Jul 4 2012
All company directors should be forced to repay bonuses if they underperform.
A new report by leading think tank Policy Exchange says that introducing “clawbacks” to all bonus contracts would be the best way to end rewards for failure in the boardroom. Clawback would also be an effective way of ensuring shareholders are able to reduce the outgoing pay of a poor performing director who had decided to resign.
The report – Executive Compensation: Rewards for success not failure – says that remuneration committees should set downside conditions to director contracts which, if breached, would trigger clawbacks.
Clear targets such as underperformance in terms of total shareholder return, a fall in the absolute share price beyond a certain level or a rise in the credit spread of the company’s debt beyond a certain level would enable shareholders to see whether the company and its managements had failed in some way.
To build up a clawback fund, half of all bonuses and long term incentive payments would be put in an escrow account and paid out evenly over five years. The company could withdraw the funds if directors underperformed.
The report, published to coincide with the government’s consultation into executive pay and shareholder rights, says that clawback would be a much more effective mechanism to end rewards for failure than the Government's current proposals.
This still allows companies to agree termination payments with underperforming employees. While exit payments are still likely under these proposals, a properly drawn up clawback scheme could easily overwhelm these in the case of failure.
Indeed, clawback is structured to ensure that the greater the underperformance the more the executive would have to pay back.
The report makes a number of other proposals:
Shareholders should be able to hold companies to account. The government has proposed a binding vote at least every three years, with additional votes if pay policy is changed or the advisory vote on past year pay is lost. This is too convoluted. Shareholder votes should operate on a two strikes basis, similar to the system used in Australia. The vote would initially remain advisory, but with higher threshold of 65% to approve the policy. If the board fails to secure 65%, but exceeds 50%, the company has a year to change its policy in conjunction with its shareholders. If it fails again to pass 65% the vote becomes binding and a new remuneration policy has to put to another vote within 90 days. This gives shareholders the chance to fire warning shot but the company time to come up with a better policy in future. If at any time the company fails to secure 50% then the vote automatically becomes binding.
Remuneration transparency should be simpler. Remuneration has frequently been unduly complex and reporting too opaque. Remuneration reports should contain a catch all clause at the end where the board would have to disclose anything of material interest to shareholders. Pension hikes like that given to Fred Goodwin would simply not be possible to hide.
Extend long term incentive periods to five years. The period over which long term incentives should be determined should be extended from around three years currently to five years. Together with our proposals on the deferral of compensation this will mean that some part of the pay will be linked to the performance of the company over a ten year time horizon. This will help to ensure that pay is more closely linked to the long term performance of companies, a key demand of many large investors.
Employees should neither have representation on boards nor have a vote on executive pay. Aside from the practical problems shareholders own the companies and they should determine the pay.
James Barty, author of the report, “Companies should be able to pay executives well for good performance. The real problem is that too often inadequate performance has been over rewarded.
“Inserting clawbacks into director contracts would eliminate rewards for failure and would likely change executive behaviour. If the executives at the UK banks knew their bonuses could have been clawed back due to major failures, would they have presided over a culture of excessive risk taking that eventually led to a drop in the banks' share prices?”
A copy of the report can be downloaded by going to http://www.policyexchange.org.uk/images/publications/executive%20compensation.pdf
Related link: www.policyexchange.org.uk/images/publications/executive%20compensation.pdf