executive pay

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The Principle, the Agent and the Company

Over recent years executive pay has become an increasingly thorny issue. From the 1980’s onwards a growing body of thinking saw executive pay as being the vital spur to entrepreneurial growth but that levels of pay current at the time were not adequate to this. It was important to increase the level of incentive to senior managers and particularly CEO’s so they were appropriately incentivised.

In parallel with this there was a concern about how such incentives could be structured so as to align the interests of executive agents with those of the principal owners. How to align the owners long term interest in the growth of the company with the short term interests of the managers to inflate profits today.

The way around this principal/agent dilemma was to provide stock options. These were options to buy shares in the company at a point in the future at a discount to the current price. If the Executives increased the value of the company its share price would increase thus increasing the value of their share options when exercised.

The development of this theory is explored in Tom Bergin’s excellent new book Free Lunch Thinking. He charts the rise of the theory to the status of common sense and then explores problems raised by reviews of how executives actually perform when their pay is thus inflated.

His point is that the evidence about executive performance does not seem to confirm that it improves with greater pay. His first point is a generic one about the relationship between corporate performance generally and senior pay. He points out that between 1945 and 1970 corporate earnings in the US grew at the highest rate they have in the country’s history. This was a period when CEO’s were paid “like bureaucrats”, eg. in 1965 CEO’s were paid c20 times what the average worker was. By 2018 this ratio had increased to 278 times average earnings, however corporate earnings had declined.

Another problem was the link between successful management and share price. Theory would have it that the share price is the product of a multiple of the earnings of a company. However, the work of economist Robert Shiller who analysed share prices and earnings over a century discovered that the share price was far more volatile than the earnings multiple model would suggest.

For a number of other reasons Bergin finds the link between pay and performance to be tenuous at best. Generally his point is that the agent/principal problem is not sorted by increased pay channeled through share options because the link between performance and reward is not nearly so clear. If principal owners want their executive agents interests to be aligned with the success of their company ever higher pay levels and share options might not be the best way.

This picture seems to cohere with everyday experience that some people are highly motivated and some are not. The correlation of that to pay is not always obvious and any causal link is even more difficult to confirm both in terms of direction and strength.

A major assumption in this model is that the interest of principals and the companies they own are synonymous. The principal wants their company to be a success. This may have been the case in the 19th Century in private companies where all the shares were owned by an individual or family. But in an era of rapid trading the principal may have a fractionally small period of ownership and very little interest in the future success of the company.

An interesting example of this is provided by Shell’s annual accounts for the year 2019. Shell is a fossil Fuel company. In recent years the need to move away from fossil fuel use has become increasingly apparent and increasingly urgent. Given this you might think the company, with an eye to the future, would be devoting substantial resources to a move away from fossil fuels and towards alternative energy sources.

The accounts reveal however that in the year to 2019 the company invested $962m on Research and Development which might include work on renewable energy, but more than twice that amount, $2,354 billion was spent on Exploration which one might assume relates to the search for fossil fuels as we know where the sun and the wind are.

Despite the fact that it faces what many would see as an existential challenge the company feels it has got too much cash. In 2018 it launched a $25 billion share buyback programme and in the 2019 report its CEO was pleased to announce that $14.75 billion of that programme had been achieved by February 2020.

Given the longevity of Shell, which started out in the 19 century importing antiques and sea shells from the Far East, and its scale, its revenues were just under $345 billon in 2019, there are doubtless many long term investors in the company like pension funds. Will they, however, have the same level of commitment to the future of the company as its founder Marcus Samuel, or will they simply shift their investments elsewhere? And for the more frequent traders will there be any interest at all in the long term future of the business over its short term cash flow and share concentration?

Aligning the interests of the agent with the principal has been a long term concern of companies with professional management. What might have been missed is the problem of aligning the interests of both the principal and the agent with the long term interests of the company.

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The Joint Stock Company

If you want to understand more about how India became part of the British Empire you should read William Dalrymple’s “The Anarchy”.  The book is a panoramic survey of the diplomatic intrigues, rampant duplicity and naked aggression used to divide and conquer the Mughal Emperor’s power and that of the various Mughal principalities.

My reason for reading this book was a desire to know more about the East India Company (EIC) and particularly whether, as one of the first joint stock companies, it provided lessons for current corporate governance issues. What shocked me was the extent to which the creation of the British Empire in India was in fact the work of the EIC.  “The Anarchy” charts the actions of the EIC from its creation in 1599 to its effective nationalisation in  1859. In its two and a half centuries the company went from an organisation negotiating commercial privileges with Mughal princes to a colonial power with its own navy and a security force (army) of 200,000 troops, more than the British army of the time.

I had mistakenly assumed the British State had opened up India to trade, supporting  and defending private sector organisations like the EIC. Clive of India I took to be a member of the British army who paved the way for British commerce. Someone who was Knighted for his service to the Crown. Just shows how wrong you can be.  In fact Clive was always an employee of the EIC and was rewarded for his services with an enormous fortune looted (a term originating in India, which I use advisedly, meaning “theft”) from the Indian nations making him one of the richest men in Europe.

Whilst I never bought into the imperial story of Britain bringing civilisation to the Indian sub-continent I had never appreciated how thoroughly the rampant exploitation of the vast area was done by the private enterprise of the EIC. A company which many members of the British parliament had substantial shareholdings in. Explaining, perhaps, a certain reticence when it came to considering stories of brutality as highly profitable commercial transactions were transformed into outright theft. Illustrative of the rapine behaviour is the fact that Powis Castle, the home of Clive’s son, contains the Clive Museum which has the largest collection in one place of Mughal artefacts from India. Larger even than that in the National Museum in Dehli.

There is no doubt the battle for supremacy in India was a physically demanding and dangerous business. Dalrymple’s book provides an even handed description of acts of bravery and cowardice, loyalty and treachery, honour and deceit on both sides of the battle. The European battle tactics, genuine bravery, modern cannons and pure luck all played a part in the ultimate success of the EIC. But victory transformed highly profitable trade to outright pillage. This in turn led to the degradation of the existing state and at times major famine. Unbound avarice with little thought for the future eventually undermined the viability of the EIC. As profits declined moral outrage grew oddly enough.

Putting aside belated outrage what lessons are there from the history of the EIC for today. Clearly one is about effective regulatory oversight. If you rely on the moral character of shareholders to curtail the drift from entrepreneurial energy through commercial sharp practice to sharp knifed theft then you need to hope that the returns remain modest. NINJA loans in the US, in the first years of the 21st Century were little short of outright theft. When billions of pounds are at stake peoples morals flex and bend and, in the absence of independent challenge, break.

Another lesson is the danger of scale posed by private companies. As the exploitation of India grew more and more aggressive, in every sense, the returns of the EIC grew in lock-step providing the resources in dividends and outright bribes to suppress the demands for closer parliamentary oversight. By the late 18th Century the EIC generated almost half of Britains trade, it had become “too big to fail”.

It was at this point that the risks of unregulated exploitation started to crystallise. In 1772 large debts, increasing military expenditures and declining revenues from over-exploited regions meant the company was running out of cash. A dividend maintained at 12.5% probably did not help matters. In July of that year the Directors applied to the Bank of England for a loan of £400k, a fortnight later they needed another £300k by August they needed another £1m. In total, close to £200m in todays money. Inevitably these unprecedented requests for cash raised questions as to how a company generating so much wealth for its employees could go bust or as Mr Dalrymple puts it, “…the contrast between the bankruptcy of the Company and the vast riches of its employees was too stark not to be investigated.” Similar to the Parliamentary questions concerning the remuneration of Carllion Directors after they went bust building the Royal Liverpool Hospital, for example.

The Government did investigate and indeed Clive was brought to the House to defend himself which he did with vigour. And the man who “earned” something in excess of £234k (£260m in todays money) in 16 years in India, apparently without laughing, said he was, “… astonished by my own moderation.” In the end Parliament found in favour of Clive, clearing his name by a vote of 155 to 95.

This is a really well written book which compels attention and provides real insights into the values and attitudes of the time, good and bad. It is a powerful testimony to the power of the financial innovation which is the joint stock company, and what it could achieve. It speaks to the importance of effective corporate governance but also for effective external regulation. It confirms that whilst shareholder value is a necessary component of corporate purpose, on its own it is far from sufficient.

The parallels with many of the current debates around large corporations are clear. Those who do not learn from history are condemned to repeat it. This book provides lessons our politicians would do well to learn. I wish I was optimistic they would.