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Executive pay – right or wrong?

Executive pay - right or wrong?
Executive pay - right or wrong?
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If only we knew. Alas, an answer is difficult to come by, as the recent executive pay controversy at the Royal Bank of Scotland (RBS) illustrates.

In January 2012, the CEO of RBS, Mr Stephen Hester, voluntarily renounced being paid 3.6 million shares of RBS, worth about one million pound at the time. Mr Hester’s sacrifice came on the heels of a ferocious public debate that centered, precisely, on the question of whether his pay was right or wrong.

Before answering, let’s take a little detour to the board of directors of RBS. It is the board of directors that decides how – and how much – to compensate the CEO. At most companies, the board of directors is responsible, amongst other things, for hiring, evaluating, and firing the CEO. All the while, the boards is required, by law, to act in the company’s best interests, at least in the United Kingdom, the United States, and Canada.

As I argue in an article in the Academy of Management Perspectives, acting in the best interests of the company is not straightforward for a director involved in setting CEO pay.

For starters, it assumes that the director has the will to act in the company’s best interests. However, directors frequently consider interests other than those of the company: the CEO’s.

CEOs can wield substantial power in the boardroom, because they frequently sit on the board as one of the directors. This is the case for Mr Hester: he sits on the board of RBS as an executive director. As such, he is contact with other directors, including the four directors who belong to the Group Nomination Committee, which is responsible for selecting new directors. Through his social connections with directors on the Group Nomination Committee, Mr Hester is able to influence the selection of new directors. He can make his preferences about director candidates known. Research shows that CEOs who sit on boards frequently intervene, even if only behind the scenes, in director selection. As a result, particularly docile directors, who lack the will to challenge the CEO, are appointed to the board. Such directors typically raise few, if any, questions about the CEO’s pay package.

Moreover, it assumes that the director has the information necessary to act in the company’s best interests. Do directors really know a company’s best interests?

What, actually, are those interests? A company is not a black box; it represents different stakeholders, each with distinct interests. There are the owners of the company, which, at RBS, are mostly taxpayers, since the U.K. government owns 84% of RBS. There are also employees and creditors, to mention but a few other stakeholders. To set executive pay that advances the interests of RBS, the board of RBS then has to be familiar with the interests of a quite diverse group of stakeholders: the government (and, further down the road, taxpayers), employees, creditors, etc. It needs to know what the U.K. government wants, what employees want, what creditors want.

Next, the board has to design a pay package that advances these various interests. Designing pay packages can be a Herculean task, considering the many different forms of executive pay (i.e., cash, shares, options, pensions, physical goods such as a company car). Do directors sufficiently know the complexities of executive pay to set this pay in a fashion that promotes the various stakeholders’ interests? Further complicating matters is the fact that directors can have trouble communicating in the boardroom. For example, directors can, unbeknownst to themselves, engage in groupthink and fail to challenge one another. Groupthink can prevent information relevant for setting executive pay from being considered.

So, did the board of RBS do right thing in giving Mr Hester shares worth one million pound? The answer depends on whether RBS directors had the right incentives and the right information when they took that decision. Two important considerations for RBS stakeholders to mull over.

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