Executive Remuneration in Crisis: A Critical Assessment of Reforms in Europe Guido Ferrarini Niamh Moloney Maria Cristina Ungureanu Bolzano, November

IThe Incentive Contract A Tale of Two Crises – the Pathology of Executive Pay A Tale of Two Crises – the Pathology of Executive Pay Enron-era: perverse incentives to manipulate financial disclosure Enron-era: perverse incentives to manipulate financial disclosure Financial crisis: perverse incentives with respect to risk-taking Financial crisis: perverse incentives with respect to risk-taking Powerful incentive effects but malign results Powerful incentive effects but malign results Agency problem – Social problem Agency problem – Social problem How to harness incentive effects? How to harness incentive effects?

IThe Incentive Contract Dominant model for examining executive pay Dominant model for examining executive pay Incentive contract can reduce agency costs and support shareholder/manager incentive alignment in the dispersed ownership company (dominant line of scholarship: Jensen and Murphy, 1990; Bebchuk and Fried, 2004) Incentive contract can reduce agency costs and support shareholder/manager incentive alignment in the dispersed ownership company (dominant line of scholarship: Jensen and Murphy, 1990; Bebchuk and Fried, 2004) Minority shareholder protection in blockholding firms Minority shareholder protection in blockholding firms High level of pay not troublesome as long as performance link robust; risks if pay not linked to performance High level of pay not troublesome as long as performance link robust; risks if pay not linked to performance Being finessed Being finessed Stakeholder interests Stakeholder interests Fairness dynamic Fairness dynamic Agency remedy – social concern Agency remedy – social concern

IThe Incentive Contract Concerns over the Crisis: cross-sectorally Concerns over the Crisis: cross-sectorally Main concern re the upper limit of pay – the ‘outrage’ factor Main concern re the upper limit of pay – the ‘outrage’ factor Gap in remuneration – top management and employees Gap in remuneration – top management and employees Weak links between pay contracts and firm strategy Weak links between pay contracts and firm strategy Pay contracts supporting ‘rewards for failure’ Pay contracts supporting ‘rewards for failure’ UK 2009 AGM season UK 2009 AGM season Guardian Executive Pay Survey 2009 Guardian Executive Pay Survey 2009 Cheffins, 2009 Cheffins, 2009

IThe Incentive Contract Concerns over the Crisis: Financial Institutions Concerns over the Crisis: Financial Institutions An ancillary factor, but a scapegoat…. An ancillary factor, but a scapegoat…. Excessive risk taking Excessive risk taking Bonuses based on illusory/mis-stated profits Bonuses based on illusory/mis-stated profits Short-termism Short-termism Undemanding performance targets Undemanding performance targets No consideration for remuneration below board level No consideration for remuneration below board level Lack of supervision in monitoring risks and assessing performance Lack of supervision in monitoring risks and assessing performance

IThe Incentive Contract Risks of the Incentive Model Risks of the Incentive Model Manipulation of the performance link Manipulation of the performance link Rent seeking Rent seeking Outrage constraint Outrage constraint Does not address level of pay Does not address level of pay Over-reaction risk Over-reaction risk Conflicts of interest in the pay-setting process Conflicts of interest in the pay-setting process Board independence; external consultants Board independence; external consultants Competence questions Competence questions Incompetence in establishing the performance link; Incompetence in establishing the performance link; Herding effects Herding effects Increased focus on shareholder value – stakeholder concerns and the incentive model? Increased focus on shareholder value – stakeholder concerns and the incentive model?

IThe Incentive Contract But need for clear conceptual basis for executive pay analysis given risks of crisis-driven reforms But need for clear conceptual basis for executive pay analysis given risks of crisis-driven reforms Attractions of the incentive model – transparency/simplicity in a highly complex area Attractions of the incentive model – transparency/simplicity in a highly complex area Target for popular reforms Target for popular reforms Appropriateness of regulatory intervention Appropriateness of regulatory intervention One size fits all? One size fits all? Impact on competitiveness Impact on competitiveness FSA concern FSA concern ‘Remuneration Governance’ in support of Incentive Alignment ‘Remuneration Governance’ in support of Incentive Alignment Buttress the ability of the board to align interests effectively Buttress the ability of the board to align interests effectively

IThe Incentive Contract Remuneration Governance Remuneration Governance Governance link to effective incentive alignment Governance link to effective incentive alignment Process not design Process not design Supporting board decision-making; independent directors Supporting board decision-making; independent directors Disclosure Disclosure Shareholder voice Shareholder voice Interlinked elements Interlinked elements Comprehensive disclosure – Stronger board monitoring – stimulating shareholder reaction Comprehensive disclosure – Stronger board monitoring – stimulating shareholder reaction

IThe Incentive Contract Board Independence Board Independence The independent director as monitor The independent director as monitor Closing information gap between shareholders and top management (dispersed ownership) Closing information gap between shareholders and top management (dispersed ownership) Protecting minority shareholders in blockholding firms Protecting minority shareholders in blockholding firms Independent monitors of pay process Independent monitors of pay process Independent director may reduce need for intensive intervention Independent director may reduce need for intensive intervention But conflicted and incompetent boards But conflicted and incompetent boards Remuneration Committee Remuneration Committee Front line of effective remuneration governance Front line of effective remuneration governance Proposals on remuneration to board Proposals on remuneration to board Monitoring remuneration disclosure Monitoring remuneration disclosure Performance review Performance review External consultants External consultants But competence and role of remuneration consultants But competence and role of remuneration consultants

IThe Incentive Contract Shareholder voice Shareholder voice Provide systemic shock to reset pay norms (Gordon) Provide systemic shock to reset pay norms (Gordon) Disclosure Disclosure Shareholder voice; signal good practice; buttress the board; dilute unwarranted outrage Shareholder voice; signal good practice; buttress the board; dilute unwarranted outrage

IIThe EU Context Complexities of pay in the EU context Complexities of pay in the EU context The governance divide The governance divide Cultural issues Cultural issues Transplantation risks Transplantation risks What is the EU trying to achieve? What is the EU trying to achieve? Risks of harmonization so clear objective needed Risks of harmonization so clear objective needed Shareholder interest alignment? Cost reduction? Company Law Action Plan and Anglo-American influence Shareholder interest alignment? Cost reduction? Company Law Action Plan and Anglo-American influence Is intervention justified? Is intervention justified? Disclosure driven Disclosure driven 2009 reforms unclear – muddying of purpose 2009 reforms unclear – muddying of purpose Is shareholder interest alignment valid? Is shareholder interest alignment valid?

II EU Context Our research question Our research question How the EU’s efforts to support incentive alignment have fared ‘in action’; effectiveness of corporate governance codes/shareholder activism How the EU’s efforts to support incentive alignment have fared ‘in action’; effectiveness of corporate governance codes/shareholder activism MS implementation of EU recommendations MS implementation of EU recommendations Market application: FTSEEurofirst 300 Market application: FTSEEurofirst 300 Best practice, particularly re disclosure, not securely embedded across EU’s largest companies Best practice, particularly re disclosure, not securely embedded across EU’s largest companies Basic requirements – not the qualitative disclosure necessary for effective monitoring Basic requirements – not the qualitative disclosure necessary for effective monitoring Why? Why?

IIThe EU Context 2004 Recommendation 2004 Recommendation Flexible Flexible Process based Process based Effective remuneration governance ‘in action’? Effective remuneration governance ‘in action’? 2009 Recommendation 2009 Recommendation Illusion of reform Illusion of reform Wave of Corporate Governance Reforms – Related? Wave of Corporate Governance Reforms – Related?

II EU Context 2005 Recommendation on Independent Directors 2005 Recommendation on Independent Directors ‘Sufficient’ numbers of INEDs ‘Sufficient’ numbers of INEDs Guidance on independence Guidance on independence Remuneration committee: exclusively Non-Executive or Supervisory Ds, majority INEDs Remuneration committee: exclusively Non-Executive or Supervisory Ds, majority INEDs Functions of the RC Functions of the RC 2004 Recommendation on Pay 2004 Recommendation on Pay Disclosure of company pay policy (detailed recommendations) Disclosure of company pay policy (detailed recommendations) Disclosure on individual pay Disclosure on individual pay Shareholder vote Shareholder vote Prior approval of share-based scheme Prior approval of share-based scheme

IIIMS Implementation: Remuneration Committee Corporate Governance Codes: comply or explain Corporate Governance Codes: comply or explain Well established Well established But divergences re ‘independence’ But divergences re ‘independence’ Controlling shareholders Controlling shareholders How many independent directors? How many independent directors? Majority or sufficient? Majority or sufficient? Divergences re format (joined/separate committees) Divergences re format (joined/separate committees) RC Chairman RC Chairman

IIIMS Implementation: Disclosure Disclosure tends to be implemented through binding rules; more detail in Codes Disclosure tends to be implemented through binding rules; more detail in Codes (1) Separate Remuneration Report/Remuneration Policy (1) Separate Remuneration Report/Remuneration Policy EC Recommendation: Forward-looking; clarity on performance link; methods for performance evaluation EC Recommendation: Forward-looking; clarity on performance link; methods for performance evaluation Most MS do not require a separate remuneration report; little standardization on format or content Most MS do not require a separate remuneration report; little standardization on format or content Patchy disclosure relating to remuneration policy – undermines individual disclosure Patchy disclosure relating to remuneration policy – undermines individual disclosure UK regime still most detailed UK regime still most detailed Comply or explain leading to widely varying disclosure standards and practices Comply or explain leading to widely varying disclosure standards and practices

IIIMS Implementation: Disclosure (2) Individualized pay disclosure (2) Individualized pay disclosure EC Recommendation EC Recommendation Executive and Non Executive Directors Executive and Non Executive Directors Previous year; base salary and fees; variable pay; share based incentive schemes Previous year; base salary and fees; variable pay; share based incentive schemes Generally required by law Generally required by law Some MS only aggregate disclosure (Austria, Belgium Greece) but often supported by more demanding corporate governance codes Some MS only aggregate disclosure (Austria, Belgium Greece) but often supported by more demanding corporate governance codes Variations in content of individualized disclosure Variations in content of individualized disclosure (3) Share-based incentive schemes and performance conditions (3) Share-based incentive schemes and performance conditions Patchy Patchy

IIIMS Implementation: Say on Pay Limited implementation Limited implementation EC Recommendation EC Recommendation Explicit item on AGM agenda Explicit item on AGM agenda Binding/advisory Binding/advisory Approval for share schemes Approval for share schemes UK (2002) UK (2002) Germany, Spain, Netherlands, Sweden Germany, Spain, Netherlands, Sweden Italy: banks only Italy: banks only Typically implicit approval of the annual report Typically implicit approval of the annual report Disconnect between disclosure and voice Disconnect between disclosure and voice But generally shareholder vote required for share-based incentive schemes But generally shareholder vote required for share-based incentive schemes

MS Implementation: Design Terms of Contracts and Termination Payments Terms of Contracts and Termination Payments Design not a feature of the 2004 Recommendation Design not a feature of the 2004 Recommendation Key element of the 2009 reforms Key element of the 2009 reforms But disclosure on terms of contract, incentive pay design But disclosure on terms of contract, incentive pay design Essential for understanding performance link Essential for understanding performance link Performance link to long term sustainability Performance link to long term sustainability Avoiding rewards for failure Avoiding rewards for failure

IIIMS Implementation: Design and Contract Terms/Termination Limitations on notice periods – sporadic across the MS: UK – one year or less; Italy – three years; France – 4/6 years. Limitations on notice periods – sporadic across the MS: UK – one year or less; Italy – three years; France – 4/6 years. Limits on termination payments? Limits on termination payments? Range of Corporate Governance Codes Range of Corporate Governance Codes UK, Netherlands, Belgium: 1 year UK, Netherlands, Belgium: 1 year France, Germany: 2 years France, Germany: 2 years French law: most interventionist French law: most interventionist Complete transparency Complete transparency Conditional on performance Conditional on performance No rewards for failing executives No rewards for failing executives Clawbacks? Clawbacks? Recent feature Recent feature

IIIMS Implementation: Design of Incentives 2004 Recommendation not prescriptive (2009 Recommendation more intrusive) 2004 Recommendation not prescriptive (2009 Recommendation more intrusive) Restraints on incentive pay? Restraints on incentive pay? ‘reasonable’; ‘proportionate’ ‘reasonable’; ‘proportionate’ Adjustments and clawbacks? Adjustments and clawbacks? But general support of incentive pay But general support of incentive pay UK Combined Code and design of incentive pay UK Combined Code and design of incentive pay Disclosure on performance criteria? Disclosure on performance criteria? Corporate Governance Code driven Corporate Governance Code driven Poor Poor

IVRemuneration Governance in action: FTSE Eurofirst 300 Effectiveness/relevance of corporate governance codes Effectiveness/relevance of corporate governance codes Assessing disclosure and remuneration governance after the two Recommendations Assessing disclosure and remuneration governance after the two Recommendations FTSE Eurofirst 300 components; 16 EU countries FTSE Eurofirst 300 components; 16 EU countries Assessed 3 areas: Assessed 3 areas: Governance Governance Remuneration policy Remuneration policy Individual Disclosure Individual Disclosure 8 categories; 23 detailed criteria 8 categories; 23 detailed criteria

IVRemuneration Governance in action: FTSE Eurofirst 300 Firms follow national regulation rather than Community best practice Firms follow national regulation rather than Community best practice Tendency to comply with legally binding rules Tendency to comply with legally binding rules Partial compliance with comply or explain Partial compliance with comply or explain Lowest levels of compliance Lowest levels of compliance Terms of contracts Terms of contracts Qualitative disclosure on performance link Qualitative disclosure on performance link Highest levels of compliance Highest levels of compliance Presence of a remuneration committee Presence of a remuneration committee Existence of remuneration policy Existence of remuneration policy Individual pay disclosure Individual pay disclosure

Highest:Individual disclosure; Remuneration Committee Lowest: Disclosure terms of contracts for executive directors

Almost 83% established separate or joined RC 60% have RC with majority independent UK, Netherlands: all independent Germany: no separate RC

58% overall compliance High: UK, Ireland, Netherlands Low: rest Non-compliance: - Disclosure of only non-executive or only executive directors - Not all components of pay package are disclosed

Continental Europe: elements of the remuneration policy are scattered throughout the AR “A clear and comprehensive overview of the company’s remuneration”: not achieved

V Policy Issues and Reform Process MS have shown little enthusiasm for legislating on remuneration governance MS have shown little enthusiasm for legislating on remuneration governance Weaknesses in CG Codes as instruments for delivering effective pan-EU remuneration governance Weaknesses in CG Codes as instruments for delivering effective pan-EU remuneration governance Considerable confusion concerning what remuneration policy disclosure should cover Considerable confusion concerning what remuneration policy disclosure should cover Terms of contracts Terms of contracts Qualitative discussion of performance link Qualitative discussion of performance link Divergences in independence requirements on RC Divergences in independence requirements on RC Difficulties with ‘say on pay’ with respect to further harmonization Difficulties with ‘say on pay’ with respect to further harmonization

V Policy Issues and Reform Proposals Is there a role for further harmonization? Is there a role for further harmonization? What should its objective be? What should its objective be? Disclosure the most appropriate target Disclosure the most appropriate target

V Policy Issues and the Reform Proposals What approach has the EC adopted: 2009 Recommendation What approach has the EC adopted: 2009 Recommendation Uneasy mixture of more intervention (design) but failure to address effectiveness (non-binding; basic disclosure best practices not rolled out) Uneasy mixture of more intervention (design) but failure to address effectiveness (non-binding; basic disclosure best practices not rolled out) Muddled purpose: shareholder incentive alignment – public outrage – fairness – spillover from banking sector? Muddled purpose: shareholder incentive alignment – public outrage – fairness – spillover from banking sector?

V Policy Issues and Reform Proposals Focus on pay/performance link, sustainability and on restricting ‘excessive’ variable pay Focus on pay/performance link, sustainability and on restricting ‘excessive’ variable pay Disclosure on relationship between performance criteria and firm long-term interests and on termination payments√ (but non-binding) Disclosure on relationship between performance criteria and firm long-term interests and on termination payments√ (but non-binding) Competence of RC√ Competence of RC√ Clawbacks and termination payments√ Clawbacks and termination payments√

V Policy Issues and Reform Proposals But – intervention in design of remuneration But – intervention in design of remuneration ‘Limits’ on variable pay ‘Limits’ on variable pay ‘Proportionate’ remuneration ‘Proportionate’ remuneration Deferral of ‘major part’ of variable pay for a ‘minimum period’ Deferral of ‘major part’ of variable pay for a ‘minimum period’ Share-based pay: three year vesting period Share-based pay: three year vesting period

V Policy Issues and Reform Proposals √ Attempt to enhance quality of disclosure Attempt to enhance quality of disclosure Awareness of design issues Awareness of design issues Focus on pay/performance link Focus on pay/performance link X Core enforcement and consistency problems remain Core enforcement and consistency problems remain A policy distraction A policy distraction Reliance on a non-binding measure Reliance on a non-binding measure Recommendations vague Recommendations vague Spill over from financial institutions Spill over from financial institutions Clarity of purpose? Clarity of purpose? Replacing board judgment Replacing board judgment How does it address specific failure – impact assessment? How does it address specific failure – impact assessment?

V Policy Issues and Reform Proposals The Way Forward The Way Forward Harmonization to enhance standards Harmonization to enhance standards Disclosure Disclosure Binding requirement for a separate remuneration report Binding requirement for a separate remuneration report Binding core standards Binding core standards Standardization of disclosure format and key definitions Standardization of disclosure format and key definitions Rewards for Failure Rewards for Failure Mandatory limits Mandatory limits Disclosure of termination payments Disclosure of termination payments

V Policy Issues and Reform Proposals Benefits Benefits Reduce costs Reduce costs Sharpen shareholder engagement Sharpen shareholder engagement Facilitate comparative analysis Facilitate comparative analysis Closer focus on performance criteria Closer focus on performance criteria Stronger legislative intervention risk-laden Stronger legislative intervention risk-laden Complexities of design Complexities of design Dynamics of international competition Dynamics of international competition Disclosure and governance reforms should remain the driver for harmonization Disclosure and governance reforms should remain the driver for harmonization