David Paterson, former head of corporate governance at the UK’s powerful National Association of Pension Funds (NAPF) who retired in October 2013, held the last phase of his post during the Shareholder Spring of institutional investor action in 2012, when governance clashes were front page news.
The NAPF has become an active player in corporate governance, warning company management that its members would vote against pay policies that failed to demonstrate a strong link between reward and performance. Paterson remarks drily that some pay issues are remarkably similar to when he got involved in corporate governance at JP Morgan Asset Management in the late 1990s.
Paterson says the politicisation of pay issues has had beneficial effects, but that requires vigilance against unintended consequences. “Politicians were warning companies five or more years ago about ballooning pay at senior levels. The truth is, nobody paid much attention; times were good, markets rising, investors happy, and arguments around internationalisation and mobility of executives were quite powerful. Now, if you look at the figures in detail, there has been a marked slowdown in the growth of base salaries for executives. Typically they are growing at the rate of the rest of the workforce, and that’s long overdue.”
Senior executive pay is much more transparent, but the 50-60% of pay that is performance-based should fluctuate, thinks Paterson. “It’s going up at the moment because of lower growth expectations two to three years ago, but the real question is whether it went down enough before, when company performance was poorer. Being performance-based it should be properly variable.”
Otherwise, he says, the risk is that middle management and staff become disenchanted at the disconnect between executive pay and success. “We’ve tried to make the point more strongly to companies that they should be able to demonstrate this long-term value link to shareholders because it’s good for the business.”
Shareholders, Paterson continues, are broadly still more short term in their governance views than he would like, but he is seeing greater alignment around long-term business-performance metrics. “Companies have a job to do in explaining how they set their bonus policy and how they judge the outcomes,” Paterson says. “Business targets are often confidential, and we accept that might be necessary. However, shareholders should challenge whether boards are being robust in setting those targets.”
The UK’s intervention on pay via the Enterprise and Regulatory Reform Act 2013 (which amends various aspects of the UK Companies Act) passed into law at the beginning of October. It introduced a number of changes to the disclosure of directors’ remuneration. Listed companies must have a directors’ remuneration policy put to a binding shareholder vote (50%-plus) at least every three years, including payments for loss of office. The directors’ remuneration report must also include a separate, forward-looking policy section.
Paterson says: “These are some very helpful changes that we will see coming into play next year. At the moment, companies are grappling with the binding vote on pay. On paper, this looks like a good idea forcing companies to articulate their pay policies clearly and give shareholders a significant say in how that policy is structured. The problem is that it is a nuclear option: voting down a binding policy effectively means there is no policy. It’s complicated, but it will get easier as the years go on.”
Paterson believes shareholders will be reluctant to use the binding-vote stick in the 2014 voting season because it is so draconian: “I’m not convinced that the government actually wants us to use it, either, in normal circumstances. I think they would like to see negotiation in advance so that it doesn’t become a problem. I’m expecting a lot of companies to speak to their key investors in the next couple of months to say they’ve worked through the policy. I don’t expect many to have changed key elements, but I do expect them to explain better what they are doing, as well as the policies around executive exit and signing on payments, which are complicated and have never been explained properly before. Whether this will deliver what the government wants, we just don’t know at this point.”
Paterson believes two further changes are bearing fruit. The first is the reduction in senior executive contracts to a one-year notice period: “It was quite usual before, for CEOs to be on two to three-year notice contracts, and they had to be paid out in the event of a problem. Now, they are much more accountable to shareholders over a shorter time period.” The second, he says, is the concept of ‘board evaluation’. “I first came across this idea about 10 years ago and it has been in the Code as best practice for three to four years now.”
The second major governance reform area where Paterson has been involved is the creation of a new Investor Forum for corporate engagement recommended by the government-appointed Kay Review on UK Equity markets by respected UK economist and journalist, Professor John Kay. A working group, the ‘Investor Working Group on Collective Engagement’ comprising the main investment trade associations, the NAPF, the Association of British Insurers (ABI) and the Investment Management Association (IMA), among others, and chaired by James Anderson, partner at Baillie Gifford, is due to report in November.
Until now, Paterson says, when there has been a significant governance issue at a company that concerns multiple investors, the trade associations have helped to orchestrate collaborative meetings: “Those meetings don’t happen that often and we’ve never sought to measure success because they are discursive. It’s the investors that have the shares and the decision. These short-term coalitions for change have tended to be informal and then dissolved. The question for the working group is whether a more formal investor forum would add value to that process. I don’t know what the answer is.”
Paterson says the group is drawing together conclusions: “It’s been a fascinating exercise and there have been a lot of different views expressed about the merits of collaborative engagement, which is what this is really about. The question is whether you can collaborate to make engagement more effective and what form can that take? I hope the report will support the fact that it has been a very worthwhile exercise.”
The UK government has said it wants to review the effectiveness of the investor forum in the summer of 2014. Paterson says: “The challenge for investors and companies is that engagement is most effective when it is done privately out of the spotlight of the press. But how you then demonstrate that there has been engagement and that you’ve had some influence? I wonder if there is a role for the NAPF or the ABI – reasonably neutral bodies – to report to the wider public or market over the year on shareholder intervention in companies? I’m musing here, though.”
Hugh Wheelan is the managing editor of Responsible Investor, the online institutional magazine at www.responsible-investor.com, where a version of this article first appeared.