Susan Watson: Ending the corporate pay spiral

Photo / Bay of Plenty Times

The only growth in the global economy at present seems to be in executive remuneration. How can it be that executives are rewarded so handsomely when their companies have been bailed out by the Government and workers and investors have lost everything?

Blame can be laid at the door of a seductively bright but ultimately flawed idea that arose out of the law and economics movement in the United States.

Law and economics treats shareholders of a company as the principal, and the management of a company as their agents.

Shareholders entrust their money to the managers as their agents, which creates an agency problem for the shareholders.

How can management be stopped from using shareholders' funds for their own purposes? How can shareholders ensure management will safeguard their money and look after their interests with the same assiduous care they themselves would take?

The bright idea was to align the interests of management with the interests of shareholders. It was assumed that rational shareholders would seek to maximise the return on their investment in the company.

This maximisation of return could be achieved by the company paying high dividends every year and by ensuring that the share price remained high.

The solution to the agency problem was seen to be performance-based remuneration mechanisms for management, such as share options. Then it would be in the interests of shareholders and directors that the share price remain high and the company be profitable.

Seemed like a good idea. Certainly, the idea was adopted everywhere. But subsequent events have shown that the idea was flawed for several reasons.

First, no one thought enough about how much of an incentive management would need. A 2002 study showed some companies had given away up to 30 per cent of their equity to executive directors and other staff in the previous five years.

In 2008, the International Labour Organisation reported that the chief executives of the 15 largest companies in the US earned 520 times more than the average worker - compared with 360 times in 2003.

A similar relationship between worker and CEO compensation exists in other jurisdictions. So CEO remuneration levels got out of hand.

Second, the idea was flawed conceptually. It was underpinned by a conception of the shareholders as the only stakeholder group in the company whose interests needed to be considered by the board. But not since the 19th Century (and then only for a short period) have the shareholders of a company been regarded in a legal sense as the principals in a company and the directors as their agents.

Aligning the interests of managers with shareholders ignored the interests of other stakeholders, such as creditors and employees.

Creditors don't care about the share price: they just want to be paid back. Employees don't care about the share price: they just want to keep their jobs.

Third, the bright idea was wrongheaded in that it lacked common sense. Much of the remuneration was paid by way of share options, meaning that a manager, a CEO, would be incentivised to move heaven and earth to get the share price as high as possible. Inevitably this led to management taking extreme risks. If the extreme risk paid off, it would be good for everyone; if not, the manager would still get paid a salary but the shareholder could lose everything. It is not difficult to take risks with other people's money.


Of course, other factors contributed to the rapid rise in remuneration. Weakness and complacency from regulatory authorities did not help. Remuneration committees - subcommittees of the board made up of a majority of disinterested non-executive directors who were not paid salaries - were intended to act as a check on excessive remuneration.

But so-called disinterested non-executive directors were generally selected by senior management - is it too cynical to think that senior management would choose compliant individuals who would seek to please them?

Certainly, it was not surprising that remuneration committees would seek to pay their own CEOs and executives at least as much, if not more, than executives in comparable companies. So the spiral began.

Also, disclosure of remuneration which, like remuneration committees and incentive schemes, seemed like a good idea at the time, had the opposite effect to the one intended. Rather than disclosure causing executive remuneration to trend downwards because executives did not want to be seen as being over-remunerated, disclosure caused further escalation - it turns out chief executives want to ensure that they are publically seen to be paid as much and then a little bit more than their rival in the company down the road.

So what is the solution? Shareholders collectively cannot do much because shareholders don't control the company; the board of directors does. Boards of directors must recognise that their obligations are to consider the interests of the company as a whole - all stakeholders - and to ensure that the company remains sustainable - that it will carry on past the tenure of its current board and chief executive.

An English study showed executive remuneration in small and medium enterprises has not trended upwards - showing that the incentives, disclosure and comparison of remuneration in listed companies must have contributed to the current absurd levels. After all, if the going rate for a CEO was less than it is now, able individuals would still want the job.

Commercial law Professor Susan Watson is Head of Department and Deputy Director of the NZ Governance Centre at the University of Auckland Business School