Introduction to Corporate Governance: The Issues of Directors’ Remuneration and Social, Ethical and Environmental Disclosure

Report compiled by: Piotr Bakker On behalf of Westminster University Introduction to Corporate Governance 4FBL452 Submission date: March 21, 2007 Module Leader: Neeta Shah Seminar Tutor: Neeta Shah

Table of Contents TASK 1 – Directors’ remuneration ........................................................................ 2 TASK 2 – Social, ethical and environmental disclosure ........................................ 6 Bibliography and references ................................................................................... 9

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TASK 1 – Directors’ remuneration In the last two decades a phenomenon of soaring CEO’s earnings has been observed. In many cases CEOs have gotten away from troubled companies with huge severance packages. And while it is understandable that the top executives are paid well for their work, it is absolutely without merit to do so in the light of their apparent underperformance. The primary challenge of ensuring public owned companies future prosperity is to make sure directors’ interests are aligned with those of shareholders. This basic concept of the Principal-Agent theory, however easy it may seem in theory, is incredibly difficult to apply in practice. In majority of companies, most commonly directors are offered, in addition to the base salary, annual bonus and other perquisites, highly rewarding incentives1 as a compensation for performance and a stimulant for future progress. However, very little evidence has been found2 to confirm that tying the pay to the performance is the most efficient way to increase the shareholders’ wealth. On the opposite, it has been found that in most cases directors’ rewards outstrip companies’ performance in terms of shareholder return (Table I).

Table I. Rewards vs Performance of FTSE 100 in 2000 1

Total Above 40% 20-40% shareholder return Director’s 121% 69% wealth increase Source: Complied from Patterson and Jauhal (2001)

0-20%

Below 0%

23%

-20%

Nevertheless, what actually is a “fair” pay? Senior executive remuneration in the UK has drastically increased over the years and is still on the rise. In 1999, top British executives were paid an average of £717,000, which included a long-term incentive scheme. In 2005, this amount rose to a staggering £2,4m. More than 200 directors earned more than £1m. 1

E.g. option grants Empirical studies have been conducted and published: Aggarwal and Samwick, 1999; Garen, 1994; Haubrich, 1994. 2

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Overall, directors’ pay rose by 28% last year compared to 20043, more than seven times the rate of average pay and 11 times the current rate of inflation4. On the other hand, average workers' earnings in Britain rose during the same period at a rate of approximately 4.1 percent, to £22,060 ($39,700). As a multiple, average CEO pay in Britain stands at 113 times that of the rank-and-file employee. By comparison, the AFL-CIO reports in its Executive Paywatch Study that the average U.S. CEO received $9.84 million in total compensation in 2004, a 12 percent increase from the preceding year. The labour organisation's study also says average CEO pay in the U.S. is roughly 300 times that of the average worker. Is it fair to pay them that much? Extraordinary pay for great performance is fine, it is routinely said (The Economist, 2007). How does it work in reality? In reality, that is where precisely the problem lies. In recent years we often hear about the severance packages for executives, often referred to as “golden goodbyes” or “golden parachutes”. These severance packages are being payed to the executives on their early exit from the company, after they have clearly underperformed (Table II). The cost of getting rid of the old CEO and bringing in a new one is a persistently growing liability. Lester Alberthal, the CEO of Electronic Data Systems Corp. received $35 in his severance package, while bringing in his successor, Richard Brown cost the company $4.5 million of a signing bonus, 1 million in options, and in 275,000 shares of restricted stock. He also would be able to receive a large portion of his salary in case he failed to be a success (businessweek.com). Similarly in Britain, Bob Ayling, received £2.8m payment at his departure from British Airways in the face of collapsed profits. Christopher Gent, the infamous CEO of Vodafone AirTouch has been awarded £12.3m (share options included) in 2001. A year later after the share price fell to less than 150p from 399p and an announcement of a loss of £13.5bn, the largest in UK corporate history, shareholders capped his pay, but he still managed to obtain £2.4m.

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The Guardian's annual survey of executive pay 2006 According to most recent reports the rate of inflation is 2.7%

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Company Table II. CEOs compensation and shareholder return (2002)

Apple Inc Sun Microsystems Tenet Health Care John Hancock Financial Services Source: Burke and Schollser (2003)

Total CEO compensation (millions) $78.2 $31.7 $35.0 $34.3

Shareholder return (per cent) -34.6 -74.7 - 58.1 - 31.7

What makes the payouts so high? Driven by the shareholders interest, executive management is focused on short-term objectives in creating, or at least maintaining high share price at the expense of other stakeholders, in particular employees. One result of that, was the identified earlier, continuously increasing gap between executive and average pay (Table III).

Table III. Pay ratio of CEO and workers

Year

USA

UK

Japan

Germany

Sweden

France

1997

325:1

18:1

15:1

13:1

11:1

12:1

2002

600:1

20:1

15:1

14:1

11:1

12:1

Saurce: Insitute of policy studies

Since the mid 90s there has been a large increase in the use of stock options and other incentives as a compensation for directors. The executive incentive for risk taking leads to increased mergers and acquisitions and above normal market earnings to shareholders, which in turn, promote increased individual earnings to executives with the danger of giving minimal attention to sustainable growth. Hence, options lead executives to take risks that shareholders might otherwise avoid, as executives view the potential future payout associated with option pay as a form of “compensatory lottery” (Sanders, 2001). Additionally, remuneration committees, have been found to grant their directors excessive pay, mostly as a result of “a viral spread of self-serving practices” A study by the University of Texas, involving 3,000 companies, has found that CEOs at companies whose directors sat on numerous other boards were paid 13% more than CEOs whose directors did not sit on other boards (www.executiveinvestigator.com).

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However, it is doubtful whether this state of affairs will maintain its position. Since 1999, when the FTSE stock index fell by 143.4 points, a change has been observed in the way shareholders perform as the principles (Patterson et al., 2003). They are increasingly not accepting “fat cat” pay packages. Most notable has been the rejection of the remuneration policy of GlaxoSmithKline, in particular the package of its CEO, Jean-Pierre Garnier. Charles Allen, the chief executive of underperforming ITV, stepped down in November last year after pressure from disgruntled shareholders (http://www.guardian.co.uk/). Moreover, in the face of the latest executives’ misconduct, special legislation covering corporate disclosure and specifically executive remuneration is being gradually introduced to allow shareholders to fight against valueless executives. In 2002, the government put forth legislation designed to give shareholders a greater voice in pay matters. The legislation requires all listed firms to put their remuneration policies to a shareholder vote at each annual meeting. Vote results are advisory rather than binding. That, however, did not stop investors from lodging significant opposition to remuneration reports at a number of blue-chip companies. A handful of firms have seen majority votes against their remuneration reports. To sum up, executive pay, has grown tremendously high in recent years, but given the challenges one has to face while on the top it is certainly justified. However, issues of underperformance and misuse of authority especially should not be tolerated and most importantly not rewarded. Shareholder activism is crucial in countering these issues. After all, it is in their interest that the company performs well. To make sure shareholders can take appropriate actions information asymmetry needs to be eliminated and directors should be obliged to meet greater disclosure, transparency and accountability in all public dealings requirements.

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TASK 2 – Social, ethical and environmental disclosure Corporate governance has brought a significant change to the way business is conducted nowadays. However, the real improvement in corporate practices in the past decade was the development of social, ethical and environmental responsibility among companies around the world. More and more businesses decide to devote large proportions of their profits to improving their stakeholders’ welfare and reducing their own environmental footprint. This paper explores issues of social, ethical and environmental disclosure (SEED) and socially responsible investment (SRI) taking two FTSE 100 companies, BP plc and Camelot Group plc, as an example to answer these questions. SEED is a term used to describe business disclosure in terms of its sustainable development, community investment and environmental impact. Since the beginning of the last century companies are subjected to increasing levels of awareness of the public with regard to these issues. However, it was only about a decade ago when the SEED started receiving the attention it deserves. Recent corporate scandals5 have created a general lack of trust among the public and demand for greater transparency in the corporate world. It can be argued that SEED is a natural response to these concerns. SEED implementation is seen as a proof of companies’ commitment to long-term economic success, hence a safe guardian of shareholders’ funds. In addition, greater institutional involvement in the SEE area can be observed. That move reflects a general transformation in the institutional investment community from a group of traditionally passive, short-term investors into long-term, activist shareholders. As a result of stronger relationships between institutional shareholders and their investee companies enhanced public disclosure is becoming a much more common practice (Holland 1998). BP plc and Camelot Group plc are two companies in the UK that made addressing SEE issues one of the main policies in their current development strategies.

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Such as cases of Enron and WorldCom

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BP is the first in the energy industry to launch a public image campaign, tagged Beyond Petroleum. According to Lord Browne, BP’s chairman, BP chose that slogan because “it sums up our philosophy and direction. It isn't about leaving behind our core business, it is about defining what that core business means to the world in a very different way." The campaign emphasizes that BP are taking the climate change seriously and place their major efforts on tackling green house gasses emissions. BP also lists its top priorities as assuring the safety of its people and the integrity of its infrastructure. In the “BP Sustainability report” gives an insight to launching low-carbon energy business – BP Alternative Energy6. In 2005 report BP has decreased their CO2 emissions by 10% below their 1990 levels. As means of achieving that result they have developed technologies for capturing and geologically storing CO2, and extensively implemented the use of biofuels in their transport network. Nevertheless, it is unavoidable not to ask how a company involved in one of the most destructive for the planet activities can be putting so much emphasis on being “green”? Indeed, despite all the publicity, BP is not so different after all. According to the company’s financial report for 2005 the investment in their green initiatives dropped by almost 50% from $137m to $72m. Comparing these figures with $4.8bn invested in the oil and gas exploration makes it clear that BP is not all what it says. BP’s Sustainability Report for the year 2005 makes a promise the company will invest over the next 10 years $8bn in their Alternative Energy business. Looking at the current level, of only 1.5% of the total investment funding devoted to that sector, it is hard to be convinced. However, it is important to see that, despite their alleged hypocrisy, from the corporate point of view BP’s SEED is nothing but success. Regardless of a string of serious accidents7, BP’s share price has continued to rise, and its public image has managed to remain intact. 6

BP Alternative Energy is responsible for developing a wide range of cleaner energy technologies and products and taking action to raise awareness of climate change issues. 7 Most notably an explosion in an isomerisation unit at the Texas City refinery, which killed 15, injuring 170 and a huge oil spill in Prudhoe Bay - largest spill to date on the North Slope - at least 267,000 gallons (1,010,704.9 liters) were released to the environment.

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BP clearly has "banked" enough goodwill not only to withstand any fallout from its string of accidents, but also to emerge strong. Let us move on to the Camelot Group plc. Camelot Group plc has been running the The National Lottery for the past 11 years but almost lost this right in 2001 to Richard Branson’s The Peoples Lottery. Camelot did not do very well at that time. The sales were decreasing and the company’s employees found the workplace environment very poor. However, the company managed to change. Corporate Responsibility Report 2006 gives a detailed insight on how that has happened. According to the report “sales in 2005/06 passed the £5bn mark” and 78% of the staff is proud to work for them. In addition, it gives a thorough account of the company’s efforts to improve the impact on their stakeholders. As means to carry out this improvement Camelot have undertaken various actions. From the report it can be understood that Camelot benefits people and communities by promoting so called Good Causes and awarding grants for community projects. However, the company is solely responsible for raising the money and it is not documented in the report where the money goes. In 2006 they raised £1.5bn for these purposes, which has been achieved by allocating 28p of every £1 spent on National Lottery to this principle. In 2006 they also started raising money to fund the 2012 Olympic Games. Environmental policy is a big issue in Camelot. The company prints its tickets on recycled paper and recycles 95% of its paper waste. The report clearly shows the company’s commitment to reducing their environmental impact. In 2005 funding steps have been undertaken to set up Environmental Management System that would be exclusively designated to cutting down company’s emissions. It is stated that reduction of the CO2 they produce is crucial but the targets for 2006 have not been met – instead of them falling by 2% they increased by 2%. No reasons for this have been disclosed. From the report it is also clear that Camelot strongly encourages increased environmental consciousness among their partners, such as Stalfords, the company responsible for printing of the lottery tickets and play slips. 8

Overall, both of the companies show that they are serious about the SEE issues. Regardless of their actual performance in this area, both have clearly stated both successes and failures to bring to life their visions of improving their current procedures and to maximise the benefit of their stakeholders. Additionally, it is clear that additional funds allocated to these causes have benefited the companies themselves, as they are experiencing periods of above-average profitability. In the face of these facts it is feasible to conclude that SEED is a practice that by promoting social and environmental good supports the business. If disclosed properly SEED can be a tool for a win/win strategy to companies, hence all efforts should be made to promote this corporate practice.

Bibliography and references Aggarwal, R.K. and Samwick, A.A. (1999), “The other side of the trade off: the impact of risk on executive compensation”, Strategic Mangement Journal, Vol. 20 No. 1, pp. 65-105 June 2006 Burke, D. and Schollser, J. (2003), “Have they no shame?”, Fortune, 28 April, ,Vol. 147 No. 8, pp. 23-5. Financial Reporting Council (July 2003), The Combined Code on Corporate Governance Garen, J.E. (1994), “Executive compensation and principal-agent theory”, Journal of Political Economy, Vol. 102, pp. 1175-99. Haubrich, J.G. (1994), “Risk aversion, performace pay and the principal-agent problem”, Journal of Political Economy, Vol. 102, pp. 258-76. Holland, J.B. (1998), “Private disclosure and financial reporting”, Accounting and Business Research, Vol. 28 No. 4, Autumn, pp. 255-69. Miles, S., Hammond, K. and Friedman, A.L. (2002), “Social and environmental reporting and ethical investment”, ACCA Research Report No. 77, Certefied Accountants Educational Trust, London Paterson, L., Duncan, G. and Miles, R. (2003), “Shares fall to half of 1990s boom”, The Times Newspaper, Business, 29 January 2003, p. 23 Patterson, S. and Jauhal, P. (2001), “Rewarding with shares rather than options is more fair”, The Sunday Times, Business News, 15 July, pp. b1-b5.

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Polonsky, M. and Ryan, P. (1996), “The implications of stakeholder statues for socially responsible managers”, Business and Professional Ethics Journal, Vol. 15 No. 4, pp. 18-29. Sanders, G.W. (2001), “Behavioural responses of CEOs to stock ownership and stock option pay”, Academy of Management Journal, Vol. 44 No. 3, pp.477-92. Stapledon, G.P. (1996), Insitutional Shareholders and Corporate Governance, Oxforf University Press, Oxford. http://business.guardian.co.uk/story/0,,2009404,00.html http://www.businessweek.com/1999/99_16/b3625002.htm http://www.economist.com/surveys/displaystory.cfm?story_id=E1_RVTPJQJ http://www.executiveinvestigator.com/default,month,2007-02.aspx http://www.guardian.co.uk/executivepay/story/0,,1885422,00.html http://www.guardian.co.uk/executivepay/story/0,,1885422,00.html http://www.worldenergysource.com/wemr/cover.cfm?ci=21&pid=1 http://www.camelotgroup.co.uk/crreport2006/index_flash.html http://www.bp.com/liveassets/bp_internet/globalbp/STAGING/global_assets/downloa ds/S/bp_sustainability_report_2.pdf

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