Week 5

Corporate Governance II
Director’s remuneration and
relationships with shareholders
 Director’s remuneration

Perhaps the most controversial part of corporate

governance – how much directors are paid.

Leads to probably more arguments than anything

else in corporate governance –

“fat-cats” and accusations of cheating common in

the media
 Last week – this week

Last week we looked at sections 1, 2 and 3 of the

Corporate Code:
1: Board Leadership and Company Purpose
2: Division of responsibilities
3: Composition, Succession and Evaluation
(briefly)
This week we’ll be looking at section 3 in more
detail as well as picking up section 5
Remuneration (section 4 later)
 Recap – agency risk

Remember the agency risk is the risk that

directors might work in their own interests rather
than that of shareholders
 Example - Buildco

Buildco Plc. is a large listed construction company.

It pays its directors a flat rate salary.

What is the possible issue with this?

 Buildco

A flat rate salary means that the directors have no

real incentive to go “above and beyond” for the
sake of the company.
They get paid the same amount whether the
company does very well or very badly. It’s
therefore in their interests to do as little as
possible – they still get paid the same!
 Alignment of interests

For this reason most frameworks of corporate

governance aim to incentivise the directors.
This is called alignment of interests – in other
words if the company does well the directors do
well. If the company does poorly the directors also
do poorly.
This aims to eliminate the agency problem by
making both group’s interests the same – the
success of the company.
 Common incentive

A common incentive is some form of performance

related pay – but this brings with it it’s own
challenges particularly in the measurement.
 Case study – Al Dunlap and Sunbeam

Al Dunlap was a famous US executive known as

“the chainsaw” and “Rambo in pinstripe”.
First CEO role was at Lily-Tulip Inc. fired 20% of
staff, 40% of the suppliers, 50% of managers
including 11 out of 13 of the board, massively
cutting costs and culture.
BUT
He was very successful – appointed CEO 1983,
1982 loss $1.8m, 1984 profit $222.6m
Lily Tulip sale deal finalised 1986 – massive profit
for shareholders.
 Case study – Al Dunlap and Sunbeam

Next large role was at Scott Paper Co. only in position

18 months:
• 35% of all employees (11,200 staff) fired or made
redundant
• 71% of headquarter staff
• 50% of managers fired
• 50% cut in R&D

BUT
 Case study – Al Dunlap and Sunbeam

Share price rose 225%

Sold after 18 months to competitor – profit of
$6.3bn for shareholders
After his time at Lily Tulip and Scott Paper he
needed 24 hour armed protection.
 Consideration points

• Was Dunlap a successful CEO?

• What are the short term implications of cutting
staff, R&D etc. ?
• What are the long term implications of cutting
staff, R&D etc. ?
 Dunlap’s last act - Sunbeam

Sunbeam was a struggling consumer products

company making everything from blenders to
garden furniture.
Hired Dunlap in 1996 as CEO to make some of the
changes he had managed at Lily Tulip and Scott
Paper.
Soon he had:
• Eliminates 6,000 of the 12,000 employees
• Eliminated 87% of product lines
• Consolidated or sold 39 of the 53 factories
 Al Dunlap and Sunbeam

Also engaged in something called ‘channel

stuffing’ – customers commit to buying heavily
discounted products now for delivery later.
Revenue recognised straight away.

What impact do you think all of this had on

performance?

A record breaking profit of $187 million!

 Sunbeam – what went wrong?

What do you think eventually happened?

Dunlap was a “one trick pony” – cuts and channel
stuffing led to short term profits, no long term
solution though.
Sunbeam eventually collapsed into bankruptcy
 Dunlap lesson

The case study illustrates well that many directors

fall into the trap of “short-termism”.
Being rewarded, like Dunlap, for making short
term gains from things that can be damaging in
the longer term. Like cutting R&D.
A director’s package should therefore reward the
longer term growth of the company.
 How is director’s remuneration made up

• Base salary
• Bonus
• Options
• ‘Perks’
 Base Salary

The base salary of most directors forms a low part

of their total pay.
A survey of the top 500 US Companies showed
that on average only 10% of their total package
was made up by base salary.
 Bonus

It therefore seems the case that CEO’s receive a

large proportion of their package in the form of
bonuses.
As we saw from the Dunlap case, however, it is
clear that these need to be done in a way to
incentivise long term performance and
development.
 Options

A common way that director’s receive bonuses is

in the form of options.
Example:
Shares in Miranda are currently trading at £1.80 a
share. The directors are given share options which
allow them to buy shares in Miranda in three years
time at £1.95 a share.
 Options

This incentivises the directors in Miranda to work

to ensure that the share price rises – if it stays at
£1.80 they wouldn’t exercise the options – they’d
make no money!
The more the share price rises the more money
they get.
 Options

Options are therefore considered to be an

effective way of ensuring that director’s interests
align with those of shareholders.
If the share price rises they both do well – there
are, however, some problems with options.
 Issues with options

One issue with options is that it is difficult to

quantify how much of a change in share price is
due to the directors. In a rising market directors
could be rewarded for just being in the “right
place at the right time”.
On the other hand directors who steer a company
well through a recession could receive very little
reward.
Consultants Towers Perrin argued in their research
that 2/3rds of the movement in share price was
down to matters outwith the control of the
directors.
 Issues with options – short termism

Although options were originally designed to avoid

the issues with short termism in some cases they
have actively seemed to create them.
It has given directors an incentive to manipulate
share prices in the short term to increase the
amount of profit they earn.
Often this involves deliberately timing the release
of good or bad news to the advantage of the
directors.
 Case study: Brocade Communication Systems

Brocade Communication Systems is a large US data

and networking company.
In 2005 Gregory Reyes, the CEO, resigned and later
received a four month jail term and fine for
manipulation of share options.
The scandal involved deliberately releasing bad news
before share options were set, this depressed the
option price. Later good news would be issued shortly
before options were exercised, thus increasing the
profit made by the directors. It was found in court
that in a number of cases Reyes had deliberately
falsified results to achieve this.
 Issues with options – moral hazard

There is also an issue with giving directors too

much of their total package in options.
By linking so much to the performance of shares it
can cause directors to undertake “gambling” like
behaviour and excessive risk taking in an effort to
ensure that the share price increases.
Essentially if directors get little unless the
company performs very well they have little
incentive to keep things steady and instead an
encouragement to take large risks to generate
growth.
 Case study HBOS

HBOS (formed by a merger for Halifax and Bank of

Scotland in 2001) was very much dominated by
Halifax’s sales culture. This had developed in the
1990s as Halifax had been demutualised and
deregulation had allowed it to grow rapidly.
Many senior executives came from a sales
background and heavily believed in remuneration
based on a strong performance.
 HBOS (continued)

In 2008 HBOS needed to be bailed out by the UK

Government who acquired a 40% stake after a
legacy of problematic mortgages.
HBOS’s former head of regulatory risk, Paul Moore,
reported that “The entire organisation was
focused on selling, selling, selling, but not on risk
management. It flabbergasted me.”
Moore was later made redundant from his role
after raising these concerns.
 Perks

Often additional benefits that directors receive.

These include:
• Use of company aircraft
• Golf club memberships
• Car and chauffer
• Personal travel
 Perks

Limited evidence that these actually do anything

to improve director performance.
For example company’s which offer senior
executives the use of a private jet on average
underperform the market by 4%!
 Pay peanuts, get…..

Running a large company is clearly a difficult and

stressful job that relies on a high degree of skill
and knowledge.
Clear that to get the right people a decent
package will need to be paid.
Consider:
• You’re about to go into hospital for an operation,
do you want the lowest paid surgeon?
• Do you want the 6 th
best striker for the football
team you support?
 Director pay

Clearly directors need to receive a package which

fairly reflects their hard work, skill and experience.
The average US listed company CEO in 2016/17
earned 204 times more that the average worker at
their company. In the same year GE CEO Jeffrey
Immelt earned 491 times more than the average
GE worker.
Does paying more buy you a better performer?
 Top paid director’s

Pfizer CEO Henry McKinnell was dismissed in 2006

due to poor performance.
He left with a $180m retirement package despite
the share price having fallen 40% during his term
as CEO.
Michael Fingleton of Nationwide Ireland Building
Society was paid €2.3m in 2008 despite the fact
that Nationwide lost more that year than they’d
ever made in their 137 year history!
 Board committees

There should normally be three committees that

sit under the board:
• Audit committee
• Nomination committee
• Remuneration committee
 Audit committee

• Oversees the financial reporting process

• Internal audit function reports to this committee
• Oversees internal controls

Membership should consist entirely of NEDs

We’ll look at later in the course
 Nomination committee

Responsible for recruiting and hiring new

members to the board.

Membership should consist of a majority of NEDs

 Remuneration committee

Sets the executive director’s pay.

Membership should consist entirely of NEDs

 The corporate code an director’s renumeration

With director’s remuneration being such a

controversial issue there is an entire section of the
corporate code dedicated to it.
Section 5 deals with remuneration.
Remuneration policies and practices should be designed
to support strategy and promote long-term sustainable
success. Executive remuneration should be aligned to
company purpose and values, and be clearly linked to
the successful delivery of the company’s long-term
strategy.
 The remuneration committee

The remuneration of executive directors should be

set by the remuneration committee.
The remuneration committee should consist
entirely of NEDs.
The code states
There should be a formal and transparent procedure for
developing policy on executive remuneration and for
fixing the remuneration packages of individual directors.
No director should be involved in deciding his or her own
remuneration.
 Effective remuneration

• Perhaps the most costly mistake a company can

make is to establish an executive remuneration
program that motivates executives to achieve
short or intermediate term objectives that are
misaligned with the longer-term strategy or
encourage excessive risk taking.
• A significant portion of pay should be incentive
compensation with payouts which can
demonstrably be linked to performance and paid
only when performance can be reasonably
assessed
 Remuneration committee

The remuneration committee should therefore

spend considerable time considering:
• The right performance metrics
• The right performance targets
• The right performance standard
• The appropriate curve
 Performance metrics

Important to set the right targets in monitoring

performance.
• Traditionally this has been very much based on
financial targets. Do financial targets offer the
only (or even the best) measure of executive
performance?
• Think about Dunlap cutting R&D?
• Good metrics will also consider non-financial
measures and the appropriate goals for the
individual director concentrating on shareholder
wealth.
 Performance targets

Targets should be set considering:

• The company’s industry
• Industry/sector growth rates
• Historical and projected performance
• Key competitor performance
Targets should be at a high enough level to
encourage development and growth but not too
high that they encourage risk taking.
 Performance standard

Important to set a standard that is based on

factors within an executive’s control.
Little point in rewarding or punishing directors for
things outwith their control.
 The curve

The curve determines how much a director will get

paid for their performance.
Should determine how director’s get paid on
minimum, target or maximum performance.
For example how much should a director get paid
if they:
• Clearly miss their targets
• Just miss their targets
• Hit their targets
• Exceed their targets
 Effective remuneration policies

Some other thing a company can do include:

• Regular review of targets
• Transparency of policies
• Limitations on options
• ‘Clawback policies’
 Effective remuneration policies

An effective company will regularly review targets

to ensure they are effective in ensuring that the
company hits long term goals.
They will also ensure that the remuneration
policies are fully disclosed in order that
shareholders and other stakeholders can
understand what directors are paid.
It’s also important that remuneration policies are
reviewed in line with the company’s risk
framework – we’ll look at risk in more detail next
week
 Limitation of options

In order to remove the risk associated with short

termism on options many companies have put
limitations on when options can be issued or
exercised.
Can for example prevent options being exercised
immediately before or after the issue of annual
accounts to reduce the incentive to manipulate
figures.
 Clawback policy

Companies should adopt ‘clawback policies’ –

these allow them to claim back bonuses etc. in
certain conditions – for example if the accounts
need to be restated.
 Remuneration committee

Executive pay has risen dramatically,

Ratio of average US Fortune 500 CEO: Average
worker
1965 20:1
1978 30:1
1989 59:1
1995 123:1
2000: 376:1
Despite this no indication that directors are
performing any better.
 Remuneration committee

Why do remuneration committees continue to sign

off increasing executive pay?
Criticisms:
• Cronyism – part of the same “club”
• Sitting on each other’s board – self interest?
• Difficult to go against executive members

Think about some of the criticisms of NEDs we looked

at last week
 Takeovers

Is it good for a company to be taken over?

For the shareholders potentially yes – allows them

to realise the value of their investment. In a
takeover the buyer often pays a premium.
Essentially allows the shareholders to “cash out”
But for the directors – they’re out of a job
 Takeovers

For this reason many directors contract contain

what are called “Golden Parachutes” giving the
directors large bonuses if they leave after a
takeover.
 Relations with shareholders

As we saw two weeks ago directors are ultimately

accountable to shareholders. They are the ones
who employ them.
Sections 1 and 3 look at how shareholders interact
with the company.
 The Annual General Meeting (AGM)

Remember the shareholders own the company,

they have the right to:
• Change auditor
• Remove any director
• Reject the directors’ remuneration package
• Appoint new directors

This is usually done at the AGM

 A question

We’ve seen over the last few weeks a number of

instances where companies don’t always perform
as well as they could.
Where directors don’t always give value for
money
Where the board aren’t as effective as they could
be.
Why don’t the shareholders use their power and
do something?
 Who are shareholders? What do they want?

A large number of shareholders don’t vote. Many

just want a return for their investment – not
necessarily interested in corporate governance.
In 1963 54% of all UK listed shares owned by
individuals.
By the 90’s 60% owned by UK institutions, 20% by
individuals, 20% by overseas individuals and
institutions
These institutions have become increasingly
important
 Who are these institutions?

Investment funds and pension funds increasingly

own the majority of shares
Traditionally not that interested in corporate
governance:
There is a weakness in the present system of corporate
governance in that responsibility for ownership rests with
people who don’t want it and aren’t seeking it. We are
investing in shares because they give us a good return
and it is coincidental really that they bring with them this
responsibility
Anonymous pension fund director
 Shareholder activism

This is changing though – some of the corporate

scandals that we’ve seen in this course, as well as
the increased development of corporate
governance have forced many institutional
investors to pay attention.
This trend of shareholders taking a more active
role in the running of companies is called
“shareholder activism”
 Case Study Nike

Nike had long being known for being involved in

the politics of many countries where it had
factories or operations.
This was criticised by many, including some
human rights activists
In late 2017 Nike was forced by its shareholders
that going forward it would have to disclose all
political. donations
 Shareholder activism is on the rise

In 2009 there were 230 shareholder campaigns

recorded in the US
In 2015 there were 355 shareholder campaigns
recorded in the US
12% of all US Fortune 500 companies recorded
some form of shareholder activism in 2015

Source AON
 Developments

For this reason the new version of the UK

Corporate Code contains much more on
relationships with shareholders.
The board are expected to regularly consult with
shareholders and remember they are accountable
to them.
The UK Combined Code also suggests the
appointment of a senior non-executive director as a
direct link between the board and shareholders.