BUSINESS LAW INTERNATIONAL BUSINESS LAW

Business Law International

Vol 20 No 3 pp 191–304 ISSN 1467 632X September 2019

Making Less Controversial: The Rise of Pay Ratios ECHJ Lokin

Indian Public M&A: A Comprehensive Guide to the Key Concepts, Deal Structuring and Execution Considerations and Market Practice for an International Lawyer Nikhil Narayanan VOL 20 Multiparty Contractual Networks: New Tool for Global Entrepreneurship and Supply Chains

William B Bierce NO 3

The Application of US Anti-Boycott Laws: From the Arab League to Ireland SEPTEMBER 2019 Richard L Shamos

The State of Crowdfunding Regulation in the United States Noreen Weiss

Case Comment: European Commission Fines Guess over Anti-competitive Agreements to Block Cross-Border Sales (Case AT.40428 – Guess) Nelson Jung

Published by the Legal Practice Division of the International Bar Association 197

Making Executive Compensation Less Controversial: The Rise of Pay Ratios ECHJ Lokin*

Introduction

‘Sunlight is said to be the best of disinfectants’1 Louis Brandeis

Developments in executive compensation have resulted in more legislation and regulations on executive pay being introduced over the past two decades than in the previous 150 years.2 Ever since the last financial crisis, executive compensation has remained high on the agenda of many authorities. When there are concerns about executive remuneration, legislators first of all try to find the remedy through increasing the level of transparency.3 Such a transparency measure, currently favoured by various

* ECHJ (Manuel) Lokin is Professor of Company Law at Utrecht University and a lawyer at Stibbe NV (Amsterdam office) in the Netherlands. He can be contacted at [email protected] or [email protected]. 1 LD Brandeis, Other People’s Money: and How the Bankers Use It (FA Stokes 1914), p 92. The entire quotation is: ‘Sunlight is said to be the best of disinfectants, electric light the most efficient policeman.’ 2 See ECHJ Lokin, Executive Compensation in Listed Companies, IvO no 113 (Wolters Kluwers 2018) (in Dutch). This article is based partly on chapters of this book. 3 This reaction was apparent in the United States and Germany during the years of the Great Depression. See ECHJ Lokin, Executive Compensation in Listed Companies, IvO no 113 (Wolters Kluwers 2018), c19. A similar response was noticeable in the discontent about the ever-increasing executive compensation in times of financial malaise around the turn of the century. 198 Business Law International Vol 20 No 3 September 2019 countries, is the introduction of an obligation to publish the ratio between the remuneration of the average employee and that of the Chief Executive Officer (CEO), known as the pay ratio. In the United States and certain European countries, such as the United Kingdom and the Netherlands, such an obligation has already been introduced. Based on the Shareholder Rights Directive II (SRD II), all European countries must have adopted a similar regulation by June 2019. This article will discuss the various pay ratio initiatives in the Netherlands, the UK and the US, as well as the new obligation imposed by the European Union on its Member States. It will also address the substantiation that lies at the heart of the introduction of these pay ratios, identify which market failure these regulations are aimed at solving and explain how to give further effect to this obligation. This final section will also discuss and clearly demonstrate that several of those aforementioned initiatives have not been structured effectively.

The rise of pay ratios US: Dodd–Frank Act With the adoption of the Dodd–Frank Wall Street Reform and Consumer Protection Act (the ‘Dodd–Frank Act’) in 2010, the first steps were taken towards the implementation of new federal regulations in the area of executive compensation.4 In October 2015, the Securities Exchange Commission (SEC) issued a new securities rule, based on which listed companies must make public: • the median of the total remuneration of all employees (excluding the CEO); • the annual total remuneration of the CEO; and • the ratio between these two amounts.5

There is no obligation to add a narrative to this ratio to explain why it is deemed appropriate for the company it concerns. Companies had to comply with this new regulation from the 2017 fiscal year. The proposed regulation was heavily criticised because the calculation of the median of the annual total remuneration of all employees (worldwide)

4 S 953(b) of the Dodd–Frank Act introduces the obligation to make public a pay ratio. Other regulations relate to, eg, say-on-pay and the independence of the members of the remuneration committee. See ss 951 and 952 of the Dodd–Frank Act. 5 For an overview of this pay ratio regulation and further guidance given by the SEC, see www.sec.gov/corpfin/pay-ratio-disclosure accessed 24 July 2019. Making Executive Compensation Less Controversial 199 would incur substantial costs.6 The SEC therefore opted to allow some degree of flexibility in the identification of the median employee, and the calculation of the pay ratio. The SEC allows, for example, the use of statistical sampling of its employee population or other reasonable methods.7 Companies are also allowed to exclude five per cent of their employee population under the de minimis exception to exclude non-US employees from the ratio, to annualise pay for those who were only hired for a partial year and to make any appropriate cost of living adjustments to account for compensation for employees outside the area of the CEO’s residence. The rules also allow companies to exclude employees acquired in the past fiscal year.8 The first publications, showing that there are companies with a pay ratio of over 1000:1, resulted in a barrage of criticism.9

EU: Shareholder Rights Directive II A similar rule was adopted at the European level. SRD II includes the obligation to set out in the directors’ remuneration report the annual change in a director’s remuneration, in the performance of the company and in average employee (other than directors) remuneration, on a full- time equivalent basis, over at least the last five financial years (the ‘SRD II obligation’). This information must be presented together in a manner that permits comparison.10 The 2014 proposal for revision of the Shareholder Rights Directive also mentioned: (1) the obligation to include the ratio between the average executive compensation and the average remuneration of full-time employees barring the directors; and (2) the obligation to explain why this ratio is deemed to be appropriate. However, these last two obligations can

6 The reactions to the proposed SEC regulation mentioned costs that could amount to $100m for a multinational. The SEC calculated that these were the costs for all multinationals combined for the calculation of the pay ratio in the past year. 7 Eg, the consistently applied compensation method (CACM). 8 For these exceptions and further guidance given by the SEC, see www.sec.gov/corpfin/ pay-ratio-disclosure. 9 See www.ft.com/content/1ee790f0-5da8-11e9-b285-3acd5d43599e and www.theguardian. com/business/2018/aug/16/ceo-versus-worker-wage-american-companies-pay-gap- study-2018. See also the Economic Policy Institute’s report: www.epi.org/publication/ ceo-compensation-surged-in-2017. 10 Directive (EU) 2017/828, Arts 9b(1)(b) and 9a(6). Furthermore, the remuneration policy will explain how the pay and employment conditions of employees of the company were taken into account when establishing the remuneration policy. See also the consultation on the draft guidelines https://ec.europa.eu/info/consultations/ public-consultation-remuneration-report-guidelines-implementing-shareholders-rights- directive_en). 200 Business Law International Vol 20 No 3 September 2019 no longer be found in the final version of the SRD II.11 Member States were obliged to implement SRD II into their domestic law before 10 June 2019. Both in the UK and the Netherlands, legislation has been prepared that will implement the SRD II obligation verbatim in national legislation.12

Two prior regulations: the UK and the Netherlands

The UK variant

The UK already has an obligation to publish in the remuneration report the increase in CEO remuneration against the increase of the average total remuneration of all employees of the company (or at group level) since 2013. If the company deems the average total remuneration of all employees to be an inappropriate benchmark, the company is allowed to choose another group of employees; however, the company must explain why this other group of employees was used.13 Owing to the implementation of SRD II, this rule will be adjusted according to the SRD II obligation. A salient detail in this respect is that, owing to discontent concerning the effectiveness of this disclosure obligation, the UK actually introduced an additional pay ratio rule earlier this year. As of 1 January 2019, UK listed companies with more than 250 employees were required to disclose annually the ratio of their CEO’s pay to the median, 25th and 75th percentile pay of

11 See COM(2014)213, Arts 9b(1)(b) and 9a(3). The proposal included that, in exceptional circumstances, the obligation to include a ratio could be waived. In that case, it had to be explained why there was no ratio and which measures were taken to achieve the same effect. 12 See, for the UK, the Companies (Directors’ Remuneration Policy and Directors’ Remuneration Report) Regulations 2019 www.legislation.gov.uk/ ukdsi/2019/9780111185940/part/3 accessed 24 July 2019 with which adjustments are to be implemented in the Accounts and Reports Regulations 2008, Schedule 8, s 19; see, for the Netherlands, the proposed Art 2:135b(2)(e) DCC and Art 2:135a(6)(C) DCC ‘Wijziging van Boek 2 van het Burgerlijk Wetboek, de Wet op het financieel toezicht en de Wet giraal effectenverkeer ter uitvoering van Richtlijn 2017/828/EU van het Europees Parlement en de Raad van 17 mei 2017 tot wijziging van Richtlijn 2007/36/EG wat het bevorderen van de langetermijnbetrokkenheid van aandeelhouders betreft (PbEU 2017, L 132)’ https://zoek.officielebekendmakingen.nl/kst-35058-A.html accessed 24 July 2019 13 See the Large and Medium-sized Companies and Groups (Accounts and Reports) (Amendment) Regulations 2013 www.legislation.gov.uk/uksi/2013/1981/contents/made accessed 24 July 2019 with which adjustments are to be implemented in the Accounts and Reports Regulations 2008, Schedule 8, s 19. Making Executive Compensation Less Controversial 201 their full-time equivalent UK employees.14 Furthermore, the method used to calculate the pay ratio must be published, for which the company is given three methods to choose from. Under option A, companies determine total full-time equivalent total remuneration for all UK employees for the relevant financial year, while under options B and C companies are offered some flexibility in calculating the pay ratios, allowing companies to identify, on an indicative basis, employees whose remuneration places them at median, 25th and 75th percentile, using existing pay data such as gender pay data (Option B) or any other recent existing data (Option C). Employees’ pay should be calculated on a full-time equivalent basis and include wages and salary. Benefits, pension contributions and variable pay may also be included.15 In the first year of reporting, only one set of pay ratios will be disclosed, but the pay ratio data will build incrementally to a ten-year period going forward. There is also significant prescribed narrative disclosure. For example, companies will be required to explain the reasons for year-on-year changes to the ratio, and whether and why the company believes the median pay ratio for the relevant financial year is consistent with the pay, reward and progression policies for the company’s UK employees as a whole.16

The Dutch variant

In the Netherlands, a listed company’s obligation to publish the ratio between its executive compensation and the remuneration for an established representative reference group within the company was inserted into the Dutch Code 2016 (the ‘2016 Code’) rather than into the Dutch Civil Code (DCC). The company must also explain whether and how the ratios have changed compared to the previous fiscal year.17 This best practice provision, introduced in 2016, is the third stipulation in

14 The Companies (Miscellaneous Reporting) Regulations 2018 www.legislation.gov.uk/ uksi/2018/860/contents/made accessed 24 July 2019, with which ss 19A–19G are added in the Accounts and Reports Regulations 2008 in Schedule 8. Pay ratios will be calculated on a group-wide basis by reference to UK employees only. Companies will start reporting this in 2020 (covering CEO and employee pay awarded in 2019). The rules apply to UK- incorporated companies that are listed on the London Stock Exchange, an exchange in a European Economic Area (EEA) Member State, the New York Stock Exchange or NASDAQ. 15 See Accounts and Reports Regulations 2008, Schedule 8, s 19D. 16 See also the Companies (Miscellaneous Reporting) Regulations 2018 Q&A in which the Department for Business, Energy & Industrial Strategy provides guidance https://assets. publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/ file/755002/The_Companies__Miscellaneous_Reporting__Regulations_2018_QA_-_ Publication_Version_2__1_.pdf accessed 24 July 2019 17 Compliance with the 2016 Code by listed companies is based on the ‘comply or explain’ principle. 202 Business Law International Vol 20 No 3 September 2019 the 2016 Code relating to internal pay ratios. The 2016 Code also includes that: (1) for the formulation of the remuneration policy, internal pay ratios must be taken into account; and (2) the remuneration committee’s proposal to the supervisory board about the compensation package of individual executives must be based on the pay ratios within the company and its affiliated enterprises.18 Application of this new regulation by listed companies in the previous year has been criticised on several fronts. This critique mainly focuses on the lack of a uniform methodology for calculating the pay ratio, the varying locations of the disclosure and the fact that the numeric information regarding the pay ratio was (in general) not accompanied by comment from the remuneration committee on whether they believe the ratio is at a satisfactory and justifiable level.19 For example, most companies used total remuneration figures (ie, including bonuses); however, some companies used fixed pay only. A majority of companies used the CEO remuneration figures in comparison with the average pay of all the company’s employees. However, a substantial number of companies used the average executive board pay. Some companies selected the median employee, the average pay of employees in Europe and North America, of employees working at the company’s headquarters, of Dutch employees, average pay of a ‘representative group’, various staff levels and the pay of the lowest-paid person. And although the majority of the companies included the pay ratio disclosure in the financial statements (either in the report or in the annual accounts), some companies incorporated the pay ratio disclosure in a separate report placed somewhere on the company’s website. Implementation of SRD II will result in an additional, and statutory, disclosure obligation for listed companies in the Netherlands.

What is the purpose of publishing a pay ratio? A lack of consensus in the US The purpose and interpretation of an obligation to publish a pay ratio depend on the intended goal. However, the discussion that preceded the introduction of the pay ratio rule in the US demonstrates that there is no consensus about which market failure should be mitigated with the publication of a pay ratio. In the US, the SEC adopted the pay ratio rule by a very small majority (three votes in favour, two votes against). Commissioner Aguilar stated that the reason for its implementation is that the pay ratio

18 Best practice 3.1.2 and 3.2.1 2016 Code. 19 See www.eumedion.nl/nl/public/kennisbank/ava-evaluaties/2018-ava- evaluatierapport.pdf accessed 24 July 2019. Making Executive Compensation Less Controversial 203 may help shareholders to oversee executive compensation, and that it may contribute to making an informed decision with regard to say-on-pay (an informational function).20 Commissioner Gallagher stated that the above is utter nonsense and pointed out that the rule is solely a matter of naming and shaming, intended to urge companies to set a lower compensation for their CEO (a public outrage function).21 According to him and Commissioner Piwowar, no benefit whatsoever should be expected from the obligation to make the pay ratio public, but this rule does incur substantial costs for the business sector.22 The criticism of the two commissioners does not come entirely out of the blue.23 In its previous proposal from 2013, the SEC stated that ‘[t]he lack of a specific market failure identified as motivating the enactment of this provision poses significant challenges in quantifying potential economic benefits, if any, from the pay ratio disclosure’.24 Additionally, the accompanying statement to the final rule includes the claim that ‘neither the statute nor the related legislative history directly states the objectives or intended benefits of the provision or of a specific market failure, if any, that is intended to be remedied’.25 Nevertheless, doubts remain whether it is correct to say that there is no specific market failure that is intended to be remedied.

20 Luis A Aguilar, ‘The CEO Pay Ratio Rule: A Workable Solution For Both Issuers and Investors’, 5 August 2015 www.sec.gov/news/statement/statement-on-open-meeting- on-pay-ratio-aguilar.html accessed 24 July 2019. Aguilar ‘hopes’ that the publication of this information will enable shareholders to accept more responsibility regarding compensation practices. 21 ‘To steal a line from Justice Scalia, this is pure applesauce… The AFL-CIO, which lobbied for the rule’s inclusion in Dodd–Frank, has explained for us its true purpose: “Disclosing this pay ratio will shame companies into lowering CEO pay.” And, “They will be embarrassed, and that’s the whole point.”’ Daniel M Gallagher, Dissenting Statement at an Open Meeting to Adopt the ‘Pay Ratio’ Rule, 5 August 2015. 22 One of the subjects he mentions are the initial costs amounting to $1.6bn. Daniel M Gallagher, Dissenting Statement at an Open Meeting to Adopt the ‘Pay Ratio’ Rule, 5 August 2015. For critique on this section of the Dodd–Frank Act see SM Bainbridge, Corporate Governance after the Financial Crisis (Oxford University Press 2012), 127. 23 See Michael Piwowar’s critique: Dissenting Statement at Open Meeting on Pay Ratio Disclosure, 5 August 2015 www.sec.gov/news/statement/dissenting-statement-at-open- meeting-on-pay-ratio-disclosure.html accessed 24 July 2019; Michael S Piwowar, Additional Dissenting Comments on Pay Ratio Disclosure, 7 August 2015 www.sec.gov/news/statement/ additional-dissenting-statement-on-pay-ratio-disclosure.html accessed 24 July 2019. 24 Securities and Exchange Commission, 17 CFR Parts 229 and 249 Release Nos 33-9452; 34-70443; File No S7-07-13, 18 September 2013, p 90. 25 Securities and Exchange Commission, 17 CFR Parts 229 and 249, Release Nos 33- 9877; 34-75610; File No S7-07-13, final rule, 5 August 2015, p 168 www.sec.gov/rules/ final/2015/33-9877.pdf accessed 24 July 2019. 204 Business Law International Vol 20 No 3 September 2019

Market failure in setting the absolute level of executive pay The emergence of pay ratio regulations is in line with the broader trend of adopting laws and regulations to force boards of directors of listed companies to take better account of their company’s internal remuneration structure during the pay-setting process.26 These initiatives are a response to the almost exclusive role of external referencing (through benchmarking based on peer groups) when deciding on the level of opportunity pay of executives. Criticism of this method of determining the level of compensation has grown in recent years.

Criticism of the benchmark process ‘I know I’m overpaid, but this benchmark shows that I’m not overpaid enough!’27

The primary criticism focuses on the benchmark process itself and its bearing on the composition of the reference groups. Naturally, this composition is a determining factor for the compensation level of the median and the other percentiles, and hence also for the level of executive compensation. The large number of variables used for selecting the reference group, however, makes this process fundamentally vulnerable.28 The absence of objective standards may benefit customisation, but it also increases the opportunity for cherry-picking in order to justify a certain compensation level; all the more

26 For instance, the UK workforce, based on the adjusted UK Corporate Governance Code (UKCGC) 2018, has been given a more prominent role in the determination of executive compensation; see, eg, provisions 33, 38, and 41 UKCGC 2018. In the Netherlands, the works council may, among other things, form an opinion on the compensation policy and communicate this opinion during the AGM; see Art 2:135(2) DCC. It has been proposed to turn this into a non-binding consultation right; see Art 2:135a(3) DCC. A short while ago, an obligation was adopted by which the board has to discuss the annual compensation developments of the board and the rest of the company with the works council; see Art 23(2) Works Councils Act. 27 In his article, Winter refers to this statement that was made by a German executive, J Winter, ‘Corporate Governance Going Astray: Executive Remuneration Build to Fail’ in S Grundmann, B Haar and H Merkt et al (eds), Festschrift fur Klaus J Hopt zum 70. Geburtstag am 24 August 2010: Unternehmen, Markt und Verantwortung (Walter de Gruyter 2010). 28 See D Cheng, ‘Executive Pay Through a Peer Benchmarking Lens’, ISS Corporate Services, 21 July 2011, pp 3 and 4; GS Crystal, ‘Why CEO compensation is so high’ (1991) 34 California Management Review 14. The most used variables are sales, market capitalisation and assets, but all kinds of other variables can be used as well. This should be seen in the broadest sense; from the number of employees to having an equal ‘reputation’ or ‘complexity’. A company may also choose to use more global variables by which a company can be selected because it operates in the same industry or because it has its headquarters in the same city. Making Executive Compensation Less Controversial 205 so because the executive is one of the co-decision makers in establishing the composition.29 ‘Determining CEO compensation is the responsibility of the board of directors’ compensation committee. One input into the determination of executive pay is a set of peers used to benchmark executive compensation. These peers are usually suggested by the compensation committee, often under the guidance of a compensation consulting firm… executives typically review and provide feedback on the choice of peers, part of which may include executives’ views on peers that should be excluded as well as those peers that should be added to the final set.’30 In this respect, the behavioural science phenomenon of ‘over-placement’ plays a role. This relates to the tendency for individuals to overvalue themselves and measure themselves against those who are above them.31 A similar bias can be seen in the selection of peers, which results in a tendency for companies to select referents with a higher remuneration level.32 This is shown in a study conducted by ISS Corporate Services in 2011, in which

29 See M Faulkender and J Yang, ‘Inside the black box: the role and composition of compensation peer groups’ (2010) 96(2) Journal of Financial Economics 257−270. 30 AM Albuquerque, G De Franco and RS Verdi, ‘Peer choice in CEO compensation’ (2013) 108(1) Journal of Financial Economics 160−181; see also JF Reda, S Reifler and LG Thatcher, Compensation Committee Handbook (John Wiley and Sons Ltd 2007). 31 See MH Bazerman and DA Moore, Judgment in Managerial Decision Making (8th edn John Wiley & Sons 2012), 26. 32 See the Institutional Shareholder Services’ report (ISS/ICS): D Cheng, ‘Executive Pay Through a Peer Benchmarking Lens’, ISS Corporate Services, 21 July 2011; M Pittinsky and ThA DiPrete, ‘Peer Group Ties and Executive Compensation Networks’, SSRN (June) 2011; the Investor Responsibility Research Center’s report (IRRC): Compensation Peer Groups at Companies with High Pay, IRRC, June 2010, p 10; M Faulkender and J Yang, ‘Inside the black box: the role and composition of compensation peer groups’ (2010) 96(2) Journal of Financial Economics 257−270; JF Porac, JB Wade and TG Pollock, ‘Industry Categories and the Politics of the Comparable Firm in CEO Compensation’ (1999) 44(1) Administrative Science Quarterly 112−144. Bizjak et al conclude: ‘Although firms generally select compensation peers based on characteristics that reflect the labor market for managerial talent, we find evidence that the selected peers are chosen in a manner that biases compensation upward’: JM Bizjak, ML Lemmon and TL Nguyen, ‘Are All CEOs Above Average? An Empirical Analysis of Compensation Peer Groups and Pay Design’, SSRN, 14 August 2009. Albuquerque et al find comparable results, but offer an alternative explanation for the inclusion of better-paying companies: AM Albuquerque, G De Franco and RS Verdi, ‘Peer choice in CEO compensation’ (2013) 108(1) Journal of Financial Economics 160−181. Cadman and Carter only find limited evidence that companies adopt an opportunistic approach when choosing their referents: B Cadman and ME Carter, ‘Compensation Peer Groups and their Relation with CEO Pay’ (2014) 26(1) Journal of Management Accounting Research 57−82. 206 Business Law International Vol 20 No 3 September 2019 it was demonstrated that the majority of companies select peers whose size ranges between 0.5 and two times their own size.33 Another common criticism relates to the fact that the remuneration committee always opts for a compensation level that is equal to or exceeds the median34 of the compiled peer group, because this will cause a leapfrog effect.35 Executive compensation will increase significantly and indefinitely, without any valid foundation, when everyone receives a compensation level above or equal to the median; as the saying goes, a rising tide lifts all boats. This phenomenon has been recognised by some soft law regulators. To prevent the leapfrog effect at financial institutions, for example, the Dutch Banking Code stipulates that, at the time of its establishment, the total remuneration offered to an executive of a financial institution must be somewhat below the median of comparable functions within and outside the financial sector.36 Additionally, the UK Corporate Governance Code 2016 (the ‘2016 UK Code’) used to include the (supportive) principle: ‘The remuneration committee should judge where to position their company relative to other companies. But they should use such comparisons with caution, in view of the risk of an upward ratchet of remuneration levels with no corresponding improvement in corporate and individual performance

33 D Cheng, ‘Executive Pay Through a Peer Benchmarking Lens’, ISS Corporate Services, 21 July 2011, pp 3 and 4. Faulkender and Yang also conclude: ‘… we find that firms appear to select highly paid peers to justify their CEO compensation and this effect is stronger in firms where the compensation peer group is smaller, where the CEO is the chairman of the board of directors, where the CEO has longer tenure, and where directors are busier serving on multiple boards.’ M Faulkender and J Yang, ‘Inside the black box: the role and composition of compensation peer groups’ (2010) 96(2) Journal of Financial Economics 257−270. 34 In practice, fixed as well as variable pay is set on a level that is either on or above the median. Especially with regard to variable remuneration, there is a tendency to grant a remuneration that lies fairly above the median. In such cases, the remuneration committee opts for an above-median reference level (eg, between the 60th and 75th percentile) in order to increase the performance drive. This is indicated as the ambition level. H van Ees, G van der Laan, EJP Engesaeth and CAS Selker, ‘De relatie tussen de bezoldiging van bestuurders van beursgenoteerde ondernemingen en de prestaties van deze ondernemingen’, RUG/TowersPerrin, November 2007, p 53. See also JM Bizjak, ML Lemmon and L Naveen, ‘Has the Use of Peer Groups Contributed to Higher Pay and Less Efficient Compensation?’, SSRN, March 2007, pp 2–3. 35 This is also called the Lake Wobegon effect, named after the fictitious town where ‘all the women are strong, all the men are good looking and all the children are above average’. This refers to the ‘above average’ phenomenon. ‘Most of us have moderate to high self- esteem. Like the mythical residents of Garrison Keillor’s Lake Wobegon, we need to believe that we are above average. Eg, in a survey of a million high school students, only two percent stated that they were below average in their ability (Gilovich 1991)’, E Aronson, TD Wilson and RM Akert, Social Psychology (Pearson Education (US) 2010). 36 6.3.1. Dutch Banking Code 2010; for the revised Dutch Banking Code 2014, see p 13, www.nvb.nl/media/1665/000601_000601-code-banken-uk.pdf accessed 24 July 2019. Making Executive Compensation Less Controversial 207 and should avoid paying more than is necessary. They should also be sensitive to pay and employment conditions elsewhere in the group, especially when determining annual salary increases.’37 Apparently, this provision can no longer be found in the 2018 UK Code.38 A third point of criticism, mentioned less often, relates to a number of other perverse effects of benchmarking. Research conducted by DiPrete, Eirich and Pittinsky shows that, owing to how the reference group process operates, excessive compensation for a relatively small number of executives may have a significant effect on the compensation levels of the other executives in the same reference group, whereby it is no longer a question of why these executives of similar enterprises receive a certain compensation, but only how much they get.39 Lastly, there is the issue that this system ensures that executive remuneration is separated from the rest of the internal compensation structure because the internal remuneration ratios play a negligible role in the pay-setting process. This will only increase the gap between executive compensation and the wages of the regular employee, resulting in adverse effects for the company itself.40

Justification for the benchmarking process ‘A wealthy man is one who earns $100 a year more than his wife’s sister’s husband.’ HL Hencken

Notwithstanding the aforementioned criticism on the benchmarking process, most listed companies still base their ex ante executive compensation almost exclusively on external references. The prominent role of benchmarking during the determination process of the executive compensation is generally justified by two arguments.41 The most important argument relies on the

37 Principle D1 2016 UK Code. This principle was already largely included in 2014 UK Code. 38 www.frc.org.uk/getattachment/88bd8c45-50ea-4841-95b0-d2f4f48069a2/2018-UK- Corporate-Governance-Code-FINAL.pdf accessed 24 July 2019. 39 ThA DiPrete, GM Eirich and M Pittinsky, ‘Compensation Benchmarking, Leapfrogs, and the Surge in Executive Pay’ (2010) 115(6) American Journal of Sociology 1671–1712. 40 With respect to the consequences of elevated CEO pay, see Niklas K Steffens, S Alexander Haslam, Kim Peters and John Quiggin, ‘Identity economics meets identity leadership: Exploring the consequences of elevated CEO pay’, The Leadership Quarterly, 2018, https://doi.org/10.1016/j.leaqua.2018.10.001. 41 The third reason is that there is currently no simple alternative to determine the level of executive compensation, so the remuneration committee prefers to use a universally applied standard solution: benchmarking. 208 Business Law International Vol 20 No 3 September 2019 conviction that executives need to receive a competitive remuneration package so that they can be attracted and retained. This opinion is based on the theory of opportunity cost, in combination with an assumption that there is an efficiently operating market for executives. When determining the structure of executive compensation, the revenues an executive may generate with the best possible alternative must be taken into account.42 When there is an efficiently operating competitive market, with a high degree of mobility, then these opportunity costs will largely coincide with the compensation levels offered by competitors for a comparable function. These functions are usually the best (or at least the most obvious) alternatives for the person it concerns. The coincidence mentioned above justifies putting the emphasis on the valuation of the function based on external reference. Another common argument relates to the message that the level of compensation conveys to both the executive and the shareholders. By setting the compensation on or above the median, the company gives a positive signal to the outside world about the expertise of the executive and the ambitions of the company.43 In addition, it meets the expectations of the executive. Generally speaking, executives, just like regular employees, are less interested in the absolute level of the compensation they receive, but more in its relative level.44 The assumption that there is an efficient global market for executives, in combination with the universal use of benchmarking, strengthens the idea that other executives of companies in the reference group should be considered as peers. The fact that the social status of an executive partly depends on the relative level of compensation increases executives’ interest in receiving a higher compensation than their peers. ‘Though retention and market needs are most often cited as justification for the use of benchmarking, its most essential use is merely to satisfy an executive’s desire to be rewarded as well as his or her peer CEOs.’45

42 See LR Gomez-Mejia and RM Wiseman, ‘Reframing Executive Compensations: An Assessment and Outlook’ (1997) 23(3) Journal of Management 349–350. It goes without saying that other issues play a role as well, such as location, challenge, status, forecast, etc, on which an executive will base his or her decision to stay or leave. 43 J Winter, ‘Corporate Governance Going Astray: Executive Remuneration Build to Fail’ in S Grundmann, B Haar and H Merkt et al (eds), Festschrift fur Klaus J Hopt zum 70. Geburtstag am 24 August 2010: Unternehmen, Markt und Verantwortung (Walter de Gruyter 2010), 7. See also MB Dorff, Indispensable and Other Myths: Why the CEO Pay Experiment Failed and How To Fix It (University of California Press 2014), 71–73. 44 R Layard, Happiness: Lessons from a new science (Penguin Books 2005), 45. See also the remark on p 40: ‘O.K., if you can’t see your way to giving me a pay raise how about giving Parkerson a pay cut?’ 45 ChM Elson and CK Ferrere, ‘Executive Superstars, Peer Groups and Over-Compensation: Cause, Effect and Solution’, IRRC Institute, 2012, p 38. Making Executive Compensation Less Controversial 209

The non-existent efficient global market for executives Apart from criticism on the way the benchmarking process functions, more fundamental criticism has recently been raised over the use of external references to establish executive compensation.46 This criticism focuses on the implicit assumption that there is such a thing as an efficiently operating international market for executives; an assumption seldom questioned by remuneration committees. Wrongly so. When looking at the origin of the universal use of reference groups, it becomes clear that this practice is not based on extensive (academic) research or on balanced considerations by the market on how executive compensation may best be determined, but that it stems from a profitable service that was offered by pioneering remuneration consultants.47 Research into the assumption of an efficient market for executives shows, however, that this assumption is not based on reality and offers no justification for the universally undisputed exclusive role of benchmarking in determining the ex ante level of executive compensation. For example, when looking at where executives originate from, it appears that only a small percentage actually come from another listed company. Cremers and Grinstein state that less than two per cent of all new CEOs of listed companies in the US were previously CEOs at other listed companies.48 It is also rare to see an executive transfer to another company during his term. An overview of 1,200 CEO transfers showed that this amounted to only 3.6 per cent.49 Another study, focused on companies in the Standard & Poor’s (S&P) 500, identified only six CEOs who moved to another publicly traded company during their term, which is less than three per cent.50 Furthermore, it appears that the majority of the executives rise from within the company’s own ranks. A study showed that more than 87 per cent of investigated companies in the US had an internally

46 Ibid; ECHJ Lokin, Executive Compensation in Listed Companies, IvO no 113 (Wolters Kluwers 2018). 47 See n 45 above, at 13. 48 M Cremers and Y Grinstein, ‘The Market for CEO Talent: Implications for CEO Compensation’, Yale School of Management Working Papers, 2009, p 37. Most executives who are not internally trained come from small, privately owned companies that are not listed. 49 C Edward Fee and ChJ Hadlock, ‘Raids, Rewards, and Reputations in the Market for Managerial Talent’ (2003) 16(4) The Review of Financial Studies 1315. The study concerned the period 1990–1998. 50 C Edward Fee and ChJ Hadlock, ‘Management turnover across the corporate hierarchy’ (2004) 37(1) Journal of Accounting and Economics, table 1. The study concerned the period 1993–1998. Of these six, five of them accepted a CEO position with a significantly larger company and one accepted a lower executive position with a company that was 16 times the size of his previous employer. 210 Business Law International Vol 20 No 3 September 2019 trained CEO,51 which is unsurprising; various studies have shown that succession through external hiring is linked to substandard performance in the long term.52 Company-specific competencies are preferred over general competencies, reducing the potential mobility of executives.

51 D Bolchover, ‘Global CEO Appointments: A very domestic issue’, High Pay Centre, 2013, pp 7–9. The study conducted by Bolchover showed that, within the US, only five CEOs – 3.5 per cent of the total number of CEOs of the Fortune 500 companies in the US – transferred from another company within the US where they held the position as CEO. In Eastern Europe, Japan, Latin America and North America, not one CEO was appointed from outside the country where the company is based. Cross-border poaching of current CEOs amounts to 0.8 per cent of total CEO appointments in the Fortune Global 500, while cross-regional poaching of current CEOs amounts to 0.2 per cent of total CEO appointments. In the whole of Western Europe, there were 12 CEOs who already held a CEO position in a certain country and who accepted another position as CEO with another company in the same country. Two of these 12 CEOs went from one state-owned company to another state-owned company, which brings the total percentage to 6.5 per cent of all western European companies included in the study. 52 Several studies conducted by Booz Allen & Hamilton conclude that a CEO who previously held a CEO position at a listed company is unable to live up to his performances achieved at his former employee in his new position, and that external executives (especially in the long term) perform less satisfactorily than internal executives. Ch Lucier, R Schuyt and J Handa, ‘CEO Succession 2003, the Perils of “Good” Governance’, BoozAllen, Strategy + Business, no 39, 2004, p 16. See also Ch Lucier, S Wheeler and R Habbel, ‘The Era of the Inclusive Leader’, Booz, Allen & Hamilton, Strategy + Business, no 47 (Summer) 2007; FG Steingraber, R Magjuka and Ch Snively, ‘“Home Grown” CEO, one key to superior long- term financial performance is managing leadership succession’,A.T. Kearney & Kelley School of Business (4 April) 2011. For this study, the authors investigated (non-financial) companies with a listing in the S&P 500 between 1988 and 2007. The researchers identified 36 companies that achieved the best performance over the past 20 years. It became clear that they had one thing in common, which was that their executives all came from their own internal ranks. In his work ‘Good to Great: Why some Companies make the leap… and others don’t’, Jim Collins reaches the conclusion that ‘larger-than-life, celebrity leaders who ride in from the outside are negatively correlated with taking a company from good to great’, J Collins, Good to Great: Why some Companies make the leap…and others don’t (Harper Collins USA 2001). Furthermore, after a study into the performances of CEOs over the period 1986–2005, Ang and Nagel came to the conclusion that ‘an economically significant gain is realized, on average, by hiring internally relative to what would have been obtained by hiring externally, whereas an economically significant loss is realized by hiring externally’; see JS Ang and GL Nagel, ‘The Financial Outcome of Hiring a CEO from Outside the Firm’, SSRN (14 March) 2011. Hardin and Nagel conducted a study into executives who managed several companies at the same time in order to see whether the competencies of these executives were transferable from one company to the other. As an example, they named Steve Jobs who acted as CEO of Apple and Pixar simultaneously. They found evidence that some competencies were transferable between the companies but that there was only a marginal opportunity for transferability. Even though the CEO performed superiorly with his initial company, he appeared to be able to achieve no more than competitive performances at the other company(ies). A noticeable fact was that external executives achieved a lesser performance than both this multi-executive and the internal executives. WG Hardin III and GL Nagel, ‘The Transferability of CEO Skills’, SSRN, 2007. Making Executive Compensation Less Controversial 211

‘Today’s CEOs need to know more than how to run a business. They need to understand and effectively leverage their firm’s unique culture and differentiated brand. They need to know how to inspire their people and connect with their customers. They need to balance the exogenous forces of a treacherous and continuously changing global business environment with the endogenous forces – and personalities – of their own companies to lead change and move forward. There is no substitute for mature judgment, deep understanding and well forged relationships based on trust developed over time on the playing field.’53 Based on these findings, the assumption that there is such a thing as an efficiently operating market for executives can be seriously questioned. Even more importantly, the threat that executives will transfer to a company of one of the peer groups is simply not realistic enough to justify the current process of benchmarking. These findings are not without consequences. If the assumption of an efficiently operating market for executives is without foundation, the opportunity costs of the individual executive no longer correspond to a valuation of the executive’s function, and therefore is there no justification for the almost exclusive emphasis on external referencing when determining the level of executive compensation. Apart from the criticism on the benchmarking process itself, this fundamental issue regarding the use of benchmarking should at least be a reason for remuneration committees to reconsider the way they determine the level of executive pay.54 It is exactly this market failure that needs to be remedied. Remuneration committees have already been urged by various sides to look internally and to let the internal remuneration ratios be leading when determining executive compensation.55 Ignoring this call to action results in ever further-reaching legislation and regulations to force companies to do just that. The obligation to publish a pay ratio is one of the latest examples (a behavioural change function). The primary goal of this obligation is to stimulate the remuneration committee to design an internal remuneration

53 Paul A Laudicina (managing officer and chair of the board of AT Kearney) in FG Steingraber, R Magjuka and Ch Snively, ‘“Home Grown” CEO, one key to superior long- term financial performance is managing leadership succession’,AT Kearney & Kelley School of Business (4 April) 2011. 54 With the above, I do not mean to imply that the use of peer groups cannot be useful in any way. Eg, the labour market for the management levels below the executive suit is a competitive market, which means that the company cannot afford to offer these levels remunerations below the market. 55 See eg the letter to S&P 500 index companies written by a coalition of institutional investors with $3.3tn in assets under management and advisement. A copy of the letter can be found at www2.segalco.com/sma-pay-ratio-sp500-template.pdf accessed 24 July 2019. 212 Business Law International Vol 20 No 3 September 2019 philosophy, based on which the level of executive compensation will be determined. An additional advantage is that a stronger emphasis on the internal remuneration structure may stimulate executives to look internally, instead of solely externally, when valuing their own compensation.

How should further effect be given to the obligation to disclose a pay ratio? Focusing on this goal, it also becomes clear how pay ratio regulations should be structured and in what way companies may best comply with such an obligation. First and foremost, it is important to recognise that the informative value of a pay ratio is limited to the company it concerns. Pay ratios cannot be mutually compared. The pay ratio of a pharmaceutical company, for example, which has many highly qualified employees, will be significantly lower than that of a cleaning company, without being able to derive a valuation of the respective pay ratio.56 Even within a certain sector, the information initially remains company-specific because of the way in which the pay ratio is calculated. All pay ratio regulations offer companies some degree of flexibility when selecting the representative employee(s) who act as a benchmark for calculating the pay ratio. This flexibility is necessary and benefits the applicability of the regulation, but it detracts from the mutual comparability of the different pay ratios. For this reason, it must be borne in mind that the discretionary authority of the company reduces the calculation of this remuneration information to a low quality.57 Paradoxically, the pay ratio regulation is hence most effective when the least amount of emphasis is placed on the ratio in isolation. The emphasis should be placed on the way in which the ratio relates to the further internal remuneration structure, and on how the ratio has developed compared to

56 The comparability is also inhibited by other factors, including geographical. Moreover, the pay ratio says nothing about the absolute level of the executive compensation. 57 ‘Pay ratio data, by contrast, is low-quality, non-comparable data.’ See SEC committee member Daniel M Gallagher in Dissenting Statement at an Open Meeting to Adopt the ‘Pay Ratio’ Rule, 5 August 2015. Making Executive Compensation Less Controversial 213 previous years.58 To meet this requirement, the following focal points are important. First, the obligation to publish a singular pay ratio puts too much emphasis on the gap between the median employee and the CEO. As the purpose of the regulation is to oblige remuneration committees to develop a vision on how executive compensation fits within the remuneration structure of the entire company, it is better to publish multiple pay ratios. At the moment, only the regulation adopted in the UK is explicitly in line with this focal point, but the other aforementioned regulations do not prohibit giving effect to the obligation to provide transparency in this way. Companies are allowed to provide supplemental pay ratios.59 The second point of attention is whether the pay ratio is calculated based on the opportunity pay and/or the realised pay of the executive. The existing regulations only seem to focus on the latter, overlooking the fact that this muddies the discussion. An increase (or decrease) in the remuneration level will largely depend on the annual ‘released’ variable compensation of the executive. This makes the pay ratio extremely volatile, needlessly increasing the risk of media attention, internal unrest and public outrage – and thus reputational damage. The discussion will be, unjustly, about the level of the compensation while it should actually be about the structure, and in particular about whether the granting of variable remuneration can be justified and whether the right performance measures and targets are used. This defeats the purpose of the pay ratio. While determining the level of executive pay, the remuneration committee focuses on potential compensation levels of the executive and not on what is ultimately paid. Therefore, the opportunity pay should be the foundation for regulation regarding the pay ratio so that, during the pay-setting process, the ratio between the executive’s compensation and the rest of the internal remuneration structure will be the focal point. Next, to what extent the actual realised pay is in line with the executive’s opportunity pay may also be assessed.

58 This is why, in my opinion, the trend in the US to impose additional taxes on companies with high pay ratios has an undesired gaming effect and potentially other unintended consequences (eg, outsourcing low-paid jobs or raising workers’ pay but cutting on other benefits) when calculating the pay ratio. The city of Portland, Oregon, for eg, introduced a tax regulation (a penalty business tax on firms) based on which the company has to pay ten per cent additional taxes when the CEO-to-median-employee ratio lies between 100:1 and 250:1, and an additional 25 per cent when this ratio exceeds 250:1. Nike is one of the companies affected by this tax regulation as its ratio is 379:1. Similar regulations were proposed in states like California, Illinois and Massachusetts, and at federal level. The same undesired effects are created by the naming and shaming of a company by the media solely based on the isolated number. 59 They may even be using a different methodology from the required rules for these supplemental ratios. 214 Business Law International Vol 20 No 3 September 2019

To guarantee that a comparison can be made of ratios across various years, the same method must be applied structurally when calculating the pay ratio of the company.60 This means that the company may be held accountable for the method used, and its application. Another consequence is that every material adjustment of the values on which the pay ratio is based must be made public and accompanied by an explanation that shows to what extent these adjustments result in a change to the pay ratio or to the executive compensation. Last but not least, the published numeric information must be given some degree of context. Fundamentally, it is not about the number, or the method by which this number was calculated; it is about the explanation (‘narrative’) as to why the remuneration committee has deemed the resulting internal remuneration ratios to be in the company’s best interest. With this explanation, the remuneration committee is given the opportunity to provide insight into the pay-setting process, as well into the role played by the company’s internal remuneration structure.

Concluding remarks Various countries have introduced an obligation for listed companies to publish information on the ratio between their CEO and employee pay. Despite strong criticism, it seems that these new transparency rules are here to stay. These rules are far from perfect. The most important reason for their imperfection is that the pay ratios that they produce are perceived as straightforward, high quality information, and spark a seemingly irresistible urge to mutually compare them. In reality pay ratios only provide firm- specific information unsuitable for comparison in any way. The appeal of pay ratios to media and the general public is an important feature of these transparency measures, but it is also their main weakness. The goal of publishing a pay ratio is to use investor and public outrage to change the way remuneration committees determine the ex ante pay level of their CEO. The primary objective is therefore to provoke a behavioural change. Most pay ratio rules, however, are ineffectively designed to achieve that goal, and are potentially counterproductive because they focus too much on creating outrage instead of providing information on the role internal pay ratios played in the pay-setting process. Presenting a single, isolated pay

60 As the Dutch solution demonstrates, a too non-committal regulation by which companies may choose their own method results in a discussion that focuses too strongly on the choices made by different companies. A uniform method or methods is preferable. Making Executive Compensation Less Controversial 215 ratio based on the ex post CEO pay without providing any context will not incite a useful debate about a company’s pay-setting process. The obligation to publish a pay ratio will only make executive compensation less controversial if it spurs remuneration committees to reconsider the way they determine the level of executive pay and to design a coherent remuneration philosophy based on the company’s internal pay ratios. If such a philosophy is in place, publishing internal pay ratios will provide remuneration committees with a strong narrative to support their CEO’s pay. Ignoring this call to action and simply complying with these ill-designed pay ratio rules will lead to the opposite; attracting more media attention and fuelling public outrage with the risk of executive compensation becoming even more controversial. The result will most probably be ever further-reaching legislation and regulations on pay in the near future. 216 Business Law International Vol 20 No 3 September 2019