Remcom - Newsletter - rc nl  210

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The case for imposing a ceiling limit on variable pay

It has for some time been an open debate as to whether a cap should be imposed on senior executive bonuses. Now there is pressure from a corporate governance perspective to do so.

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Outline of the problem

 

A well-supported school of thought has always held that, where the win-win equation can be shown to apply (for example, in a profit-sharing scheme), the bonuses should not be capped at all. The more that senior executives receive, the more wealth that will be created for shareholders.

 

The argument against this, often considered to be a weak and indecisive response, is that bonuses should be capped on the grounds that, if there is no downside risk assumed by the management team, then why should it have unlimited upside potential?

 

The new spotlight of attention being focused on to senior executive pay as a result of the global credit crisis caused by the collapse of financial institutions may however radically affect how remuneration committees view this policy. The post-mortem verdict of the credit crisis is in brief that unlimited upside potential without downside risk encourages greedy behaviour - and that this should indeed be regulated by boards of directors. If public companies cannot self-regulate themselves in this area, then regulations should be imposed on them (presumably by their security exchanges).

 

Is this a problem restricted to financial institutions only? The answer is that it is not. It applies in any situation in which shareholder wealth can be leveraged - including most typically the following situations:

• Financial leverage can be secured where equity is staked to raise loan capital. Using complex corporate structures, ‘other people's money' can be levered several times by borrowing against it, then converting the enlarged capital into equity at an associate company level - achieving in some cases effective debt to equity ratios in relation to the investors stake of twice or three times what is regarded as safe.

• Organizational leverage occurs where mergers and acquisitions produce a funnel effect at the top. Decision-making at the top of larger organizations after a restructuring affects the whole industry, and enables top people to influence commodity prices and through this the financial results of their companies (and their bonuses).

• Price leverage is also secured through merger and acquisition, developing monopolistic situations, and better margins as a result. Only beware that the risk of a downturn may then lever losses as well!

It will be admitted that leveraged financial results can be achieved very often on a basis in which the downside risk is totally covered - possibly outsourced and borne by an associated company or strategic partner. We will come back to this point.

 

The suggested solutions

 

Perhaps the best and most pragmatic solution within a commercial entity is to restrict the magnitude of the short-term incentives; then allow the upside potential to be converted into incentive rewards through the mechanism of a suitable share-based incentive.

The profit-flows to the management team on that basis - more demonstrably related to shareholder wealth creation - can be seen to be self-funded and sustainable in the long-term.

 

Market practice

 

What are the average levels of performance bonuses today?

Our Top Executive Survey reveals a spread of policies as shown on the table below.

 

 

 

Our analysis of the disclosed information of the Top 40 JSE listed companies reveals that 22 of them base the short-term incentive on key performance area scores, the bonus being computed as a percent of annual pay. (In these cases the bonuses are automatically capped by the top line of their tables.)

 

In the case of the other 18 companies, the scale of the short-term incentive is determined by a profit pool - funded by super-profits. It is noteworthy that five out of this number already cap the level of the bonus of the executive directors - typically at 100%, and in one case 150%, of annual pay.

We are predicting that it will become a convention to cap short-term profit-funded bonuses within the next few years.

 

Summary

 

It seems that investors are more impressed by remuneration policies which offer guaranteed packages at market-related levels, variable pay which is challenging and meaningful (but not over-aggressive) and then some form of share participation that has been checked out by the remuneration committee.

 

We say that - if that is what investors want, give it to them. It may well be a better way of dividing up the pie.

 

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