Paying the piper

It’s not quite a rerun of the French Revolution but, for captains of industry in Europe, the political atmosphere surrounding their pay packages is turning decidedly restless. Across the continent, governments are writing rules and laws to limit executive pay – and not only in sectors receiving public aid. The pressure to curb excessive compensation for top brass is extending to all sectors, particularly where pay packages are out of proportion with company profits. For many in Europe, political calls for pay for performance are becoming the modern equivalent of aux barricades!

As always in Europe, however, the approach to this goal differs greatly from one country to the next. At the EU level, for example, lawmakers are calling for increased disclosure of what listed companies pay each director, as well as public explanation of bonus policies. Lawmakers are also looking at whether shareholders should have a say on what directors and top executives are paid.

In the UK, against the background of public outrage over large bonus payments to executives and traders at failed banks, regulators are preparing guidelines to ensure executive pay in the financial industry is adjusted for the risk of the underlying business for which they are being rewarded.

In France, partly in response to huge public demonstrations against bailouts of banks and car makers, the Sarkozy government is writing a law that would force executives to award stock options to all employees if they want to receive such benefits themselves. What’s more, executive bonuses would be curtailed or eliminated at companies laying off staff, and select senior executives at companies receiving direct financial aid from the government are banned from receiving stock options at all. The details are still being nailed down but the direction of the legislation is clear.

In the Netherlands, the government is proposing to impose higher corporate taxes on golden parachutes. In Switzerland, the government is considering tougher rules on high pay and bonuses at big banks. And in Germany, the government has proposed a package of measures, including requiring directors to hold stock options for a minimum of four years rather than two years before they can be redeemed, making the entire supervisory board rather than just compensation committees responsible for executive pay decisions, and making it easier for companies to clawback incentive pay after the fact if a company’s situation worsens. The proposal would also increase the transparency of pension benefits awarded to senior managers.

‘In nearly all European jurisdictions, there is a discussion going on, or decisions have already been taken, regarding executive pay,’ says Klaus-Stefan Hohenstatt, a senior partner and executive compensation expert with law firm Freshfields Bruckhaus Deringer in Hamburg.

‘I expect to see stronger corporate governance as a result of the financial crisis,’ says Jella Benner-Heinacher, managing director of DSW, the German shareholders’ association. ‘I am pretty sure the link between executive compensation and risk management will spread all over Europe. This will start with banks and insurers and extend to other sectors. If good rules are developed in the financial sector, I expect they will also have an impact on other industries.’

Populism takes control
While better corporate governance may be the ultimate outcome of the current rule-making, the impetus for it is public rage – and a political will to appease that rage. ‘Public acceptance of the market economy has declined sharply, and one reason for that is compensation of senior managers and board members,’ explains Marcus Lutter, a law professor at the University of Bonn and member of a German government advisory commission on corporate governance.

Some prominent corporate figures, including Deutsche Bank CEO Josef Ackermann, have responded to the public sentiment by forgoing their 2008 bonuses. Indeed, a study published by the Financial Times Deutschland shows that the pay of top executives in 24 of the 30 DAX blue-chip companies fell by about a quarter in 2008. The declines in the financial and automotive industries were the biggest.

Much of the regulatory drive to limit executive pay comes from a populist impulse rather than any economic or business rationale, notes Rudiger von Rosen, managing director of the Deutsches Aktieninstitut, the German association of exchange-listed stock corporations.

‘When politicians want to limit the pay of football players, opera singers and other high-income individuals, they tend to do this through the tax system,’ he says. ‘But it is not the task of the state to single out high-earning managers to limit their pay. Regulation that arises from public anger is a scary thing. In effect, it suggests that investors are unable to enforce their own interests, and therefore the state has to regulate everything on their behalf. I do not think this is the right approach.’

‘Remuneration of management board members is, on average, 0.6 percent of operating profits at listed companies,’ observes Christiane Hoelz, a lawyer at DSW. ‘Tighter rules on that compensation might help to improve the image of executive pay in general, but financially it will not do much for companies.’

Payment by numbers
In the public ruckus over executive pay at troubled companies, attention has focused on say on pay, a provision giving shareholders either an advisory or a binding vote on management compensation policies. Only four European nations – the UK, the Netherlands, Sweden and Norway – have say-on-pay rules in force. Other countries have hesitated to take this approach, although an impulse in this direction could come from the European Commission.

The Anglo-Saxon view tends to favor shareholder empowerment over closer regulation of executive pay. ‘Efforts in the past to have public policy play a direct role in linking pay and performance have not been successful,’ says Diane Doubleday, global head of executive remuneration for Mercer Management Consulting in London.

Direct public-policy measures ‘have been fraught with unintended consequences,’ she adds. ‘The question is whether government should broadly influence pay decisions, or focus instead on enhancing transparency and shareholder rights, so that shareholders can oversee pay decisions. Policy initiatives that deal with disclosure and transparency requirements and shareholder rights have had a positive influence.’

Yet transparency alone might not establish a solid and sufficient solution, comments Hohenstatt. ‘I think transparency has helped a lot, and it is now obvious where the problems lie,’ he says. ‘Unfortunately, however, the transparency that was introduced three or four years ago did not stop some supervisory boards from setting excessive pay packages, so it would be helpful if the law is made a bit more precise than in the past. For example, the current proposal says remuneration of management board members must be ‘reasonable’ in light of industry standards. I think this is appropriate, but I would be against any fixed cap on management board remuneration.’

Rallying for reform
But according to Joachim Schwalbach, professor of international management at Humboldt University in Berlin, fundamental reform is indeed what is required. He says supervisory boards often fail at their responsibility to set appropriate pay for senior management. ‘There is a problem with the qualifications of members of supervisory boards,’ he points out. ‘Board members should meet qualification standards and carry liability for what they do, but that also means they should be paid more.’

Rather than leaving the pay-setting function entirely to market forces, Schwalbach says, public policy should encourage a link between the pay of executives and the average pay of a company’s workers. ‘The success of a company should determine the success of all its members,’ he suggests. ‘The pay of top executives has to be a bigger piece of the cake, but the cake still has to be distributed fairly.’

Schwalbach’s research shows that in 2007 (the last year calculated) top executive pay in the DAX 30 companies was 52 times the average pay of employees, compared with a multiple of 25 in the mid to late 1990s.

In a globalized market for talent, such rules would work against company interests, counters Doubleday. ‘If the actions of a company or a country go beyond limiting pay at bailed-out companies and start to affect other companies, this could have implications for where executive talent goes,’ she warns. ‘Good talent follows the money.’

Moreover, she says limiting executive pay in this way ignores key differences between industries and companies in the same industry. Some companies have large numbers of highly paid people, while others rely on a base of lower-paid workers or outsource their highly paid work. ‘It might be okay for companies to disclose the relation between executive pay and average pay, but the information may not be that useful to shareholders, and could in fact be misleading,’ Doubleday says.