciary Duty on which our companies’ structures are founded.

A global cap on cap would go a long way towards eliminating selfish financial interests from the motivation of the top people in our banks and other companies. Once you reach the US$500,000 level you can go no further financially. You have to start looking for other forms of motivation. This will create space for more generous motivations orientated towards the good of shareholders, employees, suppliers and customers and towards the wider public good.

Who should NOT be captured by the cap
Wealth creators (entrepreneurs) should not be affected by the pay cap. People who make money by growing their own business, or investing their own money should be encouraged to do so. The cap would imply no extra taxation on capital gains caused by increased business value, and no extra tax on company dividends.

The public can have quite a lot of confidence that entrepreneurs who get rich have done so by creating real value in business (and so hopefully in society). It is much harder to have this confidence about someone who has got rich by being well paid. The entrepreneur makes no money until all employees and suppliers have been paid. Bank loans and corporate taxation must also have been paid. Only after all this money has gone out to other people does money become available for dividends to the business owner. Further the wealth created in this way is critically dependent on the long term success of the business. The incentives are therefore for long term corporate successes. This contrasts sharply with the banking bonus culture which gives rise to incentives which are short term, individualistic and independent of the long term interests of the institution.

Company owners must be encouraged to take their profits out of businesses as dividends not as salaries. Only in the former case can we be sure they are creating business value.

Who should be captured by the cap
The cap on pay should apply to people who are officially working for the interests of others, not for themselves. This certainly includes all company directors and employees. It includes everyone in government.

There are grey areas. Footballers are basically working for others; their club. Pop stars might be working for a record company, or they might have their own record company and be making their own sales. Film stars are probably working for a studio, but they may well be shareholders in their own film companies. Money (or value) received as salary, fees, pay, pension, bonus, share schemes, company cars, perks, etc. should all be captured by the cap. Money received by company owners as dividends should usually not.

Accountants, lawyers and consultants
Any work that requires a fiduciary duty to others should certainly be captured by the cap. Lawyer, accountants and consultants are therefore captured. Partners in big law/consultancy firms should not earn (or take home in profits) more than the cap, even if they are owners of the firm. This is because the same issues about incentives and motivation apply to consultants in respect of their clients, as apply to normal business executives with respect to their shareholders.

Consultants have massive incentives to build large and profitable firms/companies/practices which make money by providing services to other people or companies. Because the money is made by working for others it must be caught in the cap, even though it might be paid out to partners as dividends. This is important because without it consultants have an incentive to increase the scope of their work for the client and to build dependency in their clients. A consultancy business is likely to want to grow its size and profits, but the public need to be satisfied that this is really happening for the benefit of the consultants’ clients, and not just at their expense. One example is computer consultancies who have incentives to sell vast and unrealistic computer projects to governments. Another example is remuneration consultants, as described in Performance and Reward (The book – see link on left) pages 152 to 156. In fact in the case of lawyers, accountants and consultants there is a case for a much lower cap on pay so as to avoid undesirable incentives and to strengthen fiduciary duty.

The problem of loopholes
There is a danger that a great deal of effort and talent will go into looking for loopholes in the pay cap. People will try to restructuring jobs so that they are paid separately by several different companies or in different counties. They will restructure normal pay to look like dividends. They will try to seek pay through their expenses. They will try all manner of tricks. It is very important that all such tricks must fail quickly and firmly.

Loopholes in the cap could be extremely damaging. If executives sense a loophole then very perverse incentives might arise, and very destructive behaviours might be encouraged. Executives must be so clear that there are no loopholes that they do not waste effort looking for them. The law therefore needs to be very strong. I would suggest three aspects:

1) An obligation on companies to be able to demonstrate simply (i.e. without the use of a computer model, or long remuneration reports) that the total value of all their pay to any individual in any period of 365 days does not exceed the cap. The obligation should be so strong that most companies will find that the most convenient way of paying their top employees is a simple cash payment of 1/12th of the cap each month. All value transferred from the company must be included: salary, bonus, share option, pensions, benefits, club memberships, private financial advice, cars, private use of company jet etc..

2) An obligation on individuals not to receive more pay than the cap. Seeking to structure business activities or payment arrangements to avoid the cap must be an offence. Fines for looking for loopholes must be big enough to ensure that there is no incentive to do so.

3) An obligation of tax authorities to search for pay that exceeds the cap, and to tax it at, say 200%.

How will people respond to the cap?
I believe that top executives first reaction will be to look for ways around the cap. This activity must be firmly discouraged, as discussed above. There will also be an increased interest in getting money out of companies through different kinds of fraud. Vigilance must be maintained.

If there appears to be no way round the cap many executives, and bankers in particular, will feel extremely demotivated. There will be a huge motivation problem. The effects of this problem will turn out to be far less serious than they initially appear, because it is only selfish motivation that is being curtailed. Motivations arising from doing things for other people, or because they are worthwhile in themselves will still be retained.

Really talented people, who really do want to get seriously rich will leave employment and establish their own businesses. This will be a very good thing.

Many people who are not so sure that they can make money as entrepreneurs are likely to retire prematurely to enjoy the money they have earned. This will also be a good thing.

People who remain in top jobs will do so because they are interested in the job, because they think it is worthwhile and because they want to do good things for shareholders and other stakeholders. They will be far more ready to prioritise company interests over their own. Fiduciary Duty will be strengthened and companies and institutions will start to look much stronger. This is the real reason for making the change.

There will be increasing interest in making top jobs attractive in ways that do not involve higher pay; shorter working hours, more holidays, and better staff restaurants etc. This will be a good thing.

Several thousand people will have their earnings capped. These people will no longer be competing with each other for better pay. It is likely that they will still compete for reasons of power and prestige, but a great deal of the heat of competition will disappear. Top executives will start to find it easier to work together, easier to like each other and easier to form constructive and rewarding relationships. They will start to enjoy work in a much fuller, more holistic way. New and imaginative collaborations will be born. This will be a good thing.

99.9999% of the global population will earn less than the cap and will not be affected. Many of them will still regard the cap as a very good level of pay and there will still be a lot of competition to get top jobs.

The motivation problem will lead to much simpler business structures and to a much slower and more gentle pace of life in financial centres around the world. GDP will initially fall but this will matter much less than might be expected, because the economic output that disappears will primarily be the output that selfishly favours top people. Its impact on other people will be much less. However, ordinary people will benefit enormously from a more humane and holistic business culture.

Global cap on bankers' pay

2009-12-11T11:24:00.005Z

Following Alister Darling's one-off bonus tax I have today written to the FT. This letter was published by the FT on Saturday 12/12/09.

Dear Sir,
Surely the time is now right for a global cap on bankers pay?
The argument for high pay is that banks have to compete to secure the best talent. This is a real problem but it would simply disappear if all top bankers worldwide were paid no more than say US$500,000.
Economists usually support competitive markets because competition forces out costs and increases efficiency. However competition has manifestly failed in the market for banking talent. Costs have spiralled and, but for government intervention, most banking institutions would be insolvent. Why do we allow such destructive competition to continue?
Yours sincerely,
Revd Patrick Gerard

Bankers’ pay and the financial crisis

2009-12-11T11:12:00.004Z

The Ecumenical Council on Corporate Responsibility (ECCR- see http://www.eccr.org.uk/index.html) have published an article of mine on bankers' pay (the bulletin No 75 - December 2009). A near final draft of the article is included below.

One of the most disturbing aspects of the apparent recovery in world markets since March 2009, is that banking is still being conducted in much the same way as it was before the crisis. Certainly there is much more talk about regulation, and banks are working on reducing their leverage, but the banking business model has not changed. It seems extraordinary that the traumatic events of autumn 2008 have had so little impact on banking behaviours.
One reason for this is that normal market disciplines have not been applied. Had market discipline applied then most, if not all, of our financial institutions would have collapsed. The economic consequences of this would have been apocalyptic, so it was not allowed to happen; governments bailed the banks out. Banks now operate with their risks underwritten by government. Unfortunately this means that the banks have less incentive to behave responsibly than they had before the crisis.
Another reason is that it is taking a great deal of time to define new regulation for the banking sector. The best way to regulate the banks is not obvious and sophisticated lobbying to defend vested interests is causing confusion in the process. On top of this many of the new regulations will need to be agreed internationally, so new regulation will not be implemented quickly.
But it seems to me that there are profound cultural reasons why banking behaviours have not changed, and these cultural problems most typically arise from the way that bankers are paid.
Banking culture assumes that a banker’s objective is to maximise his or her personal pay. Banks seek to constructively harness the bankers’ desire for personal reward by linking their pay to the profit of the bank. The message to bankers is, “If you make more profit for the bank, then you will be paid more!” Although very widespread, this link between profit and pay has proved to be fundamentally flawed and can only lead to further disasters if it is not changed.
The first central flaw in the pay-for-profit paradigm is that it values profit higher than the safety of the banking institution. Bonuses are far more likely to be paid for generating profit (which is readily quantified), than for keeping banks safe (which is hard to quantify). But in banking there is always a clear link between risk and reward. The most direct route to increasing profit is to increase the risks that are taken. The banker who is powerfully motivated to increase profit is therefore driven to find new and creative ways of increasing risk. This is why, in the build up to the crisis, banks increased their leverage, created hidden risks off balance sheet, and devised complex financial instruments that had the effect of hiding risk.
This is a fundamental problem. Whatever new regulations are devised by governments and whatever new controls are put in place by institutions, individual bankers still have massive incentives to create risk, to hide risk and to place risk with people who do not really understand it. It is clear that during 2006 many bankers could see that the force feeding of mortgages into the market was not sustainable, but they continued to do it anyway. Why? Because that is what they were paid to do!
But there is an even more fundamental problem with the massive incentives that bankers have to generate profit. The incentive regime has generated a culture which is entirely driven by the supercharged desire of individuals to make money for themselves. The banks can only succeed as institutions if they can constructively harness this volatile (and morally dubious) aspiration of their employees. The big problem is that it has proved impossible to perfectly align the self-interest of individuals with the long term interests of banking institutions. Forms of remuneration that take incentive alignment seriously have to have a long term focus, and have to make bankers accountable for the risks that they take. Unfortunately such forms of remuneration are considered uncompetitive in the marketplace for hiring banking talent; bankers (like everyone else!) prefer their rewards to be immediate and secure from claw back.
The gap in incentive alignment means that bankers can often maximise their own rewards in ways that are damaging to the banking institutions, especially over the longer term. Individual bankers, under intense competitive pressure, inevitably exploit incentive alignment gaps to their own advantage even if this damages the financial institution. The self-interests of bankers have therefore prevailed over the interest of banks and their shareholders. The culture has evolved into the precise opposite of Fiduciary Duty, that extraordinarily high duty of care which a company director is legally obliged to show to the company.
Bankers’ pay has therefore created a culture in banking in which the rewards of individuals are prioritised above the health and security of the financial institution they work for. This culture is extremely dangerous to financial institutions and to the governments that underwrite them. A complete change of culture is essential, and this can only be brought about by very radical changes in the way that bankers are paid.

Sermon on Lehman Brothers anniversary

2009-09-21T11:53:00.003Z

This can be found at:
http://sermonsandprayers.blogspot.com/2009/09/business-ethics.html

Bankers pay at G20

2009-09-06T15:40:00.004Z

The FT Lex column (on ft.com) had an article about the G20s efforts to develop international financial regulation. This can be viewed at http://www.ft.com/cms/s/3/e0c5d822-9890-11de-807a-00144feabdc0.html 9Subscription may be required).

In response I wrote to the editor of the FT (published 8th Dec 2009, at least on ft.com) as follows:

Dear Sir,
The Lex column is quite wrong to describe the G20's focus on bankers' pay as "populist but often tangential". Bankers' behaviour is driven by pay, and so bankers' pay has to be absolutely central to regulation of behaviour in the financial sector. It is essential that the incentives that arise from pay lead to constructive, value creating behaviours and not to behaviours that undermine the system.
As Lex points out that, "the architects of boomtime credit innovations are returning to their desks, finding new ways to tinker with balance sheets and carve through rules that are still being developed. The regulated are already moving ahead of their minders." Such behaviour could all too easily send us back into crisis, and yet the behaviour arises because of the incentives in bankers pay.
Removing incentives for destructive behaviour from bankers pay is an essential first step before any other new regulation has a chance of succeeding.
Yours faithfully,
The Revd. Patrick Gerard

In defense of the Tobin Tax

2009-09-03T15:30:00.000Z

Willem Buiter, Professor of European Political Economy, London School of Economics and Political Science, often writes in the FT and has a blog on FT.com. His article in the FT, 1/9/09 about Tobin Tax caused me to write the below response.
The original article can be seen at http://blogs.ft.com/maverecon/ for 2nd Sept 2009 (subscription may be required).

I don’t think that you can argue that the financial sector is too large because government effectively subsidises its cost of capital by providing guarantees. This form of governmental help is less than a year old, but the problem of the oversized financial sector had developed well before that time. In fact it was the oversized “too big to fail” aspect of the financial sector, which effectively meant that government had no choice but to provide the guarantees.

It seems to me that your analysis of the problems is absolutely correct. You mention excessive churning, incentives that drive traders to make transactions, too much financial activity that is not just socially worthless but actually harmful, and too much speculation and not enough insurance. You imply that regulation should be used to directly restrict the undesirable features of contracts.

But how in practice could regulators do this? How could they keep pace with market innovation? How could they be sure that each regulation added does not create some new perverse incentive?

The first step for regulators must be to distinguish socially helpful financial transactions from unhelpful ones. It seems to me that there is no clear cut test for this. However as a general rule of thumb the nearer a transaction is to the real requirements of the real economy the more likely it is to be socially helpful. If a business needs to buy a currency in order to pay for a particular import, then this is a real requirement for a currency transaction. If a foreign currency is required in six months time for an import in six months time that must be accurately costed in the home currency now, then this is a real requirement for a currency futures transaction. Such transactions, driven by real requirements, create real value in the real economy and so are socially helpful.

In contrast a financial transaction that represents a nil sum game between the participants is much more likely to be socially problematic. When a trader takes a long or short position against another trader such that one will win money and one will lose money on the transaction then this is a nil sum game which adds no real value. A small number of such transactions are useful because they provide liquidity and facilitate the efficient spreading of risk. However a large number of such transactions actively destroy value because the transaction costs are high (traders are well paid) and risks inevitably flow towards places where they are hidden or not properly understood.

In real life it would be almost impossible for regulators to distinguish socially helpful transactions from unhelpful ones. Any attempt to do this would create an unhelpful incentive to disguise transactions to make them look socially helpful. However a Tobin tax does have a real chance of making the correct distinction. Basically a transaction that is driven by a real requirement in the real economy can usually afford to pay a small Tobin tax. In contract a nil sum game transaction cannot, because it becomes a negative sum gain after the tax has been deducted.

The question you quite rightly ask is “What distortion is a tax on financial transactions targeted at?” The answer is that we have far too many nil sum game transactions, and a Tobin tax targets these because it makes them economically unattractive.

Christian contribution to business and economics

2009-04-17T20:38:00.005Z

Because of the speaking engagement on 18th May (see previous blog entry) I have been asked twice recently about the contribution that Christianity and Christian values can make to business life and to the world of economics. This caused me to write the following brief reflection.

It seems to me that the wealth of the Western world has, in large part, grown out of its religious (primarily Christian) values. The deterioration we have witnessed in those values over recent decades has been a major factor leading to the credit crunch. I don’t believe that we will find any lasting solutions to our economic problems before religious and ethical considerations are once again given far more prominence in our society and public life.

In particular we need a society where co-operation in building up the common good, takes precedent over competitive considerations. This requires a fundamental change in attitude! Competition has a useful function of controlling costs and ensuring efficiency. However this can only contribute positively to society of it takes place in the context of co-operation and a common vision at the top end of our society. Top people, (top business people, politicians, professionals) have a responsibility to work together for the good of all society. Excessive competition between top people has the effect of pulling society apart, just as we have seen our financial services sector pulled apart. Competition between top people also seems to increase pay and other costs, rather than control them.

We need to find ways of encouraging top people to co-operate in building a society that benefits everyone. The way that top people are paid is very relevant here because often it is higher pay that causes top people to compete with each other. The hope of higher pay can encourage top people to develop new agendas (for example setting up new investment funds) which might pay well, but do not actually benefit society. There is therefore a case for a cap on pay, which affects top people only. It should apply only to pay received for working for others as employees or as people who owe a fiduciary duty to others. Entrepreneurs should not be affected. People who want to become seriously rich should be encouraged to set up and grow their own businesses.

The management of risk also needs reform. Risks must be shared in a way that provides proper incentives to mitigate risk; they cannot simply traded away or insured away. Banks must take direct responsibility for the risks associated with the loans that they make. They should be able to evaluate and control these risks better than insurers. Banks should take proper account of the limitations of using of credit rating agencies. There is a serious conflict of interest associated with the issuing of a credit rating. Also, when making a loan, a bank needs to know if others are also making loans on the back of the same credit rating. Banks therefore need a far more traditional relationship with the people they lend money to.

Greed within general management must be constrained so that managers (especially top managers) are working primarily for the benefit of their company members (shareholders) rather than for themselves. Greed especially needs to be constrained in the financial services sector, where the top priority should be maintaining the health of the financial system as a whole. The second priority should be serving the genuine needs of the clients. Both of these activities must take much higher priority than maximising the profit of the financial services firm. A cap on pay could be helpful in constraining greed in these situations and restoring focus on fiduciary duty.

All these changes require far more attention to relationships, working together and values that are held in common at the top of our society. This is where I believe that the religions can contribute something extremely valuable to society and to the economy in particular.

Event notification - "Redeeming the Market ?"

2009-04-05T15:47:00.000Z

Ecumenical Council for Corporate Responsibility West Midlands

Invites you to

Redeeming the Market ?

Introduced by
Reverend John Johansen Berg

With

Father Patrick Gerard author of ‘Performance & Reward'
The Bonus Culture, its impact on companies, relationship and behaviour
&

Professor Chris Mallin of Corporate Governance & Finance.
Issues of ownership and control – the evolving role of shareholders

4.30pm – 6.30pm on Monday 18th May
@ Carrs Lane Church Centre
(Carrs Lane, B4 7SX)

Carrs Lane Church Centre is located opposite Moor Street Station, for more details please visit their website
http://www.carrslane.co.uk/

For more information please contact Barbara Hayes at cigb@birmingham.anglican.org

Lobbying, big business and the Common Good

2009-03-02T12:17:00.004Z

I was recently sent some material raising concerns about the decisions made by leading politicians, civil servants and their advisers. The concern is that pubic decisions and proposals are often developed in close collaboration with big business. Are they developed to serve the public interest or to serve the needs of big business?

It was pointed out to me that the UK Government’s Public Administration Select Committee [PASC] has recently called for:

1) consistent rules to prevent former ministers and other public servants from using contacts built up in public office to further their own and others’ private interests.
2) a single body to oversee and regulate lobbying.

Groups such as Vested interest in Politics [VIP] support this proposal and call for the banning of lobbies, large-scale funding of parties, and the revolving door (the practice of ministers, diplomats, civil servants and government advisors passing through the revolving door between government and private sector posts).

I was asked to comment on this. My comments are below:

I too am very concerned about the influence of big money on our public life. I certainly worry that many of our public policies e.g. on NHS drugs, satellite TV, financial regulation, armaments, and to a lesser extent energy and transport, are driven much more by the needs of the companies providing products and services than they are by the desire to serve the public good. To me the most outrages cases occur in the courts. It seems to me that if a case is presented in court, then justice requires some proportionality in the resources that the two disputing parties have to put into the legal case. I fear that sometimes (especially in the US) court cases are won by sheer weight of legal representation.

Unfortunately it is often very difficult to distinguish legitimate lobbying from illegitimate lobbying. Many areas of public life are now so complicated that professional input is absolutely necessary, even though it often represents a self-interest agenda. For example there are many areas of the debate about Nuclear Power, that only those involved in the Nuclear Power industry can properly comment on. Those people, and the consultants that they hire, almost always have a vested interest in the development of the Nuclear Power industry. Despite this it is still definitely in the public interest that their arguments are properly presented, even if we disagree with them and even if they are tainted by self interest.

When I lobby on the subject of executive pay, I have sometimes obtained lists of people who have submitted responses to a formal consultation about proposed amendments to the Combined Code on Corporate Governance for example. Overwhelmingly the responses come from corporations or consultancies who have the resources to get properly to grips with the issues and submit a constructive response. A few private individuals respond, but they usually have had some previous professional interest in the question. Responses from completely independent parties are very rare, and usually (like mine!) so tangential to the overall sense of direction that they cannot be worked with constructively.

What can be done?

We can't ban all lobbying; how would government ever know what to do?

I think we should do what we can to make the revolving door turn much more slowly. To ban it completely government would have to be able to grow and retain its own expertise among its own staff. This is made difficult by the hugely better pay and rewards that exist in the private sector. This could be addressed through better public sector pay, but I think that would just force the private sector pay higher. The better (but harder) solution is to constrain private sector pay. Another approach is to assume that the public sector will hire consultants when it needs expertise, but this is at best a partial solution too, because consultants always want to see growth and development in the sector they serve.

To me the most important thing is to build and develop in the Civil Service a very strong sense of public service and of the need to do things for the public good. This can only happen if the top people in the Civil service are those who have demonstrably done this over many years. It is undermined if the top people are those who have come in recently through the revolving door. It seems to me that this sense of making decisions for the public good must always be strengthened. Without this there is a danger than any restrictions on lobbying simply create a dangerous vacuum.

As ever there is an executive pay angle on this, because incentives drive our behaviours. The best rewarded people in our society should be those who make decisions for the benefit of the whole public interest; the common good which especially includes the good of the poor and those unable to represent themselves effectively. One would hope that such best rewarded people would include top civil servants and government ministers. Private sector pay, pay in specific sectors (such as healthcare) and most especially pay for consultancies, should generally be lower than top public sector pay. People who are paid owe a duty to work for the good of their employer. High pay suggests that this duty is being eclipsed by self interest. At present the top paid people in specific sectors are those who best demonstrate to the wider world the importance of the sector and why it should be developed. This situation somehow needs to be reversed. The best paid people in a sector should be those with a strong common good credentials who can explain to the specific sector how best it can serve the common good. Obviously we are a very long way away from this, but somehow the competition paradigm that we currently live under needs to be replaced by a public interest/common good paradigm, which is strong enough to control competition.

Obama Introduces Limits on Bankers Pay

2009-02-05T10:14:00.004Z

Comments in response to a Robert Peston BBC blog entry:

President Obama’s cap on pay is an important step forward. US$ 500,000 is a sensible limit. It is high enough to avoid the “If you pay peanuts you get monkeys” problem, and low enough to avoid the “If you pay gold you get pirates” problem.

It is far too easy to be cynical about the “nice warm glow” that a manager should feel for doing a service to shareholders or the public. Top people need to feel that they are making a positive contribution to society. This should always be a central aspect of their motivation for working. Without it they will never feel fulfilment from work, however high the salary. Without it we will never get a society that is run for the benefit of all. In recent years this “nice warm glow” aspect of remuneration has been total eclipsed by the issue of pay. One powerful reason for capping pay is that it will bring it back firmly into focus.

The measure applies only to the very top people in the institution. This is important because it means that, in theory, institutions can continue to pay superstar traders and other top performers very high salaries; far higher than those of the CEO and executive directors. In practice however company boards have allowed the salaries of superstar traders to become grossly inflated because they help to justify higher salaries at board level. Once board level salaries are capped we can expect, over time, to see the board make a far more realistic assessment of what star performers are really worth. I have no doubt that this will lead to reduced requirements for traders, and to lower trader salaries.

The measure is not retrospective. Companies are only affected by the limit as they increase their dependence on government. This unfortunately creates a massive incentive on the institutions to avoid or taking government help. This will lead to some completely unjustifiable behaviours rather like Barclays accepting very expensive new capital from the middle east to avoid taking much more affordable government aid. It could also lead to banks concealing their true problems in order to delay the taking of government aid. Such behaviours, it seems to me, will lead inevitably to the nationalisation of banks. This is a serious problem, but it should be seen as a transition issue, not as a problem with the measure. Quitting our addiction to high executive salaries was never going to be easy.

In his speech (4th Feb 2009) President Obama hit the key point. He said, “But in order to restore our financial system, we’ve got to restore trust. And in order to restore trust, we’ve got to make certain that taxpayer funds are not subsidizing excessive compensation packages on Wall Street.” Fundamentally the credit crunch is a problem of trust. There is an underlying question, “For whose benefit is this company being run?” Trust can never be restored while executive pay policy suggests that companies are being run for the benefit of the executives. The public sector can enforce lower executive salaries, but in the private sector they must be self imposed. If the private sector fails to do this then it will gradually disappear into the public sector.

For Obama's speech see:
http://www.ft.com/cms/s/0/ce4790c4-f2d6-11dd-abe6-0000779fd2ac,dwp_uuid=a4559040-e7c3-11dd-b2a5-0000779fd2ac.html
(Subscription to ft.com may be required.)

Full text of Robert Peston entry is at:
http://www.bbc.co.uk/blogs/thereporters/robertpeston/2009/02/obama_biffs_bonuses.html?moduserid=movabletype69_55678&pid=75447959&upm=False&asb=False&pmp=False#dnaacs
Among other things he said, "Those running banks or car manufacturers or any business which would fall over in the absence of funding from taxpayers will probably have to take much of their reward in the form of the nice warm glow that they ought to feel for doing their public duty - and defer the bonuses for a year or five."
My comment was No 229 rejected, replaced at 233.

Regulation of Bankers Pay

2008-10-18T11:38:00.005Z

On Wednesday 15th October the Financial Times published a very good article by Jamie Whyte about the diffiulties of regulating bankers pay. The article can be read (by subsribers?) at http://www.ft.com/cms/s/0/62601d32-9a51-11dd-bfe2-000077b07658.html . The article discusses the principle-agent problem (how does an owner get a manager to work for the owner's interests and not his own) and advocates inovation in devising new arrangements for performance related pay.
I responded by writing to the FT letters column. My letter was not published but is included below.

Dear Sir,
I appreciated Jamie Whyte’s excellent analysis in “Why regulating bankers’ pay is still a bad idea” (FT 15/10/08) even if his conclusions are not quite right.
Mr Whyte points out that if a business owner wants to get good performance from a greed free manager then the owner must rely on the manager’s desire to what is best for the owner. Mr Whyte then suggests that it is over optimistic for an owner to assume that he has found such a manager. Clearly to “assume” this is over optimistic, so the real challenge is to find ways of building trust between the owner and the manager such that, over time, the owner comes to know that the manager really is working for the owner’s best interests.
Trust and fiduciary duty are fundamental to success of capitalism because they are the only satisfactory solution to the “principle-agent problem”. It is hard work to sustain trust and fiduciary duty and as concepts they might be profoundly unfashionable, but we shall not escape the financial crisis until they have been re-established.
Mr Whyte prefers the alternative which is to devise remuneration schemes that align the interests of the managers with the interests of owner. In adopting this approach the owner is seeking to harness the managers’ greed to his own advantage. This drives the principle-agent relationship towards mutual exploitation and away from trust. The approach breaks down because the managers have a strong incentive (which remuneration consultants collude with) to move remuneration practice along to make it easier for managers to secure higher rewards. The moving along of remuneration practice is often presented as “innovation”, but the innovations that are easiest to agree and get implemented are the ones that work best for the managers.
Under the incentive model, owners should insist on stable long term incentives that align the managers interests with their own. One reason why they fail to do this is because owners are themselves really managers (fund managers) who are themselves seeking higher rewards from principles, so they find it convenient to collude. In reality remuneration schemes like the FILLIP, which are really serious about aligning owner and manager interests, are of little interest in the market place of remuneration ideas.
Mr Whyte’s criticisms of regulation have some validity, but regulation that imposed and kept stable real long term incentive alignment between management and owners might well be the lesser of many evils.
The real solution however is to build trust with talented and hard working managers who are willing to work for the ownership interest. How does the manager build trust? Well accepting a flat salary with no extras of, say, US$500,000 would be a very convincing start.
Yours faithfully,
Revd Patrick Gerard

2008-10-17T11:00:00.000Z

10th October 2008

Rt Hon John McFall MP
House of Commons
London SW1A 0AA

Dear Sir,

Banking Bonuses

I was very pleased to read that the Treasury Select Committee is to examine the large scale financial rescue package. I was particularly pleased that it will look at the bonus culture in the City, and the damage that this might have caused.

In this respect I hope that the committee will find my book (enclosed) useful. The book rigorously examines the incentives that arise from the typical structures of pay of top managers and executive directors. It shows how the incentives are very often too short term in outlook and too individualistic to ensure a coherent long term focus at the top of an organisation. It also proposes forms of pay that are much better aligned to the long term needs of shareholders.

With best wishes for your difficult job in these most difficult times.

Yours faithfully,

Revd Patrick H. Gerard

Letter to Hector Sants at the FSA

2008-10-16T11:28:00.000Z

10th October 2008

Hector Sants
Chief Executive Officer
The Financial Services Authority
25 The North Colonnade
Canary Wharf
London E14 5HS

Dear Mr Sants,

Banking Bonuses

In your speech about principled-based regulation on 15th May you spoke of your concerns about asymmetrical risk in the compensation schemes of securities traders. You mentioned the need for payment schemes where employees and shareholders shared more properly in the upside and downside of risks. Recent events have further reinforced the importance of your remarks! I was pleased to see in yesterday’s Financial Times that the FSA is preparing a Code of Conduct on banking bonuses.
You are absolutely right that the structures and incentives associated with banking pay have been a major factor in the development of the current crisis, and need urgent attention. This is especially important for the very top people in banks, to whom securities traders ultimately report. If executive directors and top managers have the right risk symmetry then appropriate incentives should be expected to cascade down the organisation without the need for too much prescription. My book (enclosed) makes a rigorous examination of the incentives that arise for executive directors. It makes important recommendations of how the incentives can be improved and made much safer for the longer term. I hope that your team working on the Code of Conduct will be able to make good use of the book.
There is, of course, an existing Code of Conduct on executive pay included in the Combined Code, administered by the Financial Reporting Council. This code has been singularly unsuccessful on the issue of executive pay, and any new Code of Conduct must take account of the reasons for this. An analysis of the problems is displayed at:
http://performanceandreward.blogspot.com/2006/04/combined-code.html.
With best wishes for your difficult job in these most difficult times.

Yours sincerely,

Revd Patrick H. Gerard

Executive pay and the banking crisis

2008-10-15T10:11:00.006Z

On 13th October Hector Sants, Chief Executive of the FSA wrote to banking CEOs about remuneration policies. The letter can be viewed at: http://www.fsa.gov.uk/pubs/ceo/ceo_letter_13oct08.pdf

The FSA is absolutely right that reform of banking pay is essential. The FSA's current thinking on remuneration, set out in the appendix, is a step in the right direction but much, much more is required.

The book Performance and Reward (see link "View the Book" in the left hand column) is more relevant than ever. The book proposes a form of remuneration called a FILLIP. FILLIP remuneration addresses all the FSA's concerns in a bold and systematic way, avoiding the pitfalls associated with bonus claw back. FILLIP remuneration is a straight forward way for companies to demonstrate that they have taken seriously the need to reform executive pay. The FSA says that it is difficult to be prescriptive about Executive Pay, but they could do far, far worse than prescribe FILLIPS.

Earlier today I posted onto an FT.com discussion blog the following justification for the FILLIP style approach. This was in response to a Lombard comment which can be viewed at http://www.ft.com/cms/s/0/1e710a20-9a0e-11dd-960e-000077b07658.html (Subscription may be required.)

Andrew Hill argues that “It will be bloody if regulators take axe to bonuses”. He is absolutely right, but the frightening truth is that it will turn out even more bloody if regulators do not block bonuses. The extraordinarily powerful financial incentives that have driven banking behaviours over the last ten years have led to value destruction on an unprecedented scale. Banking incentives must be completely redesigned if we are to break out of the loop of value destruction.
The top priority has to be the top people in the bank. The only credible incentive to give a Chief Executive or member of the top team is an incentive linked to long term growth in shareholder value. For top executives, all bonuses and performance related pay should be deferred. After five years they can be paid out in proportion to the total of shareholder value growth over the five year period. This approach solves many problems:
1) Risks have come to maturity before risk taking is rewarded.
2) The capital employed in creating profit is taken account of in reward.
3) There is proper focus on the long term. Behaviours with a short term focus are rewarded only in so far as they contribute to long term value.
4) The growth in shareholder value over five years is completely objective. There is no need to the resort to messy and value destroying arguments about whether past bonuses should be clawed back.
5) As a performance measure the five year growth in shareholder value has a rolling quality that evens out short term distortions. If shareholder value is overstated at the end of one five year period then growth over the five years just ending is overstated, but growth over the five years just starting is understated.
6) If all top executives have this same common incentive then many conflicts of interest are eliminated, because all top executives share a common incentive.
7) Effective team working in the top team is properly rewarded.
8) The common incentive incentivises the team of top executives to form a common mind about whether risks are justified, and the overall position of the bank relative to the market.
9) The common incentive makes top executives properly accountable to one another because they share the same objective.
10) If a large group of people at the top of the organisation all share a common incentive to grow shareholder value over the long term then there can be far more confidence that appropriate remuneration arrangements will cascade down to traders and other employees.
Revd Patrick Gerard
www.performanceandreward.blogspot.com

Faith and Finance Forum

2008-10-11T17:47:00.003Z

On 8th October 2008 I was asked to speak at a "Faith and Finance Forum" at St Faith and St Lawence Church in Harborne, Birmingham. I was asked to present a business perspective on Finance in ten minutes!
My slides can be accessed through this link.
Most of the presentation concerns financial businesses, and the difficulties that have lead to the credit crunch.

http://www.freewebs.com/hgerard/Faith%20and%20Finance%20Forum%20-%20Business%20Perspective%2008%2010%2008.ppt

The New World for Banking

2008-10-05T11:39:00.006Z

On 4th October 2008 a poll by ft.com asked the question, "Will the rescue plan work?". This was a reference to the $700bn rescue plan for the financial services industry finally approved by the US Congress earlier that day. I posted in the following comment, which can be viewed at
http://www.ft.com/cms/6c2bf1ce-91b7-11da-bab9-0000779e2340.html?a=tpc&s=646099322&f=851094803&m=9531017771&r=9531017771 .

The $700bn rescue plan can, at best, only help in the short term. Unfortunately the underlying long term attitudes which caused the credit crunch are still very firmly in place.
We should certainly hope that the $700bn might last long enough to allow development of new and tighter regulation for banks that is internationally agreed. Sadly it is hard to find solid grounds for this hope, because the regulation that banks really need is likely to work against the instincts and vested interests of most of the people involved in the discussions.
Banking need to be much, much simpler so that financial markets are more readily understandable. Complex derivatives proved to be much more effective at hiding risk that at managing it efficiently. Banks need to be much smaller so that failures are more manageable. Banks need to be less leveraged so they are safer and have more of a utility feel. The capital banks have available for speculation must be linked to market making obligations. Speculative capital should be strictly limited so that huge movements in short term capital cannot cause market lurches.
The incentives that drive banking behaviours need far more attention. The incentives that arise from holding a "long" equity position are much more constructive to the economy as a whole that the incentives which arise from holding a "short" position. The incentives that arise from pay need careful consideration. Top bankers should not be eligible for annual bonuses; all incentives should be on a long term basis. The top mangers in a bank must all have common incentives so that they work together, share information and form a common mind on the banks position and the state of the market. Above all the pay of top bankers must be much lower so that shareholders can feel confident that the top bankers are working for the shareholders' benefit not their own benefit. Very high pay increases the likelihood of ruthless and self-seeking characters at the top of the organisation; if you pay gold you get pirates!
In summary banking needs to become much, much more boring! Banking careers should appeal to steady and consistent people. Just like top athletes, top bankers should be subjected to regular drugs tests. The supercharged performance currently expected is not human and its puts inhuman pressures on other parts of the system.
Unfortunately we are still a very long way from a safe and boring banking system. And in the meantime what are the whiz-kids doing? Well I expect that the big prizes right now are for finding the best schemes to persuade government to take over and pay too much for the very worst assets. All this overcharged pursuit of money has killed many of our financial institutions. Are we going to allow it to kill our public finances?

Letter to Mervyn King, Governor of the Bank of England

2008-07-18T14:00:00.001Z

18th July 2008

Mervyn Allister King, Esq.
Governor, Bank of England
Threadneedle Street
London EC2R 8AH

Dear Governor,

Executive Pay in Banking

I am writing to say how much I appreciate your recent decision to forgo a large salary rise. This action demonstrates that it is more important to do the right thing for the community than to accumulate personal reward. I think it is a profoundly helpful leadership example in these most difficult of times.
In April you told the Commons Treasury Committee that, “I intend the bank to contribute to the design of regulatory and incentive structures … to try to curb the excessive build up of risk taking…” It seems to me that you are absolutely right to highlight the incentives which drive banking behaviour. It is far more important and realistic to regulate these incentives than to attempt to control behaviours that are driven by such powerful incentives.
With regards to executive directors and the very top executives in a bank, there are two specific problems with the incentives arising from current remuneration practices.
(1) Bonuses are paid for short term (annual) performance. It is far too easy to get a big bonus for behaviours which might prove to be damaging in the longer term.
(2) Conflicting personal incentives at the top level obscure a clear and common understand of the banks overall position. Banks that have retained some partnership feel at the top (e.g. Goldman Sachs) have faired much better than those with individual star performers at the top.
You might be interested in my book (enclosed). The book proposes a remuneration structure called a FILLIP, which address these two problems. All top executives have just one incentive; to create shareholder value over the long term.

Yours faithfully,

Revd Patrick Gerard
Copied to http://www.performanceandreward.blogspot.com/

To see the book click on "View the book" in the left hand column.

Rise in executive pay - is it sinister?

2008-06-13T22:00:00.001Z

Letter to "The Economist", 13th June 2008 (not published).

Dear Sir,

Executive Pay – Let the fight begin (Economist 14th - 20th June 2008 – page 18)

Your leader on executive pay, surprised me with the comment, “Managers’ pay has grown faster that workers’ pay, but the reasons for this are not sinister. Whereas workers’ pay depends on the labour market …, managers’ bonuses are chiefly tied to returns on capital”
The thing which does appear “sinister” is that executive pay appears to have no relationship to supply and demand in the market for executive talent. The difficulty of recruiting and retaining executive talent in a highly competitive international market is often cited as a reason for increasing executive pay. However if prices in that market are not related to supply and demand then that market cannot be competitive in the sense that leads to economic efficiency.
If prices in the market for executive talent are not driven by supply and demand then we have to ask what does drive them. The most likely answer is the market power of directors of public companies, who are both the principle suppliers and principle purchasers in the market for executive talent. The link between executive pay and returns on capital reflects the balance of power between executives and shareholders. The market power of a chief executive can be seen most clearly in severance payment. At the point of severance the company is not paying to recruit or retain executive talent, but rather it is buying off market power. An outgoing chief executive still has huge power, which could be used to damage the company.
The point about Ronaldo being paid vastly more than Pele is relevant, but it is not the whole story. Footballer talent can be assessed quite quickly, but the assessment of what a business manager contributes is far more subjective. Footballers are more readily interchangeable than executives. The market for footballer talent is more transparent and has better separation between buyers and sellers than the market for executive talent. Severance payments are less significant.
The market for executive talent certainly has its sinister aspects, which should be scrutinised by regulators, especially those who enforce competition law.

Yours faithfully,
Revd Patrick Gerard

Note: My dialogue with the Office of Fair Trading on this subject can be seen by clicking on the link "Competition Law" in the left hand column.

Executive Pay and Corporate Responsibility

2008-01-30T21:50:00.000Z

Rewarding Virtue - Effective Board Action on Corporate Resposnsibility

This most interesting report was recently brought to my attention. The executive summary can be accessed from:
http://www.bitc.org.uk/resources/publications/rewarding_virtue.html.

I have examined the report from an Executive Pay perspective. It is very noticeable that many of the points made in the report have points about executive pay lying behind them. There are very clear links between good practice on Executive Pay and good Corporate Responsibility.

In the following commentary I frequently refer to the book Performance and Reward. To find out more about this book follow the link "View the book" in the left hand column of this blog.

Tempatations against Corporate Responsibility

The report summary discussed two main "temptations" to be irresponsible.

1) Market failure creating incentives to be irresponsible.
This is precisely why it is so important that executive directors are rewarded only for long term performance. The graph top, right of page 4 suggests that (except in the case of persistent market failure) at 3-5 year delay on performance assessment would substantially remove the incentive to behave irresponsibly.
The report talks about the balance between short and long term rewards. The important point in the Performance and Reward book is that if Total Shareholder Return (TSR) is used as a performance measure for executive directors then the appropriate balance is 100% long term, 0% short term, because the long term TSR metric properly captures the lasting impact of all short term actions.

2) Internal incentives, e.g. from pay schemes, to act irresponsibly.
Executive directors (and other senior managers) usually seek to align the incentive schemes of their staff with their own incentive schemes in order to make sure that the staff and rewarded if and only if the director is rewarded. This means that incentive schemes tend to cascade down organisations. In other words if the directors rewards are based on appropriate long term measures then it is likely that the directors will resolve most other problems lower down the organisation.
The more difficult internal incentive problem concerns the incentives arising from promotion prospects. It is all too easy to promote people for good short term performance.

Exacerbating factors

The report summary notes that the two "temptations" can be exacerbated by pressure from investors and competitors.

1) Pressure from investors for short term returns is a very real and big problem that I suggested might be worthy of more research by ECCR. I sometimes fear that we have a "persistent market failure" problem here, which could be disastrous for our economies in the long term.

2) Pressure from competitors is discussed up "keeping the sector healthy" below.

The Report's six recommenations

Executive pay is an important background issue in all of the six recommendations of the report. I can't help feeling that the report has not quite grasped the nettle in working out the full implications in respect of executive pay.

1) Set Values and Standards
Executive pay is key to the values of the company. (See discussion of the Leadership Message in Performance and Reward, page 168ff.) Does the company have any values beyond seeking financial reward?

2) Think Strategically about Corporate Responsibility
This is a very important point, but it obviously prioritises the long term over the short term. Short term rewards are a big threat to this aspiration. [It is also interesting to notice how the HBOS example sees complexity as a long term problem. The credit crunch witnesses to this. (Complexity is also a problem in executive pay - see page 47, 143-146 of Performance and Reward.)]

3) Be constructive about regulation (This is discussed under "keeping the sector healthy" below).

4) Align Performance Management
This is clearly about pay, but the need to prioritise long term performance should come over much more strongly.

5) Create a Culture of Integrity
"Values" and Leadership Message are important here. This means that the level of executive pay is important. If the company incentives are too heavily dependent on financial reward then the main "value" in the company becomes "maximise your personal pay" which is a bad starting point for ethics. A more ethical organisation is going to focus more on the intangible rewards discussed at the end of page 3 of the report.
Also common incentives are very important here. See Performance and Reward pages 28-32. It is very hard for Director A to criticise Director B for behaviour which is necessary for Director B to get his bonus. However if the directors all have the same corporate objectives then they are much more accountable to each other for their behaviour.

6) Use Internal Control to secure responsibility
The common incentives point continues to be important here. Without it, it is very hard to blame someone for stretching boundaries to achieve a reward outcome. Precisely the reason that the incentive was set was to make the person stretch boundaries to achieve it!

Keeping the Sector Heathly

The report makes important points about being constructive about regulation and working with competitors to solve market failure problems. Incentives for "keeping the sector healthy" are extremely important to the public good, but are seriously undermined by comparitive forms of performance measurement. This is discussed in detail in Performance and Reward pages 37-41. The incentives would work far batter if all companies only used absolute measures of company performance. [The trouble is that it is comparative considerations that are used to justify high executive pay - so they are very popular].

The point can be taken even further. It is important that all executive directors have incentives to keep the world and national economies healthy and prosperous in the long term. Comparative performance measures certainly work against this. Defined Contribution Pension Schemes for executive directors would help here - see Performance and Reward 138-9.

Conclusion

It is very clear to me that Executive Pay is an extremely important issue that can either support or frustrate efforts to improve Corporate Responsibility. In fact my personal suspicion is that the bad practice on executive pay since the mid 1980s has been a big factor leading to the problems in Corporate Responsibility that we have seen in more recent years.

Paul Myners on Moral Hazard in banking

2007-12-06T20:50:00.000Z

Following my recent entry on the moral hazard in banking, I was very interested to read Paul Myners comments on a similar theme. These comments were made in a substantial interview reported on ft.com 4th December 2007.
The full interview can be found at (subscription maybe required):
http://www.ft.com/cms/s/0/7272fc1c-a28b-11dc-81c4-0000779fd2ac.html

Specifically on the moral hazard point Mr Myners said:

"I think there’s an inbuilt moral hazard in banking. I think that isn’t just confined to banking. I think it includes private equity and other forms of investment in which the incentives to take on risk in pursuit of reward are not symmetrical to the consequences of getting that wrong. So there’s a natural inclination to stay with risk for too long. Chuck Prince embraced this in his famous statement about the music’s still playing, but I think that’s true to some extent to equity investors as well. While the market is rising, it is better to stay in than to seek to anticipate a fall, get that wrong for a short period of time, underperform against an index and benchmark and other managers, and run the risk of losing the account. So, the economic rationality that should lie behind equity and other forms of investment, doesn’t always work in the way that the economist assumes because the economist has not factored in the agency risk for the agent underperforming against expectation."

It seems to me that the problem that Mr Myners describes is not so much "inbuilt" but rather a direct consequence of the way fund managers are paid and of performance being measured over too short a timescale.

If I had my own money invested in a market that was still rising, but expected to fall significantly at some point in the next year, then I would clearly be looking to sell [Interestingly I did move significant personal money out of equities in June 2007!].

Surely then if I employ a fund manager to look after my interests then the fund manager should also be looking to sell my assets for me in this scenario. But Mr Myners points out that this strategy does not work for the fund manager because, if the market continues to rise for several months then the funds performance will look poor over this period, and the fund manager will lose his bonuses.

[I do worry that American stock values are currently propped up by fund managers looking at each others behaviour and all desperately hoping that they can get through to year end without a big fall. Should we expect a big fall early in the new year?]

It seems top me that there are two possible ways round this problem:
1) Stop all performance related pay for fund managers. They could be paid a flat salary and encouraged to take seriously their fiduciary duty to the underlying owners of the assets.
or
2) Require all performance related pay for fund managers to be linked to long term (five years?) performance measures, using a structure similar to the FILLIP described in Performance and Reward.

Obviously it is important that the people who hire fund managers also restrict their attention to long term performance. If they move their money too often they undermine the long term thinking of the fund manager. Mr Myners comments about developing the expertise of Pension Fund Trustees are important in this respect. However it is important that any "professionalism" in pension fund trustees stops short of giving them a vested interest in outcomes, or does anything to undermine their duties to the underlying owners of the funds.

Angela Merkel on executive pay

2007-12-04T13:36:00.000Z

Following Mangela Merkel's complaints about excessive executive pay, ft.com ran a discussion, "Are top executives paid too much?" This was my contribution:

Executive Pay by Patrick Gerard 03 Dec 2007 09:24 PM
Yes, top executives are paid far to much. As the FT front page and leader reported on 15th October, even US Corporate Leaders think they are paid too much. How have we got into this situation? There are several factors:
- conflicts of interest within a unitary board
- lack of focus on fiduciary duty
- the temptation to see salary as a quantifyable (but utterly flawed) measure of business success
- Remuneration consultancies who find it easier to sell services if they promote high rewards
- Increasing professionalisation and complexity in the pay setting process, preventing outsiders from making effectively comments
- The practice of comparing salaries and seeking to pay above median
- institutional investors being so well paid themselves that they can't complain about excessive pay in management

In the UK regulatory problems have also contributed:
- Almost all the top people in the Financial Reporting Council are people who have benefited from high executive pay
- A concenus approach to the definition of the Combined Code has forced it to collude with high executive pay
- A government too dependent on support from business to raise issues that business finds difficult

Is excessive executive pay really a big problem? Absolutely yes! It creates an environment in which a manager has to "play the game" of prioritising personal rewards over the financial health of the nation. Pay (specifically stock options) was a huge factor in the dot.com crisis and short term rewards were a big factor in the credit crunch. How long before top earners are allowed to distroy our economy?Angela Merkel is absolutely right to call for intelligent regulation of these matters. Business leaders should put their own house in order before the blunt instrument of regulation does it for them.

This appeared on ft.com at:
http://www.ft.com/cms/6c2bf1ce-91b7-11da-bab9-0000779e2340.html?a=tpc&s=646099322&f=386092324&m=1781098751&r=1781098751
(subscription may be required)

A Christian Perspective on Corporate Governance and Executive Pay

2007-11-21T21:20:00.000Z

I was invited to write a Christian perspective on Corporate Governance and Executive Pay for Faith in Business Quarterly. My article is below. It was published in volume 11.2, November 2007. Find out more about Faith in Business Quarterly at www.fibq.org .

Executive Pay and Corporate Governance

Executive pay is a subject of growing importance. This is mainly because the amount that we pay to senior executives started to grow significantly in the mid 1980s and has continued to grow either rapidly or significantly ever since. Statistics from HM Revenue and Customs suggest that the total income paid to top earners in the UK has increased five fold in real terms between 1987 and 2004[1].

It is important to realise that this is part of a trend that stretches across the whole western world. Executive salaries in America have set the pace with the UK, France and Germany following close behind. Twenty years ago it was hard to become extremely rich through being employed, but now it is much more possible.

The trend is most spectacular when the distribution of newly created wealth is considered. Between 1997 and 2001, the top 10 per cent of US earners received 49 per cent of the growth in aggregate real wages, while the top 1 per cent received 24 per cent! Meanwhile, the bottom 50 per cent received less than 13 per cent.[2] In other words the benefit of new wealth creation in the US economy accrues substantially to the people who need it least. Ronald Regan used to argue that allowing the rich to get richer would cause the whole economy to grow and the benefits would trickle down to the poor. It would appear that the rich have become so effective in capturing their share of new wealth that trickle down hardly occurs. The social justification for economic growth becomes rather thin if the benefits of growth are shared so unevenly.

There has been a significant political outcry against excessive pay in most of the world’s big economies. Politicians, quite rightly, have wanted to know how these generous pay awards have come about, and whether they are really necessary. This has led to an increased focus on Corporate Governance.

A company’s corporate governance is the set of systems and procedures by which, at the highest level, the company is governed and controlled. In the US and the UK companies are usually headed up by a board of directors, so corporate governance is mainly concerned with the way that the board functions and makes it decisions. Of course, one of the key questions is how a company board determines how much it will pay its directors. The board of directors has a rather obvious conflict of interests on this question; increasing the directors pay is good for the directors, but may not be good for the company itself, which has to foot the bill.

Political interest in corporate governance, and executive pay in particular, has lead to the development of codes of best practice. In the UK the pre-eminent such code is known as The Combined Code on Corporate Governance[3] and is administered by the Financial Reporting Council.

The Combined Code requires large listed companies to have a remuneration committee that is responsible for setting the pay of the executive directors and other senior executives in the company. The remuneration committee is a sub-committee of the main company board. The members of the remuneration committee are non-executive directors, and so have no immediate or direct interest in the pay that they are controlling.[4] In remuneration reports, remuneration committees typically state that it is their policy to set pay so as to recruit, retain and motivate the best possible executives, in order to generate the maximum possible value for shareholders. This is more or less what the Combined Code tells them to say.[5]

Lying behind these statements is an assumption that the executive is selling his or her services in a competitive market for executive talent. Many companies are seeking to buy the services of the executive and the executive will work for the company that makes the most attractive offer. The executive will change company if a better offer is received from elsewhere. The company must therefore make an offer that is good enough to recruit, retain and motivate the executive in the competitive market.

This central assumption is widely accepted amongst the people with a direct influence on the levels of executive pay. However it should be noticed that many such people have a personal vested interest in high executive pay.[6] The picture that is painted by independent commentators is very different. The book Performance and Reward analyses in detail the incentives that arise from performance related pay in the UK. It concludes that the typical structure of executive pay in the UK cannot be explained by a desire to increase shareholder value in the long term, but rather owes more to presentational considerations, comparative pay positioning and the business model of remuneration consultants.[7] Also, although there is undoubtedly lots of competition to secure the top jobs in big companies, the market for executive talent is heavily distorted by the practice of comparative pay positioning, and by the significant control that executives in post can exert over the supply of future executives. The market therefore is highly problematic under competition law.[8]

The book Pay without Performance [9] argues convincingly that levels of executive pay in the US are ultimately driven far more by the power of the directors who serve on company boards than by a genuine arms length negotiation intended to maximise shareholder interests.

Pay without Performance presents the problem of directors paying themselves too much as a classic symptom of a wider “Agency Problem”:

The separation of ownership and control creates what financial economists call
an “agency relationship”: a company’s managers act as agents of its shareholders. The principals (the shareholders) cannot directly ensure that the agents (the managers) will always act in the principals best interests. As a result, the manger-agents, whose interests do not fully overlap those of the shareholder-principals, may deviate from the best course of action for shareholders. This is called the “Agency Problem”.[10]

The “Agency Problem” is the problem that you face if you employ people to look after something that you own. How do you make sure that they take care of it in a way that suits your interests, rather than in a way that suits their own interests? Shareholders face the agency problem in respect of the company directors that they elect. The general public face the agency problem in respect of the politicians and managers who they appoint to run public services.

Jesus comments on the agency problem extensively in his parables. Firstly there is the parable of the faithful and unfaithful servant (Matt 24:45-51, Luke 12:42-46). The servant is put in charge of the house while the master is away. If the master returns and finds the house in good order he responds by putting the servant in charge of all his possessions. This is “promotion”. Alternately if the master returns and finds the servant mistreating others and eating and drinking himself, then the servant will be cut to pieces. The parable emphasises the building of trust over time, with greater responsibility given to the servant with the good track record.

Luke’s account of the parable is followed by an analysis of the guilt of the unfaithful servant. There are higher expectations of those who have been entrusted with more. In terms of modern corporate governance, this suggests that the personal priority given to the shareholders should become higher, the more senior a manager is in a business organisation.

In the parable of the talents (Matt 25:14-30) the master asks no questions about the behaviour of the servants, but judges them solely on the financial return they have made. As the master has been away a long time, we can perhaps assume that any faults in the servants’ behaviours have had time to show through in the financial results. The same theme of trust being built on previous track record is emphasised when the successful servants are rewarded with greater responsibilities. This is further reinforced by the uneven initial distribution of the talents; the more able servants being given more, and by the master reallocating the unused talent to the most trusted servant, despite the fact that he already has the most. Luke’s account of a similar parable (Luke 19:11-27) echoes many of these themes.

Then there are two parables where the agency relationship is completely abused by the managers. The dishonest manager (Luke 16:1-13) knows he is to lose his job, so uses his master’s money to buy himself friends (though the master does find aspects of his behaviour to commend). In the parable of the wicked vineyard tenants (Matt 21:33-46, Mark 12:1-12, Luke 20:9-19) the tenants seem keen to forget that they are in any kind of agency relationship at all.

To scratch through these parables for insights on executive pay is probably seeking more from them than Jesus was ever intending to give! However it is interesting to see the assumptions that Jesus makes about the agency relationship and the agency problem. Jesus appears to see the agency problem as a metaphor for the difficulty that God has in getting human beings to behave properly. In the parables the master only ever seeks to manage the agency problem through trust. There appear to be no other mechanisms of audit or control. The managers are free to honour the master’s trust, or to abuse it. The consequence of honouring the trust is the building of greater trust and increased responsibility. The consequence of abusing the trust is dismissal or worse. There is a consistent theme of responsibilities and opportunities being handed over to the most trusted servants.

It is interesting to compare these assumptions of Jesus with the way that corporate governance works today. The 2006 version of the Combined Code uses the word “trust” only once in its 25 pages, and that is in the preamble. The word “honest” does not appear at all. The word “integrity” appears twice, but it applies to financial information rather than to people. In contrast the key words in the Combined Code are “transparency”, “control”, “independence” and “effective”.

Present day corporate governance is reluctant to ask shareholders to trust executives. Instead it emphasises the importance of aligning the interests of shareholders and directors. Alignment of interests is typically achieved through the way that directors are paid, and through performance related pay in particular. The idea is that executives get paid well if and only if the company performs well for its shareholders.[11]

And yet it is important to notice that this way of thinking about executives and company directors is a very recent development. Before the 1992 Cadbury Report there was no code of practice on corporate governance. In law the key concept was (and still is!) the fiduciary duty that a company director owes to the company, and in particular to the members of the company: its shareholders.

A fiduciary duty is the highest standard of care imposed at either equity or law. A fiduciary is expected to be extremely loyal to the person to whom they owe the duty (the "principal"): they must not put their personal interests before the duty, and must not profit from their position as a fiduciary, unless the principal consents. The fiduciary relationship is highlighted by good faith, loyalty and trust, and the word itself originally comes from the Latin fides, meaning faith and fiducia. [12]

The legal concept of fiduciary duty is clearly much more rooted in Christian thinking than the Combined Code. It depends on care, loyalty, good faith and trust. It also sits very uncomfortably with the current corporate governance practices described above. In particular loyalty does not fit with the executive changing companies in response to a better offer. Trust is reduced to trusting that the executive will do what is best for the executive, and company remuneration schemes must align incentives so that this is also best for the company. It is also widely assumed that the executive is using the company to progress his or her own interests, rather than seeking to serve the interests of the company. David Haarmeyer sees this as important:

…expecting managers to subvert their interests to shareholders is not realistic and indeed likely to lead to bad outcomes. This was the same idea that the Soviet state was model under -- that human nature is malleable. This is after all the point of corporate governance -- to use internal and external forces to align management's interests with those of shareholders.[13]

It is likely that David Haarmeyer is articulating the underlying assumptions of many people currently working in the field of corporate governance and executive pay. However, from a Christian perspective there are very serious problems with this position.

The first problem is that it presents an extremely pessimistic view of human nature. The human being (even those human beings at the very top end of our society) are unable to look beyond their own interests. This is much more pessimistic than mainstream business thinking which, when considering motivation, often refers to Maslow’s triangle of needs and the “self-actualizing” needs of top people.

A second problem is that it interprets good corporate governance as a balance point between the different vested interest groups which creates incentives for managers to deliver good outcomes for those vested interest groups.[14] This implicitly accepts that corporate governance is a power struggle in which executives, investors and investors’ representatives seek to optimise their own position. In reality the Combined Code does appear to be more the outcome of a power struggle between institutional investors and directors than a principle driven exercise to optimise outcomes for the underlying investors.[15] In this power struggle trust and co-operation are replaced by red-tape, regulations and controls.

But the biggest problem here is that individuals and institutions are expected to use their talents and powers solely to further their own agendas. This generally means maximising their own power and their own proportion of the wealth created by business activity. This creates a tension in which power and money are pulled towards those people who already have the most power and money, and away from those who are least able to defend themselves. This explains the increasing differentials in income, observed at the start of this article. It also resonates with the “war of the powerful against the weak”[16] perceived by Pope John Paul II.
Christians in business face the challenge of responding to these problems! The difficulty of finding responses that are both authentic and constructive should not be underestimated. Attempts to constrain executive pay when this is not what the company board really wants, tend to have undesirable consequences.[17] Effective change therefore requires a change in the hearts and mind of board members. One approach is to promote, by word and example, the positive values implicit in any Business Principles or Core Values that are published by the company. Sadly such publications are often not as constructive as the Principles for Those in Business[18] which emphasise values of service (principles 1 and 19) and trust (principle 7).[19]

Real success in corporate governance requires the directors to have an attitude of service towards the shareholders (and other stakeholders) showing that they respect the agency relationship and take their fiduciary duty seriously. The outward visible sign of this attitude is self-imposed restraint on executive pay. As Warren Buffet, America’s most successful investor, pointed out, executive pay is the “acid test”[20] of corporate governance.

Notes:

[1] Income statistics are taken from Table 3.6 (employment income only) available for tax year 2004/5, at http://www.hmrc.gov.uk/stats/income_distribution/table3-6.pdf . Table 3.6 for 1987/8 was supplied by HMRC following e-mail enquiries to the contact e-mail address provided in the website. The five fold increase compares the £6,780 million total earned by the 120,000 people earning more than £50,000 in 1987/8 with the £54,340 million earned by the 328,000 people earning over £100,000 in tax year 2004/5. Aggregate Inflation over this 17 year period was 83% [Based on Headline Rate of Inflation (RPI table RP02) from the table supplied at http://www.statistics.gov.uk/statbase/product.asp?vlnk=9412 ].
[2] Martin Wolf, “A new gilded age” in the Financial Times, London 25/04/06.
[3] Available from http://www.frc.org.uk/corporate/combinedcode.cfm .
[4] This does not mean that they are free of conflicts on interest. See Patrick Gerard A Response to the Consultation by the Financial Reporting Council October 2005, page 11, available from http://performanceandreward.blogspot.com/2006/04/combined-code.html .
[5] Combined Code, Main Principle B.1
[6] Patrick Gerard, Performance and Reward (Matador, Leicester) 2006, pages 178-182, 187-189
[7] Performance and Reward, pages 142-157
[8] http://performanceandreward.blogspot.com/2006/04/competition-law.html
[9] Lucian Bebchuk & Jesse Fried, Pay without Performance (Harvard University Press, MA) 2004
[10] Pay without Performance pages 15-16
[11] Performance and Reward argues that the credibility of this incentive alignment is seriously undermined by the structure of performance related pay typically used in the UK. Often the incentives faced by the executives have a short term and individualistic focus whereas the underlying shareholders benefit only from growth in shareholder value that is sustained in the long term.
[12] From http://en.wikipedia.org/wiki/Fiduciary, accessed 19/09/07
[13] David Haarmeyer, comment on blog entry at http://performanceandreward.blogspot.com/2006_06_01_archive.html added 04/08/2006.
[14] Compare definition in A Response to the Consultation by the Financial Reporting Council page 36
[15] A Response to the Consultation by the Financial Reporting Council pages 2-3,32-34
[16] Pope John Paul II, Evangelium Vitae, 25/03/95, paragraph 12.
[17] For example, according to the Financial Times Lex column 17/07/07, it was US Congress’ block on tax deductions for salaries in excess of $1million that lead to the explosion of executive stock options in 1993.
[18] See http://www.principlesforbusiness.com/
[19] For example Cadbury Schweppes describes “Aggressiveness” as one of the three key behaviours which should guide everyone in the company. See “our business principles” page 9 downloaded from http://www.cadburyschweppes.com/EN/AboutUs/PurposeValues/our_bus_principles.htm on 26/09/07.
[20] Berkshire Hathaway Chairman’s letter to shareholders 2003

Regulation of contracts for differences (CFDs)

2007-11-14T19:57:00.000Z

The Financial Times today (14th November 2007) published a letter of mine about the regulation of Contracts for Differences (CFDs). The letter was a rehash of the letter posted on this blog on 8th October 2007. The letter makes the additional point that holders of a CFD should have no influence over the business of a company, just as people who bet on a cricket match should not be able to affect the outcome of the match. Any such influence dilutes the proper influence of the real shareholders on the share register. The full text can be read at:
http://www.ft.com/cms/s/0/fa07bfe8-9253-11dc-8981-0000779fd2ac.html (subscription may be required.)

Moral hazard, bank incentives and the credit crisis

2007-11-12T11:21:00.000Z

In August, Mervyn King, Governor of the Bank of of England, made an important point about "Moral Hazard" which has not been taken nearly seriously enough. His point was that if the Bank of England helps banks that have taken imprudent risks then it encourages banks to take such risks in the future. Banks (perhaps imprudent banks?) complained that his stance was out of line with Europe and America and impractical. But now that the Bank of England has pragmatically made credit available there is a danger than Mervyn King's important point is forgotten about and lost.

The moral hazard problem on bank's behaviour stems from an even more important moral hazard problem in the way that bankers are paid. It is far too easy for bankers to get extremely rich on annual bonuses and other short term rewards, before the risks that they have taken properly come home to roost. When the risks finally do come home it is someone else (the banks shareholders, or public financial regulators) who carry the cost. Bonuses are not retrospectively deducted.

The problem is further exacerbated by the way that bankers are appointed or dismissed. Promotion decisions are influenced far more by personal performance in the last 18 months (before the risks taken have come to maturity) than on long term performance. Then when the risks go wrong the top man might lose his job, but he is paid handsomely for it! The message to potential future executives is clear - short termism pays both on the way up and on the way down.

To avoid moral hazard we need to take long term performance far more seriously than short term performance. In this context I was delighted to read Patrick Hosking's article in The Times, (10th November 2007, page 61, "Time to reform the way bankers are paid").

He is absolutely spot on to say that the way that pay works in the big investment banks is at the very heart of the current credit crisis. The incentives for senior bankers work over a time frame that is far too short.

As Patrick Hosking quite rightly says, shareholders should be demanding better practice on pay. But this is so obvious that I think we have to ask why it has not already happened.

I believe one reason is that shareholders are represented by fund managers and institutional shareholders who typically have exactly the same incentive problem in their own pay. They receive big incentives based on one year cycles, which are not aligned with the interests of the underlying owners of the funds. This is most clear in the case of hedge funds. A hedge fund typically charges very high fees for a good year of investment performance, but does not pay money back if the value of the fund falls. A investment strategy that makes good returns four years out of five, but which is occasionally disastrous, therefore works very well for the hedge fund manager, but not for the underlying owner of the fund.

We should be just as concerned about the way that fund managers are paid.

The book "Performance and Reward" (see link "View the book" in left hand column) suggests solutions to these problems. First of all, it sets out a form of executive pay called a FILLIP. A FILLIP depends on a far more rigorous alignment of pay with shareholders interests, such that performance for top executives is only about long term growth in shareholder value. It also, as Patrick Hosking's article suggests, holds performance related pay in a manner similar to an escrow account for, say, five years. This ensures that value lost latter in the risk cycle is properly reflected in the performance pay.

Activist investors and derivatives

2007-10-08T11:27:00.000Z

Letter sent to the FT 26/09/09 (not published).

Dear Sir,
Your article "Derivatives stand in the way of equity" 26/09/09 highlights the regulatory questions that arise from significant derivative positions held by activist investors.

It seems to me that many of the difficulties could be solved if the voting rights associated with an ordinary share did not accrue to the share owner until the owner had held the share on the share register for, say, six months. This would ensure that companies could see a potentially influential position developing over time. It would also protect companies from the activists with the most extreme short term focus.

Activist investors will obviously hate this idea, and it is true that regulation should not seek to deter legitimate activism. But how can we distinguish between legitimate and illegitimate activism? Surely a legitimate activist is one who is prepared to commit capital to a potential target for a reasonable period of time? An activist who is not prepared to do this presents no evidence of solidarity with the long term interests of other shareholders.

Yours faithfully,
Revd Patrick Gerard

Executive Pay and Competition

2007-05-10T13:00:00.000Z

Today (10th May 2007) the Financial Times published a letter of mine about Executive Pay.

The letter can be accessed (by subscribers) on the Ft.com website at: http://www.ft.com/cms/s/0977b7b2-fe93-11db-bdc7-000b5df10621.html .

The letter was writen in response to an article by Clive Crook (FT 3rd May 2007) which can be accessed (by subscribers) at http://www.ft.com/cms/s/1850f93a-f928-11db-a940-000b5df10621.html .

This is the text of my letter:

Sir, Clive Crook makes an interesting analysis of the proposition that America's rewards-for-merit contract is breaking down ("America frets about executive pay", May 3).
He refers to Prof Lucian Bebchuk's evidence that patterns of top pay reflect an abuse of management power. Mr Crook appears to accept these arguments in specific cases, but seems reluctant to accept that there is a system-wide problem, because market forces should be expected to deliver appropriate outcomes on executive pay.
If there was a well-functioning competitive market in executive talent then we would expect executive pay to reflect changes in supply and demand in that market; more big companies needing leaders would push pay upwards, more suitable candidates would push pay downwards. Instead, as Mr Crook observes, the growth of CEO pay appears linked to the growth of the companies they manage, and has very little to do with supply and demand. Mr Crook believes that this anomaly can be explained because the CEOs of big companies are not readily interchangeable.
Clearly they are not readily interchangeable, but this fact increases the market power of the incumbents. It should make us more rather than less concerned about the abuse-of-power hypothesis.
Clearly, many people compete to become CEO of large organisations, and it is very difficult to secure such jobs. However, all the competitors benefit if executive pay moves generally upwards, and collectively they have the power to ensure that it does.
This kind of competition has nothing to do with the economically efficient competition that squeezes out surplus costs for the public good. There is indeed a very serious system-wide problem.
Patrick Gerard

As the above letter suggests, there are serious problems with the way that competition works in the market for executive talent. This matter should be investigated by competition authorities. I myself have raised the matter with the Office of Fair Trading in the UK (follow the link "Competiton Law" in the left hand column) and the US (see blog entry for 3rd August 2006).

If you don't like it, sell the Stock!

2007-03-01T11:56:00.000Z

Letter to the FT - 26/02/07 (not published)

The letter below was written in response to a letter by Peter Woan, published in the FT 26/02/07. The Peter Woan letter can be viewed in full at http://www.ft.com/cms/s/4ebe74f2-c53e-11db-b110-000b5df10621.html (subscription to ft.com required).

Dear Sir,
Peter Woan's advice that, "If a public company conducts itself in a manner that a shareholder finds offensive [in respect of excessive executive pay], the shareholder's remedy is simple and quick: sell the stock," is a refreshing reminder of the traditional investment remedy. (Letters: "If you're not happy, sell your stock" 26th February 2007)
The assumption behind this remedy is that the capital realised by the sale can be reinvested in other public companies that do not indulge in excessive executive pay. Unfortunately this assumption is not valid in the UK. The practice of setting executive pay by comparison with other companies makes the executive pay of all public companies ratchet up to unacceptable levels in unison. The investor who wants to invest in public companies with lower executive pay has nowhere to turn.
The practice of comparative pay positioning is recommended by the Supporting Principle of section B1 of the Combined Code. This supportive principle should be removed. Instead remuneration committees should be encouraged to consider the leadership messages conveyed by their executive pay. This would then give investors real choice in respect of executive pay.
Yours faithfully,
Rev Patrick Gerard

Article for ECCR

2007-02-06T12:32:00.000Z

Article on Executive Pay, written for Ecumenical Council for Corporate Responsibility, to appear in the bulletin, March 2007

In 2004 I started to research executive pay in detail, and I became more and more disappointed in what I found. Coming from a business background I was very ready to believe most of the standard business arguments used to justify high executive pay. But as I looked deeper, I realised that actual practice in the field of executive pay had very little to do with the standard arguments.
For example, I often heard the argument “We need to pay well to attract and retain the best executive talent in a competitive market.” But the market in executive talent is not competitive in the economic sense; certainly there is no market price at which “supply” balances “demand”. The “supply” of future executive talent is firmly under the control of the existing chief executives, and is not affected by how much they earn. Further, this argument cannot explain why such huge sums are paid to departing directors. The high level of executive pay is far better explained by the power of the incumbent chief executives rather than by any market considerations.[1]
Similarly I often heard the argument, “This additional incentive scheme has been introduced to increase alignment between the interests of directors and shareholders.” What I found was that a remuneration committee that is serious about increasing the alignment of director and shareholder interests always has much better options than introducing a new incentive scheme. For example, it would be far more effective to align all existing incentive payments with long term growth in shareholder value. It would be more effective to move from defined benefit to defined contribution pensions schemes. The introduction of a new incentive scheme is much more believably explained by the desire to pay more, than it is by alignment with shareholder interests.
So, if high executive pay cannot be explained or justified by the traditional arguments, how has it come about? One factor has undoubtedly been a situation in which almost all companies aspire to pay their directors at above median rates. Of course, by the mathematical definition of median, it is only possible for half of all companies to achieve this, but this does not seem to discourage most companies from trying!
Another factor is the business model of remuneration consultants. The consultancy sales pitch “Hire me and I will increase your pay” is compelling! The consultancies who work hardest at justifying higher executive pay been the ones that have thrived and become most influential.
So why should we be concerned about excessive executive pay?
Well first of all, it is giving rise to a new form of inequality. In the US a CEO often earns about 400 times what the average employee earns.[2] We have not yet reached this extreme in the UK, but we are moving in that direction.
Secondly a huge share of all new created wealth is accruing to a very small number of individuals through executive pay. Between 1996 and 2001, real median earnings in the US rose by 11 per cent. Over the same period, the earnings of those in the top 1% rose by 121 per cent. Economists are becoming concerned that the economic justification for creating new wealth is undermined if the new wealth is shared so unevenly.[3]
Thirdly, whereas we can have some confidence that entrepreneurs who get rich through company dividends are creating wealth for the rest of society, we cannot have this confidence in the case of executive pay. For example, the buyers of MG Rover extracted £47m in directors’ fees before the business collapsed in April 2005[4], without ever creating a viable business plan for the company.
Fourthly, badly structured executive pay often creates damaging incentives. Pay structures can easily promote individualism, a focus on short term results, and a focus on presentation rather than substance.[5]
Fifthly, excessive executive pay contributes to a culture which equates personal success with high pay, irrespective of the success of the operation being managed or its impact on other stakeholders. Such a culture values people according to what they take from society, not what they contribute to it, and this is disastrous for the public good.
So what can we do about executive pay? Well, with regard to the way that executive pay is structured, it is relatively easy to make the business case for better structures.[6] With regard to the level of executive pay it seems to me that Competition Law might provide a way forward[7], as might a legal analysis of the concept of Fiduciary Duty. More attention to executive pay by pension fund trustees would help. Personally I think that there is some scope for improvement driven by regulation, but real progress depends on a change in culture on the part of the people who make the decisions. Such radical renewal of hearts and minds is never easy, but this is the field where the Church makes its contribution.

Rev. Patrick H Gerard, 22/01/07
Assistant Curate, St Alphege, Solihull
www.performanceandreward.blogspot.com

[1] Pay without Performance by Lucian Bebchuk and Jesse Fried (Harvard University Press, 2004)
[2] William McDonough, Chairman of Public Company Accounting Oversight Board, in testimony before US congress in June 2004, reported in UK’s Financial Times 24/08/04, page 15.
[3] Martin Wolf: A new Guided Age on ft.com site 25/04/06
[4] Financial Times front page 22/04/05
[5] Pages 28, 60 and 61 of Performance and Reward by Patrick Gerard (Matador, Leicester 2006)
[6] Chapters 1 to 10 of Performance and Reward
[7] See http://performanceandreward.blogspot.com/2006/04/competition-law.html

Simplifying Executive Pay

2007-01-09T16:30:00.000Z

Comment on "It pays to simplify executive compensation" - 4th January 2007 by John Plender (Financial Times) Click here to see the original article (subscription required)

John Plender appears to be unduly sceptical about TSR as a performance measure. It is true that many TSR based remuneration schemes are badly designed and do pay out windfalls that are not attributable to executive performance. However this is not the fault of the performance measure, this is the fault of the scheme design. A well designed scheme will only pay out if performance has been good compared to the performance of a set of comparable companies.Similarly a well designed remuneration scheme will only pay out for genuine long term increases in TSR. Short term changes in TSR are meaningless because of share price volatility, but a well designed scheme can eliminate the effect of volatility.Growth in the TSR index over the long term is what creating shareholder value is all about. All other performance measures (including Economic Value Added) matter only because they are predictors of long term growth in shareholder value. Long term growth in TSR is the one and only performance measure on which directors should receive variable pay.John Plender is quite right to point out that it pays to simplify executive compensation. A single incentive scheme based on long term TSR growth would provide far, far better incentives than the plethora of incentive schemes with which most executives are currently rewarded.

As appeared on ft.com subscription website (9th January 2007):
http://www.ft.com/cms/6c2bf1ce-91b7-11da-bab9-0000779e2340.html?q=y&a=tpc&s=646099322&f=6361039231&m=8361039231

Home Depot & Bob Nardelli

2007-01-03T21:30:00.000Z

I sent the following letter to the FT on 3rd January 2007. It was not published.

Dear Sir,
I find it ironic that the departure of Bob Nardelli from Home Depot is being described as a victory for shareholder activists, who thought he was overpaid. Your report (Home Depot chief Nardelli steps down – ft.com, 3/1/07) suggests that Mr Nardelli will receive a severance package worth $210m, in addition to the more than $120m that he has received in compensation since joining the company. The problem of overpayment is therefore even greater now that Mr Nardelli is not running the company!
Home Depot’s share price rose 3% on this announcement, suggesting that shareholders value the potential improvements in performance far more than the $210m.
The traditional argument for high executive pay is that shareholders have to pay high to attract the best performers. However, in this case, shareholders are paying even more to get rid of a perceived poor performer, than they were paying to attract a perceived good performer. This is surely conclusive proof of Professor Bebchuk’s contention that high executive pay in the US is far better explained by the power of CEOs than by considerations of markets or performance. (Pay Without Performance by Lucian Bebchuk and Jesse Fried, Harvard University Press, 2004).
Yours faithfully,
Revd. Patrick H Gerard

Mannesmann re-trial and fiduciary duty

2006-11-02T12:50:00.000Z

The Mannesmann Directors Bonus re-trial has opened in Germany. For the FT report setting out the background see http://www.ft.com/cms/s/4cd5d0c4-648e-11db-ab21-0000779e2340.html (subscription may be required).

It seems that in this re-trial the issue in question is whether or not the bonuses paid to the Mannesmann directors represented a breach of Fiduciary Duty. I am not familiar with the technicalities of fiduciary duty under German law, but the key question would appear to be whether or not the directors were putting their own interests ahead of the interests of the company when they approved these bonuses.

At the most straight forward level it is clear that the bonuses were in the interests of the directors; they received the Euros 57 million.

In contrast, in it is not at all clear why the bonuses were in the interests of the company. First of all there was a direct cost to the company of Euro 57 million. Secondly the controversy surrounding the payments has been damaging to the company. Thirdly it seems that there was no benefit to the company in terms of the recruitment, motivation and retention of the directors. Mannesmann was being taken over by Vodaphone and the directors were effectively redundant.

So, on the basis of this straightforward analysis, the motivation for the payments must surely have been self interest rather than the interests of the company.

How might it be argued that the payments were in the interests of shareholders?

Apparently the Mannesmann directors argue that the directors should be rewarded for increasing the size of the Vodaphone bid, thereby increasing the value of the final deal to Mannesmann shareholders. To me this argument appears weak. Directors rewards should normally be defined in advance, and then paid in accordance with the promises made. The directors should rightly expect their normal salaries and any bonuses paid under pre-agreed incentive schemes, to the extent that the performance targets under those incentive schemes have been met.

The benefit of paying a reward that has not been envisaged in advance is very questionable. It might be argued that paying such rewards now encourages people to perform in the future because similar rewards might once again be paid in this way. However this argument is poor. Firstly, in the case of Mannesmann, there was no future because the company was being taken over by Vodaphone. Therefore there was no value in establishing a future rewards culture. Secondly if people are being encouraged to perform in the future would it not be far more effective to have a pre-arranged scheme so that people know what the performance objective are, and can work towards them, and know what the rewards will be.

It seems to me that a far more plausible explanation is that the Mannesmann directors somehow understood from Vodaphone that, if the takeover where to go through successfully then, for Vodaphone the question of the legitimacy of bonus payments to departing directors would be an extremely low priority. In other words Vodaphone pragmatically recognized that the personal interests of the Mannesmann directors would be seriously damaged by the takeover (because they lose their jobs) and needed to be compensated if the directors were to accept the deal.

This kind of pragmatic thinking about the interests of the threatened directors must be very prominent in any Anglo American style contested takeover. Despite this it seems clear to me that it does amount to a breach of fiduciary duty because it is primarily concerned with the personal interests of directors rather than with the interests of the company. Vodaphone might just be able to argue that it was in the interests of Vodaphone to pay off the Mannesmann directors. Mannesmann cannot make that argument because its only justification comes from recognizing a conflict of interest between its own director’s personal interests and their duties to the company.

At the first trail about these Mannesmann bonuses the defense team continually presented such payments as normal in the Anglo American business model. They may be normal, but that does not make them right. In fact under the UK’s Combined Code the Mannesmann payments are clearly wrong because they were not required to “attract, retain and motivate directors of the required quality” (Main Principles B.1). It also seems to me that any such payments are extremely problematic under the UK notion of fiduciary duty, about which I hope to write more soon.

Presentation to TUC Policy Officers

2006-09-27T14:00:00.000Z

On 27th September I made a presentation to policy officers at the TUC, Great Russell Street, London. The TUC has already done some campaigning on the issue of executive pay. The purpose of the presentation was to encourage the TUC to take this further, and to seek constructive ways in which this can be done.

Click here to see the slides (20 page Powerpoint presentation)

Fake Owners

2006-08-31T13:52:00.000Z

On 27th August the Sunday Times included an excellent article by Nicholas Berry under the headline "Fake Owners are ruining capitalism". The article is available at http://www.timesonline.co.uk/article/0,,2095-2329967_1,00.html

The point that Nicholas Berry makes is that for many listed companies the major owners of shares are pension funds, investment trusts, hedge funds, unit trusts and the like. He calls these "fake owners" because the people making the investment decisions are not the people whose money is at risk. Fake investors make their money from selling their services as investment managers. Unlike real owners, they are often not concerned about whether a particular business investment will prove to be a success or failure in the long term. They are much more concerned about the short term performance of the share price and making themselves look good as investment managers.

This is a huge problem with capitalism as we experience today. There is great pressure on business managers to meet the short term needs of fake owners. This detracts from management's ability to focus on the long term growth in business value which is what ultimately matters to end investors and to society as a whole.

The proper incentives to manage executive pay also arise from a concern for long term value creation. Fake owners find it much easier to collude with a culture of high executive pay, because they themselves like high pay and because they are not personally damaged by the negative long term effects of overpaying executives.

All of us who hope to live off pensions or savings in the future are dependent on a healthy environment for business ownership and efficient capital allocation. Without a healthy investment environment the value of the investments that underwrite our savings and pensions will be seriously damaged in the long term. We therefore need to champion real ownership and try to minimize the influence of fake owners. Here are some suggestions for how this can be done:

1) Invest in simple financial products that select good businesses to invest in and invest in them for the long term.

2) Avoid investment products that pay high fees to the investment managers.

3) Seek to invest in large funds, so that the cost of management is small compared to the size of the fund. Insist that the savings are passed back to the investor.

4) Only accept performance payments to an investment manager if the performance is measured over the long term. An investment that makes a good return four years out of five, but a serious loss in the fifth year should not get any performance payment.

5) Ensure that the fund manager can never receive commission payments directly for decisions about how your capital is invested. Hedge funds sometimes pay managers a proportion of the commission associated with stock leading. If the manager is influenced by this commission it means that the best interests of the investors is taking second place.

6) Encourage your pension fund trustees to follow these principles.

Antitrust case against the Business Roundtable

2006-08-03T13:00:00.000Z

On 3rd August 2006 I sent the following e-mail to the Antitrust Division of the US Department of Justice.

To the Citizen Complaint Centre
Antitrust Division
Department of Justice

I would like to report an antitrust violation in the market for executive talent.

Companies justify paying their top directors very generous salaries, bonuses, pensions, benefits and stock option allocations by claiming that very generous overall packages are needed in order to recruit and retain the best executive talent in a competitive market for executive recruitment and retention.

However the market for executive talent appears to be very uncompetitive in respect of the very top jobs at the very top companies. The prices that executives are able to earn in this market are extremely high and growing.

The prices that are attained in the market cannot be explained in terms of supply and demand. The number of MBA graduations is many times higher than it was twenty years ago, but the price of a CEO has still risen dramatically. Increasing executive pay does not increase the number of potential new CEOs who become available. Potential CEOs have to be trained up, given exposure and opportunities by exiting CEOs. The CEOs therefore have considerable control over supply in their own market.

The members of company boards are both hirers and providers of executive talent. This fundamental conflict of interests gives them very considerable market power in the executive talent market.

In any negotiation between a CEO and compensation committee about pay, the CEO has huge power. This is very fully documented by Lucian Bebchuk and Jesse Fried in their book Pay without Performance: The Unfulfilled Promise of Executive Compensation (Harvard University Press, November 2004) (see http://www.pay-without-performance.com/)

There is considerable coordination of the supply side of the market by the main players. Coordination takes place through the Business Roundtable. According to its November 2003 publication Executive Compensation: Principles and Commentary the Business Roundtable “is an association of chief executive officers of leading corporations”, which, “has developed six interrelated principles…to serve as best practice for the design, implementation and oversight of executive compensation at publicly held corporations.” (See http://www.businessroundtable.org//publications/publication.aspx?qs=2806BF807822B0F13D142 pages i and ii. Through the Business Roundtable forum senior CEOs work together to coordinate how they should be paid.

The CEOs of America’s largest corporations also work together, through the Business Roundtable, to defend high levels of executive compensation. This can be seen in the Business Roundtable press release of 7.5.06. (See http://www.businessroundtable.org//newsroom/document.aspx?qs=5906BF807822B0F1AD2408522FB51711FCF50C8 .) It is clear that consultants have been hired and analysis completed with the express aim of defending the rate of growth of CEO compensation over the last 10 years.

In the press release, the Business Roundtable asserts that, “Executive compensation has closely followed the growth that companies have experienced in the last ten years.” The press release is supported by analysis by Frederic W. Cook & Co. using the Mercer Human Resources Consulting database of executive compensation. The analysis shows (in chart B) a strong correlation between CEO pay and Total Shareholder Return (TSR). It seems that shareholders are prepared to accept growth in executive pay, provided the rate of growth is no greater than the rate of return that shareholders see from their investments. The relationship between TSR and growth in CEO pay suggests that CEO pay is constrained by what shareholders find politically acceptable. This demonstrates that CEOs have sufficient market power to increase pay at the maximum politically acceptable rate. It is clear that CEO pay is not constrained by market considerations such as the price of hiring a replacement CEO.

Co-ordination of the market prices is also brought about by the use of compensation consultants. Such consultants (e.g. Frederic W. Cook and Mercer) are very widely used. They compare practices in different companies and advise on levels and structures compensation that are politically acceptable. The consultancies have strong incentives to push executive pay upwards because their sales pitch to management is far more effective if they are saying, “We think you guys deserve a pay rise”.

The natural allocation of one CEO per company forms a natural market allocation scheme that executives use to keep reward packages high. Very seldom does the CEO of one large company to seek to replace the existing CEO of another. On the rare occasions when this does happen (most commonly through a take over bid) it is usually necessary to pay the outgoing CEO a very significant compensation payment. Such payments cannot be explained by the need to recruit, motivate or retain the executive; they are best explained a payment to buy the CEO out of the cartel.

IRS data tables on the internet suggest that high income (>$500,000 per annum) employees earn in total about $300 billion per annum in salaries and wages. This makes executive pay a major sector in the US economy. Even if executive pay levels are only 20% higher than competitive levels then the detriment to US economy is already $60 billion per annum.

In recent months the scandal about backdated stock options has revealed that some aspects of executive pay have had far more to do with extracting rent than they have had to do with providing the right incentive or the need to offer competitive compensation. The fact that the SEC has recently found it necessary to intervene to make executive pay more transparent (http://www.sec.gov/news/press/2006/2006-123.htm) further suggests that there are serious problems in this market.

Executive compensation and the market for executive talent should be urgently and thoroughly investigated by the Antitrust Division.

Patrick Gerard

http://www.performanceandreward.blogspot.com

A copy of this e-mail has been sent to the Federal Trade Commission: Bureau of Competition, for information.

*************
*************
Solihull
West Midlands
United Kingdom

SEC requires single figure disclosure of remuneration

2006-07-26T20:00:00.000Z

In the United States, the Securities and Exchange Commission (SEC) has decide to go ahead with new regulations to increase the transparency of executive pay.

Currently American companies publish a huge amount of detail about what they pay their various directors, but because of the complexity of the pay, the difficulty of valuing stock options and the difficulty of attributing the value of deferred compensation to specific periods, it is very difficult to determine from the reports how much in total is actually being paid to each director. In future the SEC will require companies to publish, for each director, a single figure (in US dollars) that best indicates how much in total the director was paid in the financial year.

This is a big step forward and it will significantly increase the transparency of executive pay in the US. However the technical difficulty in determining the total value of pay cannot be overlooked. There are two main difficulties in determining the total value:

1) When compensation is given in the form of options there is the difficulty of appropriately valuing the option. How do we know that the valuations are given in a fair and consistent way?

2) When compensation is deferred, or conditional, there is the difficulty of knowing in which year it should be shown.

Click here to link to spreadsheet which displays an executive pay report layout. The proposed layout addresses both of the problems identified above. This is done by including an estimate of the present value of compensation in the year in which the compensation is awarded. That estimate is then revised in each subsequent year until the compensation is finally unconditional transferred. The changes in value of past compensation are added or subtracted to each year's compensation.

This approach ensures that poor valuation methodologies can have limited long term impact. It also ensures a consistent and realistic treatment of deferred compensation.

The layout forms appendix 2 of my book "Performance and Reward". See link "View the book" in the left hand column.

This suggestion was made to the SEC via their website on 26th July 2006. Unfortunately the SEC online facility was not able to upload the attached spreadsheet, so the comment posted on the SEC site is incomplete.

Cable and Wireless - Long Term Cash Incentive

2006-07-22T09:33:00.000Z

It seems that Cable and Wireless have secured shareholder support for their controversial long term incentive plan, despite the many problems with the scheme:
Firstly the size of rewards on offer are extremely large. It would appear that 10% of any growth in the value of the business over the four year performance period will go to the executives who manage the business. Why does this need to be such a huge amount? Are the executives really working for the best interests of shareholders, or are they primarily seeking to reward themselves at the shareholders expense? Very high executive pay, such as this, makes it hard for shareholders to believe that their best interests are really being perused. Suspicion and mistrust inevitably follow.
Secondly the scheme lacks consistency over time. There will be a big push to maximise the value of the business at 31st March 2010. There is nothing in the scheme to ensure that the value created will be sustainable or will endure over any meaningful period of time. Certainly, towards the later part of the performance period the executives will have massive incentives to cut all expenditure on research, long term development, long term marketing and customer satisfaction. Their attention will be completely tied up with short term valuation issues and all focus on the longer term will be lost. This is a very bad incentive to give, and their is no need for it. All advice on long term incentive plans says that awards should be phased over time so the incentive to grow value is consistent over time and not lumpy.
There is a particularly uncomfortable provision that allows for up to 75% of all awards to be paid out a year early in such a way that they cannot be clawed back. This provides even greater opportunity for a short term grab and run approach to the rewards.
The third area of concern is the complexity, particularly of the valuation process. The good thing is that the valuations are always tied back to real stock price values. However the separation into two business units creates complications. In particular there appear to be some circumstances in which the "Group Costs" which do not lie in either business unit might get ignored. When a process is complicated it often becomes politically necessary for those who manage it to manipulate it to their own advantage in ways that others will never realise. This has to be a concern in this case.
A four concern is that the flexibility of the corporate structure is reduced going forward. The scheme vests in full if either business unit is bought out, so this might become unduly attractive to managers. Corporate reorganisations that do not fit comfortably with the two business unit approach would become unthinkable in the business because of the reward structure. Is there any really synergy between the two units? If there is synergy, then Group level co-ordination should add value, but is strongly disincentivised by the new arrangement. If their is no real synergy, why are we not looking for an immediate demerger?
So why did shareholders approve the scheme? I think they approved it because they felt it was the best deal that they were likely to get out of the management. This is a long way short of it being the best thing that the management could do for the shareholders.

My comments on the scheme are based on the scheme set down in Appendix 1 of the Notice of AGM available through the C&W Investor Relations website.

Non-executive directors and shareholder interests

2006-07-05T19:18:00.000Z

Below is another letter not published by Financial Times. Follow the link to see the original article referred to. Level 1 subscription to ft.com may be required.

Sir, Your article "Higgs suggests 'lite' rule regime for Aim" (3rd July 2006) suggested that the Higgs driven changes to the Combined Code entrenched independent non-executive directors as the guardians of shareholders' interests. This is a widely held misconception.
The Combined Code's philosophy is rather more that the chairman, chief executive and finance director are principally responsible for communication with shareholders (A.2, A.3.3, D.1). In contrast, "Non-executive directors should constantly seek to establish and maintain confidence in the conduct of the company" (page 63) so providing some checks and balances on the behaviour of the executive directors.
In fact a closer study of the Combined Code 2003 shows that it does not envisage that the non-executives have any specific responsibility to represent the ownership interest. Further, non-executives who have a significant shareholding in the company, or who have any longstanding relationship with the company are unlikely to be considered as independent in accordance with the codes criteria (A.3.1). A non-executive who is not independent cannot serve on the remuneration committee (B.2.1) or on the audit committee (C.3.1) and can only be in a minority on the nomination committee (A.4.1) and on the board as a whole (A.2). Non-executive directors who are not independent therefore have very limited scope in their role, and consequently can have only limited influence.
Unfortunately therefore the Combined Code has the, perhaps unintended, consequence of marginalising rather than increasing ownership representation on company boards. This is a serious problem because the natural incentives of company ownership are essential to the efficient working of capitalism.

Yours faithfully

Patrick Gerard

Executive pay and incentives in capital markets

2006-06-22T08:06:00.000Z

On 20th June the Financial Times published a letter from David Haarmeyer which emphasised the role of activist shareholders with large stakes as an important constraint on executive pay. Whilst Mr Haarmeyer clearly has a point, the significance of the point is overstated. It is in fact completely unrealistic to assume that the incentives of the capital markets will ensure responsible practice on executive pay. I wrote to the Financial Times on this subject. The letter was not published, but is set out below.

(To see Mr Haarmeyer's letter or any of the relevant FT articles follow the links below. Level 1 subscription to FT.com may be required.)

My letter:

Sir, David Haarmeyer's letter ("Active investors are critical for controlling management"), 20th June) was too hasty to suggest that your article "What Price talent?" (Comment and Analysis, 16th June) was "high on moralistic indignation but less so on substance".

Mr Haarrmeyer quite rightly points out that independent directors are not in a position to properly hold management to account. His gives good reasons for this, the most crucial of which is the lack of proper incentives faced by the independent directors. Independent directors usually hold little or no equity stake.

However Mr Haarmeyer then rushes ahead to suggest that active investors with significant stakes do have proper incentives to control executive pay. If only it were that simple! Sadly however there are very important mismatches between the incentives faced by active investors and the behaviours which would be optimal for the underlying owners of the funds that they control.

Firstly, the hedge fund style active investor gets paid a big bonus in a year in which investments do well, but suffers no penalty in a year when investments do badly. As John Plender points out ("The games investors play", 18th June, ft.com) such investors therefore have a big incentive to provide the equivalent of catastrophe insurance.

Secondly, a person in the role of active investor has a disproportionate need to present strong recent performance because this is the basis on which that person is assessed, measured and given new opportunities. Long term performance is therefore compromised.

Thirdly, many large active fund managers are owned and controlled by FTSE 100 companies. This completely compromises their ability to comment critically on the corporate governance or executive pay of such companies.

Fourthly, and specifically on the subject of executive pay, activist fund managers are themselves notoriously well paid. In many cases, through their own pay they take far more from the underlying owners of their funds than company chief executives could ever justify. Activist fund managers are therefore in no position to critique the pay of chief executives. In fact their incentive is to support excessive executive pay to make their own position appear more credible.

For these four reasons it is not realistic to depend on the incentives of the capital markets to control executive pay. Rather we are quite right to demand that chief executives put the shareholder interest before their own, and provide evidence of this by exercising restraint on their own pay.

Yours faithfully, Patrick Gerard

Executive compensation in crisis

2006-06-16T11:58:00.000Z

The FT is full of executive compensation today (16th June 2006). On page 13 there is a full page of "Comment and Analysis" digesting the effects in the US of the options backdating scandal and the shareholder revolt over executive compensation at Home Depot. On page 16 the Lex column contemplates the inevitable feeling among investors that they have been taken for a ride by executive compensation arrangements.

I am grateful to the Lex column for its timely comments on executive compensation. Now is the time for a complete reconsideration of the way that executive pay is set.

As Lex points out, the traditional defense for high compensation is that this is what it takes to attract talent in a competitive market. If we take this argument seriously then we must question if the market is truly competitive. Lex also notes that executives appear to have very significant protection against real market pressures. Part of this arises because, as appointers of executive directors, company board members are dominant in their own market. Part of it arises from price distorting mechanisms, such as the near universal desire to pay executives at median level or above. These two issues ensure that the market in executive talent is far from truly competitive. It should be investigated by competition authorities. I seek to make the case for a competition law enquiry elsewhere in this blog.

The idea of recruitment in a competitive market can never provide a sound basis for setting executive pay. It implies that executives are selling themselves in a market to maximise their own personal return. This is completely in contradiction with the fiduciary responsibilities to act in the shareholders best interests. It introduces a fundamental conflict of interests in the board as both buyer and provider of executive talent. The executive director can only make sense as a role of service to shareholders. Executive pay has to reflect this and be set at a level which provides confidence in that attitude of service.

And where has this unhelpful idea about a competitive market in executive talent come from? I think we need to look at dynamics behind the remuneration consultancy business. Surely the best way of getting new consultancy business is to approach management with the message "You deserve more pay". Somehow the consultants have to justify that message.

This entry was originally written as a comment on the Lex Live page of ft.com. See:
http://forums.ft.com/2/OpenTopic?q=Y&a=tpc&s=646099322&f=813102159&m=923102159

Welcome

2006-04-02T22:00:00.000Z

Welcome to the Performance and Reward blog.

This blog is about executive pay. It is mainly concerned with executive pay in large companies in the UK, but executive pay is a worldwide problem so all executive pay is of interest.

Follow the links in the left hand column to access the resources available through this blog.

The Problem

2006-04-02T21:00:00.000Z

Current the bigger FTSE companies in the UK manage executive pay very badly. There are two key problems:

Firstly the way that executive reward packages are structured provides the executives with very bad incentives. Instead of encouraging executives to focus on the long term interests of the shareholders the incentives often encourage them to focus on their own personal short term interests. Executive reward packages need to be restructured so that incentives are focused on the long term interests of shareholders.

Secondly the overall level of executive pay has risen far too high. The level of executive pay is now so high that it is almost impossible to think of the executives as agents of the shareholders, working to promote the shareholders' best interests. Instead the very high pay suggests that we should think of executives as excessively concerned about their own personal rewards. This creates a very unhelpful image. If companies are to thrive we need to maintain a positive view of executives as people primarily concerned with the interests of shareholders and other stakeholders. For this reason it is important that the overall levels of executive pay are reduced.

These two problems have caused company boards to loose sight of their primary objective of serving the long term interests of their shareholders. This has caused a complete breakdown of trust between shareholders and board members. Huge efforts have been made to restore trust through "Corporate Governance" but often this fails to address the real underlying problem which is executive pay. Instead it results in more and more red tape, scrutiny, excessive requirements for external communication, and business environments that are unreasonably averse to risk.

All of this is very bad for the returns generated by listed companies in the UK. This in turn threatens the returns generated by investment products and pension funds throughout the UK, having an adverse effect on everyone in the country. The problems of executive pay need to be addressed urgently.

Solutions

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There are no easy solutions to the problems in executive pay. However there are many helpful steps that can be taken and this blog explains some of them. This blog provides three particular resources to help address the problems of executive pay. The three resources are:

The Combined Code Changes. The Combined Code provides guidance on how company boards should be managed for listed companies in the UK. The Combined Code is currently very ineffective in addressing executive pay. Click here or follow the link “Combined Code” on the left to see how the Combined Code could be improved.

The Competition Law Case. The current arrangements for setting executive pay in the UK amount to an appalling breach of competition law. An investigation by the competition authorities is long overdue. Click here or follow the link “Competition Law” on the left to understand the case under competition law.

The Book. I have recently published “Performance and Reward” as a book. This sets out in detail the problems with executive pay and what can be done to address them. Click here or follow the link “View the book” on the left to find out more about the book.

Combined Code

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The Financial Reporting Council (FRC) publishes the Combined Code which provides guidance on how listed companies in the UK should organise their company boards. A company is listed is you can buy and sell shares in that company on a stock exchange. The Combined Code does give some guidance on executive pay, but the problems we now have show that the guidance has been very ineffective.

In October 2005 the FRC conducted a consultation about the implementation of the Combined Code. I sent in a detailed response showing how the Combined Code could be improved to make it more effective in respect of executive pay.

Clear here to open my submission to the FRC (pdf file, 41 pages, 4th Oct 2005)

Competition Law

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Executive pay in a large listed company is set by the Remuneration Committee. Most remuneration committees decide the appropriate level of executive pay by making comparisons with what other similar companies are paying. This practice is called Comparative Pay Positioning.

The big problem with comparative pay positioning is that almost all companies want to pay their executives an average amount or more than an average amount. Of course this is impossible because, by defintion, half of all executive pay must be below average, but this does not stop the remuneration committees from trying! Each year they increase executive pay to achieve average postion or better. Almost all remuneration committees do this so the level of executive pay is forced ever higher.

Comparative pay positioning creates a powerful upward ratchet on executive pay. It is therefore a price fixing mechanism and so it is illegal under competition law. I have been in dialogue with the Office of Fair Trading (OFT) who enforce competition law in the UK. The OFT should investigate and clamp down on comparative pay positioning before it forces executive pay up even higher.

Click here to open my first submission to the OFT (pdf file, 28 pages, 9th April 2005)

Click here to open the OFT's response (pdf file, 2 pages, 26th April 2005) reconstructed from scan.

Click here to open my second submission to the OFT (pdf file, 16 pages, 28th June 2005) attachments not included.

Click here to open the second response from the OFT (pdf file, 2 pages, 10th August 2005) reconstructed from scan.

Click here to open my third submission to the OFT; a letter requesting a market study (pdf file, 9 pages, 9th September 2005)

Click here to open a description of my exchanges with the OFT between September 2005 and June 2006 (pdf file, 3 pages, 9th June 2006)

Click here to see the antitrust case for the US market (Posted 3rd August 2006)

The book: Performance and Reward

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Click here to view the book on the publishers website. Google Preview is available through this site, allowing you to read most of the book and to search its pages.

Click here to view the book on Amazon.co.uk. From this site it is possible to search the pages of the book.

Click here to view the book on Google Books. It is possible to read most of the book from this site using a larger window than in Google Preview.

Performance and Reward was published in April 2006. The book reviews typical executive pay practices in the UK and highlights the problems that these cause. It also shows how the problems can be solved.

Most of the book is concerned with a detailed examination of the incentives arising from a typical executive reward package. Unfortunately the incentives are seldom properly focused on the creation of long term shareholder value. Short term, individualistic incentives are far too common, and the book shows how damaging these can be. The book proposes a new executive pay structure called a FILLIP, which ensures that executives have incentives to create shareholder value in the long term.

The last part of the book is concerned with the level of executive pay. It explains how the current very high levels of pay have come about and examines some of the problems that these have caused. The book highlights the limitations of a comparative approach to setting executive pay. It encourages remuneration committees to consider the leadership message that is conveyed by the level of executive pay.

The book is important reading for anyone directly involved in executive pay policy. Members of remuneration committees will find it particularly useful, although all directors of listed companies need to be aware of its main points. Activist shareholders, consultants, lawyers, accountants and regulators concerned with executive pay will find in the book an essential critique of current practice and constructive suggestions for making improvements.

What can be done?

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If you are interested in executive pay policy or serve on a remuneration committee then you should read the book. Use the link "View the book" on left.

If you are a private investor you could ask a question about executive pay at a company Annual General Meeting. You could ask:

Given that sharholders are interested in the long term growth in value, why does the company operate such a generous annual bonus scheme based on one year targets?; or
Has the remuneration committee examined the possibility of implementing a FILLIP structure for executive pay, as described in the book "Performance and Reward"?; or
Does the company's remuneration policies provide any evidence that the directors are more concerned with creating value for shareholders than they are with their own personal rewards?

If you are an ordinary UK citizen you still have a legitimate interest in executive pay. You may well own shares indirectly through a pension scheme or through an investment product. Even if you are simply a consumer, some of what you spend is used to fund executive pay. You could:

Ask your MP if he or she supports an Office of Fair Trading investigation of executive pay.
Ask your trade union whether it lobbies on executive pay, and whether it is aware of this website.
Write letters to newspapers about executve pay.
Tell your friends about this website.

About Me

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I have 16 years of experience working in larger FTSE 100 companies. My experience covers utilities, regulated networks, commodity markets and oil and gas. I have worked in India and Brazil, as well as the UK.
I have been interested in executive pay since my own reward package was changed in the year 2000. The incentive regime after the change was much worse than it had been before. I could not understand why the change had been made. This caused me to start researching executive pay.

I left industry in November 2003 and concentrated on writing the book "Performance and Reward". I also trained for ordained ministry in the Church of England. On 2nd July 2006 I was ordained deacon in Birmingham Cathedral and started full time work as an Assistant Curate in the Parish of Solihull. I consequently have less time to devote to this blog! I was ordained priest on 3rd June 2007.

My e-mail address is gerard@solihullparish.org.uk .