Are remuneration and other governance “best practices” just fads? A checklist for boards
11/10/2016
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There have been many great advances in corporate governance.

Now we have “best practice”.

This article provides a checklist to determine if a “best practice” or any other practice, is effective or just a fad.

Governance changes have come in waves, generally after economic recessions. A few examples – the 1637 “tulip” bubble that burst in the Netherlands brought about new laws on futures contracts, the first global great depression in 1897 saw major advances in UK legal precedents for establishing the rights of dispersed shareholders resulting from mergers and consolidations, the second global Great Depression saw the US Securities Act of 1933 and the subsequent creation of the Securities and Exchange Commission (SEC) to enforce it, the bursting of the tech bubble saw the US Sarbanes Oxley Act, while the most recent Global Financial Crisis (GFC) has seen unprecedented global coordination on bank governance, and various other initiatives across most developed countries.

The majority of these responses have resulted in sensible, workable improvements that, over time, have contributed to less extreme volatility in our capital markets. And, after several hundred years of governance initiatives, it has only been in recent decades has there been a resort to the concept of “best practice”.

The first step on the road to adoption of governance “best practice” can be attributed to the 1992 UK Cadbury Report. The report was a response to major corporate scandals associated with governance failures and resulted in the UK Corporate Governance Code.

The initial Cadbury recommendations did no more than reflect the practices of companies considered to have the best governance at the time. Hence we have the term “best practice”.

The Cadbury Report did not provide scholarly research to validate the efficacy of these practices across companies. Indeed, it was emphasised by Cadbury that there was no such thing as “one size fits all” (see HERE).

In 1994, the Code’s principles were appended to the London Stock Exchange’s Listing Rules, and it was stipulated that companies need not comply with the principles, but had to explain to the stock market why they did not comply. Since then, the UK has added to the Code, and other regulations, with the Greenbury report on remuneration, the follow-up Hampel report, the Turnbull Committee, the Higgs Review, the Myners reviews (2, no less), and the Walker Review.

The London Stock Exchange automatically picked up all changes to the Code.

Then came “say on pay” (SOP) in the UK (2002), Australia (2005) and the USA (2010), among other countries. With SOP came the UK Investment Association’s guidelines based on, no less, “best practice”. Similar guidelines were picked up by proxy advisers, and spread in their various forms around the world.

The UK Code has only recently been amended for companies to design remuneration plans that are best suited to their own business strategies, philosophies and cultures. However, somewhere along the way, people who developed governance guidelines failed to heed Cadbury’s initial advice that “best practice” was not a “one size fits all”.

The absurdity of these “best practice” guidelines becomes apparent once you realise they reflect local market practices. This was verified recently with comments by ISS that the UK Investment Association Working Group’s alternatives to “simplify” executive remuneration would not be acceptable purely because they do not reflect common practice (see HERE).

So this means an Australian-listed company with LTI vesting from the 25th percentile relative TSR performance gets an automatic “no” SOP vote, while a US-listed company does not. Global proxy advisers and their institutional investor clients have not explained why a governance practice can be acceptable in one geography and not in another with similar capital markets..

It is also apparent that “best practice” changes with the times as well as geography. In 2005, ASX-listed companies did not receive proxy adviser support for an LTI grant that was not contingent on relative TSR. By 2010, it was acceptable for part of an LTI grant not to be contingent on relative TSR performance, providing it was for EPS growth.

Now, in 2016, it is acceptable not to have any LTI contingent on relative TSR, and capital efficiency measures as well as EPS growth are considered acceptable.

One would think there would be evidence that a specific practice has a materially negative (or positive) effect on a statistically significant proportion of listed stocks’ longer term returns for an SOP or other governance voting guideline. If you are sceptical that such evidence exists, you may be mistaken.

There is actually a plethora of behavioural economics and social psychological research that can be drawn upon to determine effective executive remuneration and other governance practices. There is more than enough, for example, to provide a concrete, indisputable, evidence-based answer for what is the most effective relative TSR vesting scale.

However, the actual presence of established research does not mean it forms the basis of a guideline – au contraire.

The Principals of Guerdon Associates have never seen any external stakeholder’s remuneration and governance guidelines specifically founded and developed on the basis of valid economic or other behavioural sciences research.

This is not to say there has been no improvement in governance guidelines.

There is certainly change, as we have observed above. Most of the change is a slow evolution of practices and guidelines as stakeholders realise that mandated “best practice” is not well suited to many companies, or has unintended consequences.

Readers of Darwin’s “The Origin of Species” will know the problem with evolution is that it takes millions of random mutations for nature to determine by natural selection what works best. While not trespassing into theology, it could be argued that intelligent design should at least be applied to the various mutations of remuneration and board governance practice. Unfortunately, looking at both practices and stakeholder prescriptions, it often seems that the hand of intelligent design is absent. Further, there are fewer variations in design that are desirable to test what works best in given environments. This is ascribed to the affliction of “best practice”.

It appears that “best practice” is more akin to a fad or fashion. “Best practice” is not, ahem, a practice that has proven to result in better long-term value creation for shareholders. This is not to say that, coincidently, a “best practice” is also not an effective practice. But that is the point! It could be just a coincidence. A company board should not take it as a given.

The challenge for boards is to determine whether the latest “best practice” is a passing fad or an enduring, effective practice, before jumping on the bandwagon to follow what others are doing (BTW, we do know this mixed metaphor does not logically work – but we like it).

To assist in this task, three researchers developed eight criteria for deciding if a practice is a fad “best practice” or an effective practice that works (see HERE for original research).

Here is a board checklist to test if external governance guidelines could be a “fad”. The research indicates they are likely to be a fad if they:

1. Are easy to understand, communicate and are usually described with labels, acronyms, buzzwords and lists.

2. Are typically overly-prescriptive. They provide specific actions to improve companies and leave management little leeway to decide how to solve problems.

3. Promise results that rarely occur. They are better at raising hopes than delivering results and provide no criteria for success.

4. Claim universal relevance. Practices are said to apply to almost any industry, organisation and culture.

5. Must be simple and easy to apply. Fads can be added to existing procedures and localised to departments. Outside of these pockets, it is business as usual and the organisational status quo remains unchallenged.

6. Respond well to the pressing needs of the day and have triggers to create a need.

7. They simply repackage or extend existing ideas. They get attention based on their novelty, but their freshness is often superficial because they do not challenge basic management values.

8. Gain credibility and stature through the status and prestige of their advocates and followers rather than through empirical evidence. New ideas are justified not by citing research, but by asserting they are true, based on the status of the person advocating them.

So what makes a remuneration practice or other governance practice effective?

Unlike most fads, effective governance often demands real organisational changes at significant cost, and has lasting effects. Effective governance emerges out of company responses to economic, social, and competitive challenges. It is often complex, multifaceted, and applied in different ways to different businesses.

Effective governance does not come with simple primers on how to make the changes, nor do they have simple rules everyone must follow or any guaranteed outcomes. To illustrate this, the current debates regarding the governance of organisation culture just skim the surface of what, to many company boards, are very real challenges.

Effective practices can, for example, have gurus—think of Peter Drucker’s work (but then again – he was a statistician, so his work is usually based on evidence).

However, if an external stakeholder’s governance approach shares several of the fad features described above, beware. If it looks too simple to work, it probably is.

So when boards evaluate a governance practice, directors should ask these questions:

1. Does it have any of the properties denoted as a fad? If so, beware.

2. Is it a knee-jerk reaction to external stakeholders’ votes or voting recommendations based on unsubstantiated governance guidelines? Ask for the evidence.

3. Does the approach have a foundation in research for performance and measurable outcomes? If not, again, beware.

4. Does the guideline address problems or opportunities that are high priorities for the company, other than just to tick an external stakeholder’s guidelines?

5. Are the changes it would require, within the company’s capabilities and resources?

Your answers to these questions may suggest an approach to governance likely to pay off and endure.

© Guerdon Associates 2020
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