As world of corporate governance, nothing stands still”.1

As Peter King recently
wrote, “in the world of corporate governance, nothing stands still”.1
Legislative bodies, regulatory agencies, and international organisations
consistently seek to improve corporate governance issues. And yet, as we bear
witness to the largest and arguably most successful global coordinated effort to
enforce compliance within corporate governance, the prevalence of executive
compensation remains an issue of great proportion. The UK government has
recently responded on a national level in regards to such issues, submitting three
specific measures to be incorporated as legislation into the UK Corporate
Governance Code2
(the “Code”). This paper will critically explore such measures in relation to
their potential effect in combatting excessive executive pay and pay without
performance, demonstrating that while the aim of these legislative measures may
create greater transparency and employee protection, the underlying methodology
by which these aims are to be achieved remains flawed and therefore unlikely to
produce the intended results.

Before analysing the government’s
proposals, it is prudent to first understand the context surrounding executive
compensation and why it remains at the forefront of corporate governance
reform. Scholars argue that the bulk of executive compensation debates began in
the 1980’s emerging in parallel with the ‘agency theory’, that is, the
separation of ownership and control with the interests of the former being
pitted against the latter.3 This quintessential ‘agency relationship’,
although addressed in legislation and soft law measures, nevertheless remains a
controversial issue – most notably when executive compensation becomes
uncorrelated to company performance.4 It can
be said that the following addendums to the Code are intended to resolve such
controversy.

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The first measure of the government’s
three-prong approach to executive pay is the mandatory requirement of listed
companies to annually publish and justify the pay ratio between the CEO and
average UK worker’s pay. This legislative measure can be assumed to tackle the
issue of companies being disconnected from their performance as well as the
worrying lack of transparency, both key concerns addressed in Theresa May’s
introductory comments. In particular, this measure is used to address the fact
that UK CEO’s earn 129 times more than the average worker, as well as ‘Fat Cat Wednesday’
(Jan 4th), the day by when a CEO has already earned more than an
average worker earns during the entire year.5 Unfortunately
for the May government, there is little empirical evidence supporting the
potential effectiveness of this first measure.6

In a peer reviewed study
conducted in 2016, it was noted that although the financial media and popular
press frequently denounce what is perceived as a large and growing gap between
CEO and median pay employees, pay ratios are generally much lower than levels
discussed in the press.7
Furthermore, the study found that “pay ratios do not inform shareholder voting or
director elections”8,
indicating that other factors within the firm may be the cause for shareholder
dissatisfaction. With that said, however, there is no denying that mandatory
disclosure of a pay ratio can be helpful in creating transparency as well as
providing a mechanism to assess the reasonableness of executive compensation.9
Nevertheless, the government should not remain complacent in believing that pay
ratios are the only issue contributing towards shareholder dissatisfaction, and
furthermore, that disclosing them will have any substantial effect towards
minimizing the gap. A potentially detrimental effect to UK businesses could
develop if companies, in light of these disclosure requirements, were to
improve the ratio by outsourcing lower paid jobs. This would simply circumvent
the pay ratio scheme, frustrating parliaments objective altogether while also subjecting
the job market to considerable hardship. To take one step further, the
suggested pay ratios might not have any real effect in circumstances where
companies have relatively acceptable or even small pay ratios but continue to
compensate executives unjustly (i.e. performance targets missed, share prices
fall, yet compensation rises).

Beyond this, and the
negative implications which may arise, is the notion that pay ratios as a whole
are an unfair comparison10; that
is, critics of pay ratios argue executives work in unstable and complex market
places and therefore their remuneration appropriately reflects this.11 However,
advocates of pay ratios rightly note that excessive pay can be highlighted by a
given pay ratio12,
leading to the objective sought by the government. Nevertheless, while the governments
aim to crackdown on excessive pay makes a positive headline contributing to its
political platform, it is important to bear in mind that executive
compensation, to a large degree, is set by public markets and therefore comparing
average worker salary against CEO pay runs the risk of disrupting effective market
forces at play.

The governments second
legislative action is to publish on a public register those companies that
receive greater than twenty per-cent opposition to executive pay packages. This
can be seen as an extension of the already implemented ‘say on pay’ measures
(albeit non-biding), thereby giving further weight to shareholder
dissatisfaction when it comes to executive pay packages. At first glance this policy
sounds promising; however, central to its methodology is the idea of public
shaming. Tom Gosling, leader of PwC’s UK Reward Practice notes, “the idea that
people are going to be shamed into paying top executives less by a given
ratio….is fanciful”.13 A
countering view might argue that public shaming is an effective behavioural tool
because it could inflict negative sentiment. Conversely, the likelihood of
long-term meaningful consequences, that is, enough to reform remuneration
policy is slim since the measure is more analogous to a soft law measure (lacks
legislative teeth). In other words, the provision doesn’t require the company
to change; it only relies on negative sentiment from investors. Legislation
that relies on negative public sentiment is not an adequate strategy.

Therefore, unless the government were to impose a mandatory reduction of
compensation after significant shareholder disproval, the current proposal is
unlikely to produce the desired results.

Furthermore, and beyond
the limited effect of the public register is the inherent flaw of pay ratios
altogether. That is, pay ratios are misleading representations of a company’s
remuneration framework due to the complex nature of public companies within
their respective sectors. To demonstrate, consider the following data from the
High Pay Centre on the ratio of chief executive to average employee pay. In
2016 Lloyds Banking Group paid its CEO £8.5m
which was 200 times the £42,719 average pay of
its 75,000 employees, but Goldman Sachs, a sector competitor, paid its CEO $21m
last year (roughly twice as much as Lloyds), but was only 45.5 times the
$460,889 average pay of its 6,149 employees.14 This comparison
clearly establishes that pay ratios are misleading statistics; therefore,
unless the number of employees and respective salaries accompany a ratio, a pay
ratio alone will not produce the intended results. Furthermore, not only will pay
ratios be ineffective in achieving their aims, they also have the potential to
misinform investors with inaccurate (statistical) representations of a company’s
remuneration framework. Assuming the May government is aware of these
shortcomings, one can only deduce that the notion of transparency is supreme.

However, this paper maintains that transparency is only as good as the
information it reveals.

The third and final update
to the Code is intended to strengthen representation of employee interest mandating
employee representation on a board level. Scholars contend that companies who
maintain and encourage employee involvement at the managerial level are more
sustainable and more likely to exert long-term performance.15 Furthermore,
Germany’s adoption of a similar approach, the use of a two-tier board system,
one of which represents employee interests, has brought considerable economic
and social success16 –
giving added authority to the governments proposals. However, while evidence exists
to support these measures in enhancing employee protection17, the
same is not true in reducing excessive and unjustified executive pay. Therefore,
inherent in the government’s policy are two fatal assumptions. First, it
assumes that employee and executive interests are at odds with each other; and
second, that the employee director or advisory council will act as a barrier to
limit excessive and unjustified pay.

With respect to the
former, consider an average employee to demonstrate; he/she likely desires job
security and career advancement, two things which are inextricably linked to a
company’s success. Therefore, while it is a logical consequence that a company’s
success will be met with additional remuneration, such remuneration is not to
be discouraged by employees since the more success the company bears the more
likely the employees interests are to become realised. Therefore, employee/executive
interests are not binary. In regards to the second assumption, critics might argue
that the employees will want the distribution of profits (i.e. executive
compensation) to be more fairly distributed within the company and will
subsequently act to moderate excessive/unwarranted remuneration. However, even
if you were to reduce executive compensation of one of the highest paid18 (£22.4 million) UK CEO’s, Arnold Donald of Carnival
Cruise Line to nil, and distribute it evenly amongst its 120,000 employees, the
net result would only be an extra £186.67 per
employee. Therefore, given the absence of any practical justification for
reducing CEO compensation from an employee perspective, it is highly unlikely
that an employee represented board will take action against pay regimes as the
money saved would not have any material impact on employee interests within the
company.

Under the proposed
methodology of pay ratios, public registers, and employee represented boards,
it has been demonstrated that failing a more robust hard law strategy, the
government is unlikely to see a reduction is excessive compensation and pay
without performance. It has been established that without the appropriate
information, pay ratios will not produce their intended effect of disclosing
corporations with unreasonable pay gaps; in fact, pay ratios alone can give
rise to conflicting information leading to a total and complete
misrepresentation of a corporation’s remuneration framework. Furthermore, in
regards to the public register proposal, it has been demonstrated that such a
strategy is too reliant on negative public sentiment leaving it without the
necessary legislative teeth required to implement meaningful long-term change. The
penultimate paragraph demonstrated that although employees will be better
represented at the managerial level with the third legislative measure, the
same would not effect excessive pay and pay without performance as a result of
two fatal assumptions. Going forward, the May government must be cognisant of
the drawbacks of pay ratios, public registers, and employee represented boards
when addressing executive remuneration and instil a more robust, hard law
approach if it wishes to achieve its intended results.

 

 

 

 

1 King
Peter, Pau Lauren, ‘Disclosure of executive remuneration in the UK: recent
developments and US comparison’ (2013) 1

 

2 UK Corporate Governance Code, 2016

 

3 Bebchuk Lucian, Fried Jesse, ‘Executive
Compensation as an Agency Problem’ (2003) 17 JEON 77

 

4 Bebchuk
Lucian, Fried Jesse,’ Paying for Long term Performance’ (2010) 139 UOP 6

5 Edmans
Alex, ‘Why we need to stop obsessing over CEO Pay Ratios’ (Harvard Business Review, 2017) < https://hbr.org/2017/02/why-we-need-to-stop-obsessing-over-ceo-pay-ratios>
accessed Dec 3 2017

 

6
“Empirical investigation of pay inequality within firms is challenging due to
lack of publicly available data” Mueller Holger, Ouimet Paige, Simintzi, Elena,
‘Within-Firm Pay Inequality’ (2017) 30 RFS 3608;

The only other country that
has implemented this measure is the United States through Section 953(b) of the Dodd Frank Act.  Although the SEC’s proxy disclosure rules are
intended to educate investors, the Center on Executive Compensation notes that
“the pay ratio
provision does not provide material information to investors, would be
extremely costly to implement and is inconsistent with the purposes of
compensation disclosure in a company’s proxy statement” Cottingham
Jan, ‘CEO vs. Worker: New Rule Requires Pay Ratio Disclosure’ (2013) 30 AB 13

 

 

7 Crawford
Steven, Karen Nelson, ‘Mind the Gap: CEO-Employee Pay Ratios and Shareholder
Say on Pay Votes’ (2016) BSB 27

 

8 Crawford
Steven, Karen Nelson, ‘Mind the Gap: CEO-Employee Pay Ratios and Shareholder Say
on Pay Votes’ (2016) BSB 28

 

9 Lacmanovic Sabina, ‘The Relevance
and Effects of the Executive-to-Worker Pay Ratio Disclosure’ (2013) 26 JDUP 174

 

10 Marino
Biagio, ‘Show Me the Money: The CEO Pay Ratio Disclosure Rule and the Quest for
Effective Executive Compensation Reform’ (2016) 85 FLR 1362

 

11 Bloom Mark,
‘The Performance Effects of Pay Dispersion on Individuals and Organizations’
(1999) 42 AMJ 37

12 Ferrarini
Gian, Moloney Ned, ‘Executive Remuneration in the EU: The Context for Reform’
(2005) 21 OREP 318

13 Oakley David, O’Connor Sarah, Parke
George, ‘Theresa May’s plan to expose boss-employee pay gap flawed’ (Financial
Times, 2016) accessed Dec 4 2017

 

14 Kalinina Elena, Patel Katherine,
Shand Louisa, ‘Research Report: Review of FTSE executive     

pay packages’
(2017) HPC 4

 

 

15 Salazar Alberto, Mohamed Munthana
‘The Duty of Corporate Directors to Tie Executive Compensation to the Long-Term
Sustainability of the Firm’ (2016) 12 OLS 12

 

16 Franks
Julian, Mayer Colin ‘Ownership and Control of German Corporations’ (2001) 14
RFS 949

17 Addison
John, Teixeira Paulino, Zwick Thomas, ‘German Works Councils and the Anatomy of
Wages’ (2010) 63 ILRR 249 ?

 

 

18 McLay Rebbeca, ‘Highest-Paid CEOs
in the UK’ (Investopedia, 2017) accessed Dec 18, 2017

 

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