SPEECH NOTES TO
The National Press Club
Bellamys
Tuesday 10 March 2009

Andrew Little

“Failing their way to success:
senior executive pay for performance – but performance of what?”

There has never been a better time to closely examine the culture of high salaries and performance bonuses endemic in many large corporations and merchant banks around the world.

And the examination should be not just of the economic justification for these rewards but of the moral case for them and the social implications.

Just how much added value have these super finance wizards created? The question is an obvious one as we have all sat and watched nearly $US40 trillion being wiped off the value of stocks, shares and bonds – and, therefore, off many superannuation and retirement savings funds – over the last 12 months. The figures beggar belief. They defy comprehension.

We instinctively know what is behind the collapse of finance capital over the last 18 months. Credit was relaxed in the early 2000s to lend for property. Property prices increased at unrealistic and unsustainable rates. Credit was extended to more marginal borrowers solely on the basis that they would quickly acquire some equity in properties fully burdened by debt. These questionable loans were bundled with more reliable debts into securities and sold as products around the world, hedged against, or had bets taken against the failure of the questionable loans and dodgy securities. The questionable loans stopped being repaid, the rapid rise in property prices eased and the house of cards began to collapse.

So, how is it that some of the most talented and well trained business brains of the business world can collectively act in such an obviously self-destructive way causing hundreds of millions of others, either as taxpayers or as investors in retirement savings or other assets, to pick up the cost?

It may be that the excesses we have seen in the US and the UK in particular have not been replicated here. But there is no question, in my view, that there has been a culture for many years in many of our corporates which has been consistent with the culture of excessive and disproportionate reward that we have seen overseas.

Let’s look at some of the cases we are now seeing overseas. And I should point out that these cases, and the figures in them, perhaps look different to us now as we look at them through the lens of world wide recession, job cuts and dropping incomes. But the truth is the culture of excessive reward has been with us for a long time; it might just be that we have collectively been prepared to turn a blind eye when we thought the times were good or that these institutions were creating wealth that we could all share in.

The heart of the problems behind the current recession is in the US. Two of the biggest lenders to questionable borrowers were Fannie Mae and Freddie Mac. In August last year, when the chief executives of these two outfits could no longer continue in their roles because of the damage they had done, they walked away from their jobs with nearly $10 million in retirement and pension benefits. No doubt, thanks for a job well done.

You may remember Lehman Brothers. It was the one bank the US Federal government allowed to collapse, possibly as some sort of signal that the Government wasn’t really there to help, but it was a signal that was never repeated again. Its chief executive, Richard Fuld, was paid $US22 million for his fine work during 2007. By September 2008 he was out of a job and explaining to the congressional committee enquiring into the financial mess how hard life had become for him being out of work.

And then there is Merrill Lynch. And I am thankful to John Tizard for this information. The US government did not want Merrill Lynch to collapse and arranged for the Bank of America, which by that time it had already propped up, to purchase it. It purchased Merrill Lynch for $US50 billion. Its then chief executive, John Thain, left with a $US200 million payout. He had been there less than a year.

What beggar’s belief is what Merrill Lynch then did as political and public pressure was mounting on these banks to abandon their excessive rewards and bonus schemes.

Merrill Lynch decided that it would award performance bonuses to its staff for the year ending 2008 before the year actually ended. Bear in mind that Merrill Lynch in the last quarter of 2008 alone lost more than $US15 billion and for the year as a whole more than $US27 billion. The Federal government had put in $US20 billion to enable Bank of America to purchase Merrill Lynch and underwrote $US188 billion of the Merrill Lynch portfolio. As a mark of gratitude for this spectacular performance, the heads of Merrill Lynch awarded bonuses throughout the organisation of $US3.6 billion.

The top four bonus recipients received $US121 million between them. 14 individuals received bonuses of $US10 million or more. 149 individuals received bonuses of $US3 million or more and this 149 received total bonus payments of $US858 million. Nearly 700 individuals received bonuses of at least $US1 million.

At Goldman Sachs, another gild-edged US merchant bank, the chief executive, Lloyd Blankfein, took home nearly $US54 million. And this was after the bank received $US10 billion in public money to prop it up.

Wells Fargo of San Francisco took a slightly more constructive approach. Having taken $US25 billion in taxpayer support, it gave its top executives $US20,000 each to pay personal financial planners.

The UK fares little better. Sir Fred Goodwin, the former Royal Bank of Scotland chief executive, refused to give up his £693,000 per year pension payable after he turned 50. He had resisted calls to resign until he turned 50 so he could be assured of the benefit of his generous pension, part of a £16 million package. The bank reported a £24 billion loss for 2008 and only last month took a further injection of up to £25.5 billion of government funding. The British taxpayer now owns 90% of the bank.

Johnny Cameron, who ran the bank’s loss-making investment banking division, last year had his pension topped up to £1.5 billion.

The Mayfair office of AIG, the American insurance company, played by rules of its own. It recently reported a $SU61 billion loss. Its British operations were known as “the Casino in London”.

In New Zealand and Australia we haven’t seen anything anywhere near these sorts of figures. Although, I should note what has happened to the Australian company Pacific Brands recently. Its chief executive, Sue Morphet, has been in the role for a short period. Her salary went from about $AU 700,000 to $AU1.86 million in a year. Her predecessor received $AU5.8 million last year, including a $AU3.4 million retirement payment.
Last week, Pacific Brands announced they were cutting 1800 jobs in Australia and New Zealand.

In a 2008 report in the NZ Herald (22 March 2008) on 2007 salaries in NZ’s top corporates, it was noted that David Houldsworth, chief executive of Hellaby Holdings, received a total payment for the year of $1.59 million, including a severance payment of $425, 250 in a year in which the company lost $9.8 million.

Theresa Gattung, former chief executive of Telecom NZ, received $5.4 million in 2007, including a termination payment of $1.8 million. The value of Telecom shares has been declining steadily over the past few years. Even though that business has faced local unbundling, the reality is that the business has remained intact as a single legal entity and the only threats to it are its usual business competitors.

A 2008 NZ Herald report noted that in 2007 the average increase in base salaries for the top 50 chief executives was 14% (this excluded termination payments). The labour cost index for the same period was around 3.6%.

A study by Sheffield shows that in New Zealand the proportion of CEO remuneration that is dependent on performance averages about 16% of a CEO’s total earnings. The world average is 39% and the US average is close to 60%.

In Australia, of the top 100 companies by market cap, the average CEO remuneration is $AU4 million. One that stands out is the Macquarie chief executive salary which in 2007 was $AU33 million.

Going back to the US, in 2007 the CEOs of the Standard & Poors 500 companies received an average remuneration package of $US14.2 million (the median was $US8.8 million).

In 1985 the ratio of the average CEO salary to the average worker’s income in the US was 40 to 1. In 2005 this ratio blew out to 450 to 1.

In NZ, the ratio may not have been that great but there is no question that there has been a growing inequality in incomes between senior executives and other wage and salary earners.

So what can be done to reign in the excesses and extremes of senior executive remuneration packages?

Let’s begin by understanding the origins of the idea of a limited liability company. The whole idea of the limited liability company entails a social contact.

Limited liability companies are a creation of statute, of the state, to protect investors who in good faith and with confidence take a risk and entrust funds to others to produce goods and services.

It can be credibly argued that capital aggregation is in public interest because it enables economic activity, usually at scale, that would not otherwise happen. To reflect the fact that these investors no longer control exactly what happens with the funds they entrust the state to protect them. It limits their liability to the extent of their investment. In this way, it is recognised wider society has a stake in effectively functioning companies and corporations.

This is not, and should not be, a licence for company managers and directors to do as they please. One aspect of an effectively functioning company is the extent to which it contributes to, or at least does not detract from, social cohesion.

If in order to avoid excessive and extreme rewards which incentives excessive and extreme – and ultimately destructive - risk-taking, if it is necessary for the state as the representative of the public interest to intervene, it should do so.

Possibly one reason why salaries are set the way they are by boards is because of the small catchment of directors who carry out this task. It is a self-perpetuating club. This is not just a feature of small countries like New Zealand. Cross-directorships are common in the US, and having chief executives of other companies acting as directors is a practice common to most developed countries.

Suggestions to address the issue include:

Eliot Spitzer, notwithstanding his fall from grace, has made the following suggestions to push back on excessive remuneration packages:

- Give the SEC (or our Commerce Commission) the power to investigate remuneration packages that are out of proportion to value created. The trigger for this might be sudden adverse financial performance of a company of a certain cap, or the placement of the company into receivership;
- The investigating authority could look at the financial incentives, sources of advice and information used to set packages
- Regulations or guidelines should ensure genuinely independent processes are in place for remuneration setting
o Any consultant who advises the board or company does no other business with the company
o An independent shareholder representative is involved in setting the package
o No other CEO is involved in order to avoid cultural capture and ratcheting
o No person who is involved in remuneration package setting to have any shared interests with the CEO, e.g. not be in the same golf club, not be an associate or friend, etc
o Any package to be approved by the shareholders.

Ben Heinemen talked in the Harvard Business Review of June 2008 of linking performance pay to the integrity of conduct. This would include:

o Evaluating how crises are handled – was information concealed or was an open approach adopted?
o Evaluating whether the CEO or senior manager has displayed ethical conduct in the discharge of his or her duties
o Evaluating the extent to which employee voice was respected in relation to ethical matters.

What about a more obvious solution? Involve a worker representative or two on the company’s Remuneration Committee. This perspective is as important as any, and if the effect is a constraining one then so what? The workforce ought to have confidence that decisions like those over senior remuneration can be explained and justified.

Finally, boards could be encouraged to set limits, for example limiting the ratio of CEO remuneration package to the average remuneration of others who work in the business. And then there is the matter of ensuring incentives are related to the long-term creation of value. Discussion in the US is now centering on stock and share options being managed in such a way that CEOs are not allowed to dispose of stocks and shares for at least 10 years after they have left the post.

The culture of excessive reward at the senior level of companies does not necessarily deliver better value for the stakeholders in a business. Reward schemes need to do the job of rewarding good performance, including in the long term, and ethical performance. We need a public discussion on this issue if we are to avoid the excesses evident over the last 25 years or more. Let this be a beginning to that discussion here.

ENDS

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