Financial Times, June 2, 2009 column

Guy Jubb cannot remember when he last spoke out publicly at a company’s annual meeting – until this year, that is. Last month the head of corporate governance at Standard Life Investments travelled to The Hague from Edinburgh to look the board of Royal Dutch Shell “eyeball to eyeball” as he outlined his grievances at the oil group’s attitude to executive pay.

The anger evident at Shell’s meeting pointed to a new determination among shareholders across Europe to be seen to hold boards to account, clamp down on excesses and stave off the political backlash that many see brewing against corporate greed.

The mood was polite rather than ugly, with none of the violence that has marked demonstrations against bankers’ pay in the US, severance packages in France or the £700,000 ($1.15m, €810,000) a year pension awarded to Sir Fred Goodwin, former chief executive of the nationalised Royal Bank of Scotland.

But Mr Jubb’s protest at Shell, made alongside other big international investors such as the Ontario Teachers Pension Plan and Franklin Mutual of the US, was no less important in broadcasting that shareholders will no longer tolerate boards paying themselves what they wish. More than 59 per cent of Shell’s shareholders voted against the oil group’s remuneration report.

The trigger was the board’s decision to pay €4.2m ($6m, £3.6m) in bonuses to five senior directors even though the group had failed to meet set targets. Jeroen van der Veer, who steps down as chief executive this month, was awarded €1.35m from that discretionary pot, receiving a 58 per cent rise in his total pay for last year to €10.3m. Last year, the Anglo-Dutch group also broke with what shareholders view as best practice to pay three executives retention bonuses without performance hurdles. “The system is sick and needs mending,” Errol Keyner of VEB, the Dutch shareholders’ association, told Shell.

The vote against the remuneration report was non-binding but signalled an almost unprecedented level of dissatisfaction. The vote in favour of remuneration reports is usually well above 90 per cent. Only RBS’s remuneration report drew a higher No vote, of just over 80 per cent.

In the past, institutions have at times withheld their votes as a subtle indication of disapproval. Now, it is clear that those kid gloves have been flung aside. In the Shell vote, only about 2 per cent of investors abstained.

Voting down Shell’s pay plan sent a chastened company back to consult over revised proposals. It also set a new high-water mark for annual meetings in a year marked by battles about pay across Europe and an increase in No votes. According to Manifest, the proxy voting agency, four UK companies’ remuneration reports have been voted down this year – apart from RBS and Shell, they were Bellway, a housebuilder, and Provident Financial, a subprime lender – the same number as the total for the previous six years since the UK introduced its say on pay.

Other rebellions have been forestalled only by a directors’ retreat. Jean-Nicolas Caprasse, head of European governance at RiskMetrics, which advises investors on voting, says European companies including Heineken, DSM, Volvo and Carrefour, have been stopped in their tracks by shareholders and withdrawn contentious pay proposals at the last minute.

The temperature is rising everywhere. Proxy voting agencies say turnouts at meetings have risen across Europe as shareholders seek to deflect accusations from regulators and politicians that they were soft on boards and the reward cultures now blamed for contributing to the banking crisis. “Institutional investors have moved up at least one gear and probably two,” says Mr Jubb.

Underlying this is a fear that the three-part approach to pay – guidelines on best practice, enhanced disclosure and a shareholder vote holding boards accountable – that was developed in the UK and has spread into continental Europe has been found wanting and is under threat. “Investors have a lingering concern that the vote on the remuneration report is losing its power,” says Tom Gosling, PwC’s lead partner on executive compensation. He detects a “growing shareholder frustration that pay seems not so much for performance but regardless of performance, and that remuneration committees are too quick to exercise discretion”.

Shareholders have become suspicious of what too often seems like an institutional culture of generosity to executives, itself a symptom of too little challenge in the boardroom, for which investors are now being blamed. PwC warns of a “sense in the shareholder community that companies cry ‘retention’ too easily” and as a result pay has ratcheted up. “At the heart, there is a huge deficit of trust between executives, shareholders and remuneration committees,” says Mr Gosling.

UK shareholders are looking for a more powerful lever than a non-binding vote and are pushing for the annual re-election of directors who serve on remuneration committees, rather votes just as part of their normal rotation every few years.

But is this all only a momentary outburst? Mr Caprasse at RiskMetrics sees that as unlikely. If nothing else, he says, public indignation at executives’ remuneration, both in absolute terms and relative to other employees, is still high and will drive politicians and regulators towards reform.

The overhaul has begun in the crisis-hit financial services sector, with UK, US and European Union policymakers all looking at caps on bonuses and increasing the fixed element of pay. Now the urge is leaching into other sectors. The UK’s Financial Reporting Council, which oversees the country’s combined code on governance, is reviewing the efficacy of its provisions and shareholders’ role in holding boards to account on issues such as remuneration. The European Commission in April urged member states to bolster previous recommendations on disclosure and a shareholder vote on remuneration and strengthen the links between pay and sustained performance and the role of remuneration committees. Brussels also urged states to boost shareholders’ oversight of remuneration policies, ensure shareholders attend meetings and use their votes.

A bill brought before the German parliament last week will meanwhile give investors a non-binding vote on pay similar to in the UK and the Netherlands, in addition to measures to increase the transparency of board-level compensation and to put certain caps on pay.

Yet pay consultants say these regulatory changes only reinforce the dynamism of a model that pays for performance and uses share-based awards to align managers’ interests with those of shareholders. “No one can deny that some aspects of executive reward in some quarters have failed. But nobody, including investors, is prepared to throw away the model,” says John Carney, principal of Towers Perrin, one leading consultancy. “There has been a mood shift to more restraint. But there has not been a philosophical shift. The fundamental model is very much alive and kicking.”

Thirty years ago, just 10 per cent of UK executives were awarded performance-related incentives, says Towers Perrin. Now, most executive pay is tagged to performance. All executive directors of companies in the FTSE 100 index are awarded share-based bonuses. Salaries on average make up only one-quarter to one-third of a total pay package, annual cash bonuses another third and the rest are long-term share-based incentive plans.

The downturn demonstrates the system is working, says Towers Perrin. Executive salaries have largely been frozen, bonuses have not been paid out and the value of executives’ shares have fallen. As executive pay has dropped in line with shareholder returns, “rewards for failure” are being steadily squeezed out of the system, say consultants. Things are moving in the right direction, agrees Christian Strenger, a board member of DWS, Germany’s largest fund management group. “There are tangible signs that some controls are working. Pay has gone down in the financial sector and should go down this year in industry.”

Nonetheless, changes to the structure of pay seem an inevitable result of the unease over the way that performance-based bonuses have allowed executive pay to rise to ever higher multiples of ordinary staff salaries in the past decade.

In the UK, Incomes Data Services says median total pay of chief executives of FTSE 100 companies, including their options and incentives, rose 167 per cent to £2.4m between 2000 and 2008. Full-time employees’ median pay grew just 32 per cent to £25,000.

In a nod to the new spirit of restraint, some remuneration experts suggest disclosing “affordability” and “relativity” measures – that is, how directors’ pay compares with company profits and how it relates to pay for most staff. The debate also covers how much more disclosure of pay below board level should take place, as well as what are appropriate measures of performance, how rewards can be adjusted for risk and whether to ban outsize severance payments.

Penalties for failure rank high on the Commission’s and other policy-makers’ to-do lists, with calls for contracts to allow companies to claw back bonuses in the event of misstatement or fraud, or deferred bonuses that could be forfeited if executives are subsequently found to have underperformed. The UK Financial Investments, which manages Britain’s government bank holdings, has insisted that RBS and Lloyds Banking Group pay deferred bonuses after three years in the form of subordinated debt subject to clawback.

In response to the public and political pressure to end the culture of short-term rewards regardless of risk, international regulators have moved pay up the agenda. But with limited powers to intervene directly in pay, they have put the onus on shareholders to fill the governance vacuum.

Shareholders such as Standard Life’s Mr Jubb know if they fail to make their voices heard by companies, the risk is that politicians and market regulators will step in. Then both companies and investors would be likely to lose out, say pay experts. Germany has recently debated capping pay at 50 times the average wage of workers and taxing pay above a certain level at punitive rates.

“Companies ignore [this risk] at their peril,” says one EU consultant. “The danger is the unintended consequences of hastily imposed regulation. That is what should terrify everyone.”

PROPOSED US CURBS: DEATH THREATS, CLAWBACKS AND A ‘SAY ON PAY’ FOR SHAREHOLDERS

When it emerged in March that AIG planned to pay $165 (€116m, £100m) in bonuses, just after receiving more than $180bn in US government support, death threats were sent to the insurance group, writes Tom Braithwaite.

Senator Charles Schumer: backs right of investors to non-binding vote on pay

Yet, rather than the anonymous suggestions that AIG executives should be executed “with piano wire”, it was lawmakers’ outrage at the payout at that gave corporate America serious concern. It seemed that a broad range of companies – not just AIG and banks taking taxpayer money – would be hit by draconian curbs on compensation.

The anger has ebbed, and with it the most severe proposals for curbs and clawbacks, but the furore is behind prospective regulatory and legal changes to the ways publicly listed corporations are run and the rights of investors to hold them to account.

The Securities and Exchange Commission proposed last month that large shareholders should have the right to nominate directors; a bill by Senator Charles Schumer would give investors a non-binding “say on pay”; and Congress will next week start examining whether to limit short-term executive bonuses.

For David Herro, a partner at Harris Associates, the Chicago-based asset management firm, reform is overdue. He sees “a pretty stark difference” between the UK and US corporate governance regimes: “I think the US guys have got away with murder in the last couple of decades.” He advocates taking the “best bits” of the Cadbury report, which paved the way for UK corporate governance reforms when it was published in 1992, and making it mandatory for a majority of the directors to be independent and for the roles of chief executive and chairman to be separate to avoid a concentration of power. Either boards need more independent directors willing to fight for shareholders’ interests on pay, he says, or shareholders need the tools to fulfil the function themselves.

David Lynn, partner at Morrison & Foerster and a former lawyer at the SEC, says Mr Herro is typical: “Access is the Holy Grail for the investor community and they see it as the ultimate governance tool.”

But it is strongly resisted by the business lobby, which prefers the current flexibility on shareholder access, board composition and votes on remuneration. Some states give investors more rights than others and many companies have separated the functions of chairman and chief executive independent of any regulatory imperative.

“We think ultimately those proposals [from the SEC and Mr Schumer] do a lot more harm than good and they create a platform for activist agendas,” says Thomas Quaadman, an executive director at the US Chamber of Commerce. “If you’re a member of a pension fund do you want the manager of your pension fund to be making political statements or [helping you provide for] a comfortable retirement?” he asks.

But most people on both sides of the debate believe more shareholder access and a say on pay is coming, with Mr Schumer’s legislation working its way through the Senate. Investors in favour of a change can expect the support of President Barack Obama, who backed defeated legislation that would have introduced a say on pay in 2007. For businesses resistant to reform, this threat is less violent than those posted to AIG but it is real.