The long and paradoxical history of corporate governance in Britain

 03 December 2016

Politicians have threatened to clamp down on business behaviour and boardroom pay for decades

The power and complexity of the industrial enterprise and the remoteness of decision-making have led to demands for large companies to be more responsive to the needs of society in general and of their employees in particular . . . [T]o regard the company as solely the property of shareholders is to be out of touch with the reality of the present-day company.”

If you think I have plucked this statement from the British government’s green paper on corporate governance reform, published this week, think again. It comes, in fact, from the 1977 report of the committee of inquiry on industrial democracy, chaired by Alan Bullock.

In that era of low boardroom pay, strong unions and high inflation, Bullock aroused visceral antagonism on the part of leading industrialists at one extreme and trade union class warriors at the other. For the Labour government the report was an important ingredient of its social contract with the unions. Yet it was a minority administration, beholden to Liberal and Ulster Unionist MPs who were not uniformly keen on the report’s recommendations. Industrial democracy was shelved.

Today union power has been curbed. In a world of exorbitant boardroom pay, increased inequality and an overwhelming lack of trust in business, Theresa May’s flirtation with the idea of employee directors as she campaigned for the Conservative leadership in July was aimed at creating a more inclusive economy. The green paper confirms that the prime minister has retreated from this strangely unconservative plan to have owners of capital cede power to labour. Industrial democracy, it seems, is to be strictly voluntary.

The government is now more interested in harmless advisory panels on which stakeholders would sit, together with the appointment of designated non-executive directors to take responsibility for particular stakeholder interests. The green paper also explores a number of worthy tweaks to the processes whereby executive pay is set. Yet it fails to address the real causes of the governance vacuum that has led to sky high executive pay that shows little correlation with corporate performance.

The quadrupling of boardroom pay in the 18 years to 2015 is largely down to annual bonus payments and equity-related long-term pay incentives. The thinking behind the growth of such equity-based pay in recent years rests on the need to align the interests of executives and shareholders. Yet alignment is a chimera. Chief executives’ motivation and risk appetite vary according to their age and their personal balance sheets. Even if those balance sheets and risk appetites were all the same, whose interests are they being aligned with anyway? Sovereign wealth funds, pension funds, high-frequency traders and hedge funds all have different time horizons and perceptions of risk.

The performance metrics in long-term incentive schemes, which are in reality mostly short term, are fundamentally flawed. The most popular - total shareholder return and earnings per share - are easily manipulated by, for example, shrinking investment, cutting research and development or by accounting sleight of hand. Executives engage in share buybacks regardless of the level of the share price or the existence of real investment opportunities.

All of this is economically damaging. Research in the US has shown that compared to private companies, publicly quoted ones invest less and are less responsive to changes in investment opportunities, especially in industries in which stock prices are most sensitive to earnings news. So, too, in the UK.

Meanwhile, Andrew Haldane of the Bank of England has pointed out that paying in equity even appears to increase the probability of failure. Among US bank chief executives before the financial crisis the five top equity stakes were held by Dick Fuld of Lehman Brothers, Jimmy Cayne of Bear Stearns, Stan O’Neal of Merrill Lynch, John Mack of Morgan Stanley and Angelo Mozilo of Countrywide. All bar Morgan Stanley were basket cases in 2008.

This suggests the need to shrink the proportion of performance-related pay in the total pay package as far as possible and put more emphasis on old-fashioned salary. It is also time to recognise that it is impossible to design metrics that accurately capture the performance of complex modern companies. Nor is it possible to isolate the contribution an individual executive makes to a company’s performance.

The wider paradox of the British corporate governance approach is that it is less about shareholder primacy than widely assumed. The Company Law Review Steering Group set up in 1998, on which I sat, proposed a definition of directors’ duties that required directors to serve the interests of shareholders first and foremost; but they were also required to “have regard” to wider interests, including those of employees, suppliers, customers, the environment and the community. That was incorporated in the 2006 Companies Act.

The difficulty with this stakeholder-tinged definition is that it is sabotaged by the short-termist culture of a capital market in which fund managers are fixated by a narrowly financial view of corporate performance.

The real answer to building an economy that “works for everyone”, in Mrs May’s phrase, lies less in corporate governance than redistributive taxation, regional and industrial policy and an exchange rate that works for people north of Watford. The last of these has unexpectedly been delivered courtesy of Brexit. On the others, we await the outcome with interest.

Copyright The Financial Times Limited 2016


(c) 2016 The Financial Times Limited