RI Interview: David Paterson talks about the future of executive pay and board evaluation

Part one of a two-part interview with the respected NAPF corporate governance head who retires this month.

When David Paterson, Head of Corporate Governance at the UK’s powerful National Association of Pension Funds (NAPF), leaves his post today (October 18), he takes with him 30 years of level-headed corporate governance experience that will be missed. This time around it’s real retirement. Paterson laughs that he joined the NAPF in 2006 to lead its corporate governance policy development and high-level engagement with companies on a part-time basis: “I actually retired seven years ago from JP Morgan Asset Management (where he led corporate governance), with the aim of ‘doing a bit of governance’ part time; since then I’ve worked harder than I’ve done for years!” Paterson held the post during the so-called Shareholder Spring of institutional investor action in 2012, when governance clashes were front page headlines. The NAPF covers over 1,300 pension schemes with combined assets of £900bn (€1.1trn), and it become an active player, warning company management its members would vote against pay policies that failed to demonstrate a strong link between rewards and performance. However, Paterson remarks drily that some pay issues are remarkably similar to when he got involved in corporate governance at JP Morgan back in the late 1990s: “Back then one of the biggest governance and remuneration issues we were dealing with was a company called WPP headed by a younger Martin Sorrell…” In 2012 – at the height of the Shareholder Spring – a 59.5% majority of WPP shareholders voted against the company’s executive pay report, including £11.9m for Sorrell. This year, 26% of investors again voted against Sorrell’s £17.6m pay package, albeit after extensive negotiations in the interim to restructure Sorrell’s remuneration to more stringent long-term targets. Paterson says the politicisation/socialisation of pay issues in recent years has had beneficial effects that also require vigilance against unintended consequences: “Politicians were warning companies five or more years ago about ballooning pay at senior levels. The truth isnobody paid much attention; times were good, markets rising, investors happy, and arguments around internationalisation and mobility of executives were quite powerful. Now, if you look at the figures in detail, there has been a marked slow down in the growth of base salaries for executives. Typically they are growing at the rate of the rest of the workforce, and that’s long overdue.” He says senior executive pay is much more transparent, but that the 50-60% of pay that is performance based should clearly go up and down: “It’s going up at the moment because of lower growth expectations two to three years ago, but the real question is whether it went down enough before when company performance was poorer. Being performance based it should be properly variable.” Otherwise, he says, the risk is that middle management and staff become disenchanted at the disconnect between executive pay and success: “We’ve tried to make the point more strongly to companies that they should be able to demonstrate this long-term value link to shareholders because it’s good for the business.” However, Paterson believes linking executive pay to a staff average, as has been suggested, is not required and may even be dangerous for corporate prospects: “What we’d rather see is a fair distribution of profits and a sense that all company staff are in it together.” He says shareholders are broadly still more short-term in their governance views than he would like, but that he is seeing greater alignment around long-term business performance metrics: “Companies have a job to do in explaining how they set their bonus policy and how they judge the outcomes. Business targets are often confidential, and we accept that might be necessary. However, shareholders should challenge whether boards are being robust in setting those targets. They can look at the share price, growth in revenue and profits, the dividend policy and previous expectations for the health of the company. There are quite a lot of tools they can apply if they choose to do so to see that executives have earned their
bonuses. If they are then not happy then there are a number of weapons at their disposal – and more coming – that they can then decide to use.” The UK government’s regulatory intervention on pay via the Enterprise and Regulatory Reform Act 2013 (which amends various aspects of the UK Companies Act) passed into law at the beginning of October. It introduced a number of changes to the disclosure of directors’ remuneration. Listed companies must have a directors’ remuneration policy put to a binding shareholder vote (50%+) at least every three years, including payments for loss of office. The directors’ remuneration report must also include a separate, forward-looking policy section. Says Paterson: “These are some very helpful changes that we will see coming into play next year. At the moment companies are grappling with the binding vote on pay. On paper this looks like a good idea forcing companies to articulate their pay policies clearly and give shareholders a significant say in how that policy is structured. The problem is that it is quite a nuclear option: voting down a binding policy effectively means there is no policy. It’s complicated, but it will get easier as the years go on.”
Paterson believes shareholders will be reluctant to use the binding vote stick in the 2014 voting season because it is so draconian: “I’m not convinced that the government actually wants us to use it either in normal circumstances. I think they would like to see negotiation in advance so that it doesn’t become a problem. I’m expecting a lot of companies to speak to their key investors in the next couple of months to say they’ve worked through the policy. I don’t expect many to have changed key elements, but I do expect them to explain better what they are doing as well as the policies around executive exit and signing on payments, which are complicated and have never been explained properly before. Whether this will deliver what the government wants we just don’t know at this point.”Paterson believes there has been a sea change in the way investor and companies interact: “What you have now is a recognition from both sides that governance is an important side of how companies are run: good governance is part of good management. A good board shouldn’t just be saying it can tick the governance box. It should be saying: ‘What does this mean to us?’” The UK’s Corporate Governance Code, which operates on a comply-or-explain basis, he says, has been restructured in recent years to put more emphasis on factors such as board evaluation and effectiveness. Paterson says: “I think these are terribly important issues, but they don’t lend themselves to box ticking. The stuff that grabs newspaper headlines is voting down pay policies or kicking out a CEO, but the truth is that doesn’t happen very often. The key governance thing is looking at how boards are seeking to deliver value over time for their shareholders.” To that end, he says there are two regulatory changes of recent years that are bearing interesting fruit. The first is the reduction in senior executive contracts to a one year notice period: “It was quite usual before for CEOs to be on two to three year notice contracts, and they had to be paid out in the event of a problem. Now, they are much more accountable to shareholders over a shorter time period.” The second, he says, is the concept of ‘board evaluation’. “I first came across this idea about 10 years ago and it has been in the Code as best practice for three to four years now. It’s a test of whether a board is being run well and the directors are supporting where they ought to. I expect it to become “just what boards do”. Sustaining business success is a really difficult challenge for management and shareholders. But these are governance changes that help do just that.”