Democratise companies to rein in excessive banker bonuses

Prem Sikka

In times of austerity, one of few things that seems to be booming is the trade in wheelbarrows. At least, company directors at major corporations will need them to collect vast amounts of remuneration they continue to award themselves, with the help of ineffective remuneration committees.

The financial dealers on Wall Street have collected about US$26.7 billion in bonus payments, the equivalent of a year’s pay for the 1.1m workers on the minimum wage. The UK is not far behind. Bonuses in the City of London have increased by 49% compared to 2012, a higher figure than for Wall Street.

The chief executive of the crisis-ridden Cooperative Bank, Euan Sutherland, was to receive a remuneration package of £3.5 million, but has since resigned. The state-owned Royal Bank of Scotland declared a loss of about £8 billion, but has given 11 directors a bonus package worth about £18.25m between them. At Barclays and Lloyds Bank, the chief executives could be collecting more than £7m each. Of course, wheelbarrows come in handy at other corporate boardrooms too. Despite the costs arising from the Deepwater Horizon disaster, the pay packet of the BP chief executive has tripled to US$8.7m (£5.2m).

The corporate boardrooms are addicted to bonuses, but are the bonuses justified? The claims for bonuses and excessive rewards presuppose that executives exert superhuman efforts to generate wealth. The anatomy of corporate decisions does not really support that. When a new executive arrives at an organisation, for some time s/he is likely to be managing and living off products, services and strategies already in place. So the claims of distinctive contribution are hard to sustain.

Now suppose an executive decides to launch a new product or a project; this will always take some time to develop, plan and launch. The same applies if the mission is to rescue an ailing business. The success or failure of the new projects will not be known for many months or years. Meanwhile, the company will probably incur upfront costs, with no guarantee that the outlays will be recouped. Even after the initial celebrations, the product/service may turn out to be a failure and become a costly burden, as evidenced by payment protection insurance and other financial scandals.

Even if new ventures are successful, the success will depend on the involvement of other employees. It is hard to relate the success of anything to the efforts of few superstar executives. If the success cannot easily be related to the input of one person then the idea of performance-related pay becomes highly problematic. This suggests that higher rewards are claimed simply because some individuals or groups have sufficient power and control to give themselves disproportionate rewards.

So the question then is how to control the institutionalised fat-cattery. The UK government’s preferred solution is to empower shareholders by giving them a binding vote on executive remuneration. Such a step assumes that shareholders are owners of companies and bear most of the risks, and will somehow act in the interests of broader society. The evidence for this is not persuasive.

Shareholders in UK banks have average shareholding duration of about three months. Their position is no different from that of a speculator or a trader seeking short-term gains. They don’t have strong incentives to constrain directors. The UK Parliamentary Commission on Banking Standards looked at the operations of HBOS and concluded that shareholders did not exert “the effective pressure that might have acted as a constraint upon the flawed strategy of the bank”.

The commission also noted that “shareholders failed to control risk-taking in banks, and indeed were criticising some for excessive conservatism”. Shareholders often profit from harmful practices without any personal responsibility. A company can be mandated to sell harmful products, for example, cigarettes. Shareholders can share the resulting profits, but are not personally liable for because they are shielded by the doctrine of limited liability. Thus shareholder irresponsibility is written into the system and they don’t have strong incentives to consider the social good.

Besides, shareholders don’t provide most of the risk capital either. At major UK banks, shareholders only provide between 4.22% and 7.24% of total capital. The rest is provided by savers and creditors. Therefore, it is hard to make a good case for shareholder supremacy.

The proper approach is to empower the public. In the case of banks; employees, savers and borrowers are a good proxy for the public at large. They should appoint directors and vote on their remuneration. Elsewhere, employees, consumers and suppliers could be mobilised to invigilate directors as they all have a long-term interest in the welfare of the company. In a democratised company, directors are unlikely to get high remuneration without paying attention to the interests of employees and other stakeholders.

• This article first appeared on The Conversation website

Banks are serially corrupt. But Vince Cable's shareholder plan won't work

Prem Sikka

Banks are serial offenders and can't be controlled by shareholders. Vince Cable, the business secretary, has correctly identified the problem of corruption at banks, but his policy prescription of asking shareholders to invigilate abusive organisations and executives has not worked and will not work. Contrary to Cable's claims, shareholders are traders and speculators rather than owners. They barely hold shares for more than three months and do not have a long-term interest in the business. They have been utterly ineffective at curbing corrupt practices at banks, as evidenced by the tide of scandals.

Banks are under the spotlight for the Libor scandal and mis-selling of loans to small businesses, but they are serial offenders. The mid-1970s secondary banking crash highlighted fraudulent practices, which also engulfed the property and the insurance sectors. The government bailed out the banks and in turn had to resort to loans from the International Monetary Fund.

In the 1980s the financial industry sold around 8.5m endowment policies for repaying mortgage loans. These were not suitable for all borrowers. Banking staff received commission for selling the policies. The risks were often not explained to the borrowers. Banks made profits but eight out of 10 policies failed to pay the promised returns and did not even provide the amounts needed to redeem the mortgages. A 2004 UK Treasury committee report estimated that 60% of borrowers had been the victims of mis-selling, facing a shortfall of around £40bn.

This was followed by the pensions mis-selling scandal where people were encouraged to abandon good employer-based pension schemes and join a private one instead. The £13.5bn scandal affected some 1.4 million people.

The late 1990s saw the precipice bonds scandal. Some 250,000 retired people were lured to invest £5bn in investments misleadingly described as low risk. Thousands of investors lost 80% of their savings.

The 21st century did not provide any respite from financial scandals. Payment protection insurance is still being played out; some 3 million people were sold expensive and unnecessary insurance and are battling for compensation which could top £10bn. Now we have the Libor and small-company loan scandal.

In between the above, banks engaged in organised and aggressive tax avoidance, tax fraud, money laundering, corruption and feeding misleading stock market research to investors to drum up business and higher fees – just to mention a few of their misdeeds.

Fines, penalties, forced compensations and regulatory action have become part of normal banking business and the costs are just passed on to customers. It is hard of think of any instance when shareholders have sought to curb rapacious behaviour of banks or their executives. They have always been focused on short-term gains and cared little about the social consequences of the quest for higher returns.

Democracy and public sunlight are effective antidotes to institutionalised corruption and should be applied here in large doses. If the government is serious about changing the predatory culture of banks then it needs to change the whole system of corporate governance. The market pressures for higher returns should be checked by turning all banks into mutuals and co-operatives. Employees, customers and borrowers have a long-term interest in the business of banks and should be empowered to elect and remunerate directors. Directors need to be made personally liable for the cost of criminal practices. At the moment banks are fined, but executives walk away with a stash of profit-related pay, with virtually no penalties. All major banking contracts should be publicly available so that we can all see the shady dealings.

The banking regulators have frequently come from the finance industry and are too close to banks. They act only after the stench of scandal has become too strong, and frequently they have been part of what a US senate report described as a "cover-up". This inertia should be checked through annual hearings by the Treasury committee. All policy meetings of the banking regulators should be held in the open, and information in the regulator's possession – including background papers – should be made publicly available.

The above is not a magic bullet for eradicating institutionalised corruption, but the beginning of reforms necessary to curb the worst excesses of an industry that has damaged the lives of millions of people.

This article first appeared on Comment is Free

Auditors must be held to account

The shareholder spring is the perfect time to challenge the poor performance of unscrutinised accountancy firms

Shareholder spring is in the air, with increasing numbers voting against fat-cat executive rewards for failure and mediocre performance. However, the same scrutiny is not being applied to the business advisers and consultants implicated in headline failures. They continue to receive huge financial rewards. Company auditors are good example.

PricewaterhouseCoopers (PwC), Deloitte, KPMG and Ernst & Young, collectively known as the Big Four accountancy firms, audit around 99% of FTSE 100 companies. These firms audited all distressed banks. At the height of the banking crisis they gave the customary clean bill of health to Northern Rock, Abbey National, Alliance and Leicester, Bradford & Bingley, HBOS, Lloyds TSB and Royal Bank of Scotland (RBS). Bear Stearns and Lehman Brothers went bust shortly after receiving the all-clear. A subsequent inquiry by the House of Lords economic affairs committee accused auditors of "dereliction of duty" (para 161) and "complacency" (para 167) and basking in a culture of "box ticking" (para 6) rather than delivering meaningful audits. Despite the damning criticisms, some partners in audit firms still charge over £700 an hour for their services.

In 2011, Barclays, the bank that forced the government to introduce retrospective legislation to combat its tax avoidance schemes, paid £54m to its auditors PricewaterhouseCoopers, including £15m for consultancy and advice on tax matters. PricewaterhouseCoopers, which once audited Northern Rock, collected another £48m from Lloyds Banking Group , including £10m for consultancy. HSBC has paid a whopping £56m, including about £8m for tax and consultancy services to its auditors KPMG, the firm that audited HBOS and Bradford & Bingley. RBS has paid £41m, including £7.4m for consultancy to Deloitte, the firm that audited Abbey National, Alliance & Leicester and Bear Stearns. Ernst & Young, the firm that audited Lehman Brothers, earned £36m in audit and consultancy fees from BP and another £28.5m from Aviva. At major companies, the fees paid to accountancy firms are larger than CEO salaries, but rarely attract sustained media attention.

The auditor dependency on companies for vast fees neuters any impulse to deliver an independent opinion on company accounts. No one at any accountancy firm is ever promoted for blowing the whistle on dubious practices of companies and losing a client.

At company AGMs auditors are appointed often without any discussion. The resolutions on auditor appointment are not accompanied by any information on the composition of the audit teams; time spent on the job, audit and consultancy contracts, information obtained from directors, list of faults found with company accounts, regulatory action against auditors or anything else that might shed light on the quality of audit work or conflict of interests. With weak accountability measures, auditors deliver little of any social value.

The charges of "dereliction of duty" and "complacency" have not led to any worthwhile UK reforms though there is plenty of spin about encouraging auditors to be sceptical and tweaking auditing standards. There is no scrutiny of the basic auditing model which requires entrepreneurial accountancy firms to somehow invigilate giant corporations. The success of auditors is measured by private profits and they have no obligations to the state, or the public, which eventually bears the cost of bailouts and fraud. This mutual back-scratching has been a key factor in the debacles at Enron, WorldCom, Lehman Brothers and the banking crash. Yet no real change is in sight.

The EU is proposing minimalist reforms to check the collusive relationship between auditors and companies. These include a ban on the sale of lucrative consultancy services to audit clients and forcing companies to regularly change their auditors. At present, FTSE 100 companies change auditors every 48 years on average. Inevitably, major firms are using their financial and political resources to oppose even these modest proposals.

Major accountancy firms have got used to collecting mega fees for failure and mediocre performance. Shareholders should check that by turning the spotlight on them and demand refunds for poor performance. The government should sharpen liability laws so that auditors are forced to make good the damage done by their silence.

This article first appeared on Guardian Comment is Free

‘Empowering’ shareholders won’t revolutionise corporate culture

Prem Sikka
Executive remuneration is out of control in the United Kingdom. The final report by the High Pay Commission concluded that “there is rarely a link between directors’ incentives and the way a company performs. In the past 10 years, the average annual bonus for FTSE 350 directors went up by 187% and the average year-end share price declined by 71%”. The average pay levels of workers rose only by 10% during the same period.

The Cameron Government is now promising to clamp down on executive pay. Details will be announced later in the year, but the key idea is to empower shareholders. The British government could follow the Australian two-strikes law, which ensures that a 25% vote against executives' remuneration packages at two consecutive annual general meetings triggers a compulsory re-election of the board. However, laws developed in particular social and economic contexts can rarely be exported.

The UK government assumes shareholders are the owners and main risk-bearers of companies. This is not the case. Most shareholders are traders and speculators and have little long-term interest in invigilating companies.

The average duration of share holding in UK-listed companies has fallen from about five years in the mid-1960s and about two years in the 1980s to about 7.5 months at the end of 2007. The average shareholding periods for banks has fallen from about three years in 1998 to about three months in 2008. This does not suggest any long-term commitment to companies or corporate issues.

Since the 1980s, governments have privatised state-owned industries and given shares to UK citizens at knockdown prices. Governments have given tax incentives to individuals to buy shares in companies. None of this has expanded share ownership.

The table below shows the structure of shareholding in the UK listed companies.

The biggest change is the massive reduction is share ownership by individuals and the increase in foreign ownership by rich oligarchs, sheikhs, sovereign funds, hedge funds, offshore funds and private equity investors. Even 100 years ago, foreign companies were listed on the London Stock Exchange and UK and foreign individuals could hold shares in them. But with the increased mobility of money, their numbers have expanded.

There is little evidence to show they are interested in corporate governance issues. If foreign investors choose not to vote on executive remuneration packages, the UK government is hardly in a position to impose sanctions.

Individuals also indirectly hold shares through insurance companies, pensions funds and banks, but in these cases they do not have the right to appoint directors or mandate managers of these organisations to vote on AGM resolutions. Besides, corporate pay levels elsewhere form the benchmark for remuneration of mangers of financial institutions. Their incentives for curbing executive pay are low.

At the moment, the outcome of AGM resolutions is advisory rather than binding on directors. Even if that was changed and shareholders mustered some courage to shackle directors, they can easily be defeated because directors and their representatives are permitted to cast thousands of delegated proxy votes.

Voting rights should be given to other risk-bearers too and to those with a long-term interest in companies. Banks provide an interesting example. The leverage ratio of many banks shows that shareholders do not bear the main risks or provide most of the risk capital.

A bank with 10 billion pounds of equity and 100 billion pounds of assets in its balance sheet is said to have a leverage ratio of 10:1. In other words, for every 10 pounds of investment by shareholders, it borrowed 90 pounds.

In 2007, Barclays Bank had a leverage of around 39:1; Royal Bank of Scotland 31.2:1; HSBC 21.3:1; Lloyd’s TSB 31:1, Lehman Brothers 31:1 and Bear Stearns 33:1. Most of the long-term finance to banks is provided by savers and lenders.

Therefore, they should have the right to vote on executive remuneration, as well as for appointing directors. Employees have a long-term interest in the wellbeing of companies as their jobs and pensions depend on them. They are in a strong position to know whether the bosses deserve high rewards and should the right to vote too.

As UK politics is drifting to the right, democratisation of corporations is unlikely. Shareholder empowerment is unlikely to solve the problem of excessive executive pay.

This article first appeared on The Conversation website