Regulating Executive Remuneration in the Post-Financial Crisis Era: A Common Law Perspective

1. Regulating Executive Remuneration in the Post-Financial Crisis Era: A Common Law Perspective 6 May 2010 Jennifer Hill Professor of Corporate Law, Sydney Law School; Visiting Professor, Vanderbilt Law School

2. Background Developments in Executive Remuneration from the 1990s • 1990s paradigm shift re executive remuneration – from corporate governance problem to solution (Jensen & Murphy 1990; Frydman & Saks 2008). • Two major shocks to financial markets since that time:- (i) Enron (2001) (ii) Global financial crisis (2007-2009) • Puzzling differences in international regulatory responses to these financial shocks (Coffee 2004; Hill 2005) • Executive pay scholarship – shift in focus from determinants of pay to regulatory policies (Dew-Becker 2009)

3. Post-Enron Regulatory Responses to Executive Remuneration US s 304 Sarbanes-Oxley 2002 (clawback provision) (SEC v Jenkins (2009) s 402 Sarbanes-Oxley 2002 (prohibition on loans) 2006 – tighter SEC disclosure rules Absence of shareholder participatory rights (Chandler & Strine 2003) UK s 439 Companies Act 2006 (UK) (Directors’ Remuneration Report Regulations 2002) Australia s 250R(2) of the Corporations Act 2001 (Cth) - nonbinding shareholder advisory vote s 300A CLERP 9 Act 2004 (enhanced disclosure) Principle 9, ASX Corporate Governance Council, Principles of Good Corporate Governance and Best Practice Recommendations (2003); Principle 8 (2nd ed, 2007)

4. Are corporate excesses are “a foreign phenomenon”? US vs Australia Convergence versus culture and norms re compensation (Conyon & Murphy 2000; Ferrarini & Moloney 2005; Piketty & Saez 2003; Frydman & Saks 2008) US - 1993 - 2003 - average CEO compensation at S&P 500 firms rose 146% from US $3.7m to US $9.m (45% growth compared to 2.7% for average worker). Cf Gordon 2009a - end of rising inequality? Australia - 2007 - average CEO compensation in top 100 listed Australian companies was A$5.53m (up from A$4.56m in 2006 and A$3.77m in 2005) (2001-2007 – median total CEO remuneration increased by around 96% in total compared to 32% for average worker). NB stock options far less important in Australia than US. Also, large gap between top 20 companies and ASX 300. Why has CEO pay accelerated in Australia? (i) “mobile worldwide executive talent pool” (ii) increases in firm size (Gabaix & Landier 2008; Frydman & Saks 2008)

5. Did Executive Pay Cause or Contribute to the Global Financial Crisis? Bebchuk & Spamann 2010; cf Core & Guay 2010 and Fahlenbrach & Stultz 2009. “Extreme capitalism”, characterised by “[o]bscene failures in corporate governance which rewarded greed without any regard to the integrity of the financial system” (Kevin Rudd, 2008). “The financial crisis had many significant causes, but executive compensation practices were a contributing factor. Incentives for short-term gains overwhelmed the checks and balances meant to mitigate against the risk of excessive leverage”. (Timothy Geithner 2009) See also FSB Principles for Sound Compensation Practices (2009). Cf Turner Review (2009) – remuneration less important theme than eg inadequate regulation of capital, accounting and liquidity.

6. Globally Coordinate Regulation for Large Financial Institutions • November 2008 – G-20 stresses need for greater global coordination in monitoring of systemic risk. • 2009 – Release of Financial Stability Board (FSB) Principles: “Action in all major financial centers must be speedy, determined and coherent. Urgency is particularly important to prevent a return to the compensation practices that contributed to the crisis”. • Example of “regulation beyond the state” (Black 2010).

7. Australian Regulatory Responses to Executive Pay and “Extreme Capitalism” Responses are broad-ranging and amorphous, in spite of far less serious impact of gfc on Australia eg:- There have been a litany of government reports and initiatives, eg:- APRA Guidelines 2009 – Industry specific regulation. Issues of enforcement and convergence/divergence. Productivity Commission Final Report, Executive Remuneration in Australia (December 2009) – 17 Recommendations. Issue of “say on pay” (Gordon 2009b; cf Sheehan 2007; Ferri and Maber 2009). “Two strikes” recommendation re “say on pay”. Australian Government supports PC’s recommendations with further strengthening (April 2010). Professional body guidelines eg AICD Guidelines on Executive Pay (February 2009) – strong preference for self-regulation. Statutory reform on termination pay (Corporations Amendment (Improving Accountability on Termination Payments) Act 2009).

8. Some US Regulatory Responses to Executive Pay October 2008 – Emergency Economic Stabilization Act of 2008 (EESA) rules. February 2009 - Treasury Guidelines (eg for “exceptional assistance” companies, pay cap of US$500,000 total annual compensation; non-binding “say on pay” shareholder vote; expanded clawback and golden parachute restrictions; certification re excessive risk taking). February 2009 - American Recovery and Reinvestment Act of 2009 – (limits bonus payments; “say on pay” for TARP recipients). June 2009 - Kenneth Feinberg appointed “Special Master” or “Pay Czar” (described as a “hard to believe turn” for the US “market” economy). 19 May 2009 - Senator Schumer’s proposed Shareholder Bill of Rights and shareholder power (Bratton & Wachter 2010). 20 May 2009 – SEC commissioner 3-2 approve increased shareholder participation in director nomination process. November 2009 - Christopher Dodd-sponsored Bill, Restoring American Financial Stability Act of 2009 (NB 2010 version of Act has been somewhat diluted). Controversy re federalization of US corporate law (Paredes, 2009; Veasey, 2009).

9. Some Key UK Regulatory Responses to Executive Pay FSA, Turner Review: A Regulatory Response to the Global Banking Crisis (March 2009); FSA, Code on Remuneration Practices (August 2009) Walker Review: A Review of Corporate Governance in UK Banks and Other Financial Industry Entities: Final Recommendations (November 2009) - Strengthening board of directors - Increased institutional investor activism and Stewardship Code - Governance of risk - Recommended banded disclosure - Extending role of remuneration committee Financial Services Act 2010 (April 2010):- - Financial stability as a regulatory goal - Executives’ remuneration report (ss 4-5) - FSA has the ability to void non-compliant remuneration contracts (s 6). Temporary bank payroll tax of 50% on discretionary bonuses above £25,000 (December 2009 ). New tax rules for 2010-2011 (from 40% to 50% for top rate).

10. Central Themes in the Regulatory Responses and Proposals Risk-based approach to executive pay and excessive leverage, particularly in banking context (recognition of the need to avoid perverse incentives and moral hazard in executive contracts) (Bebchuk, 2009). Long-term focus and sustainability is in (short-termism is out) (eg Feinberg rulings; Bebchuk & Fried 2009; Bhagat & Romano 2009) Re-evaluation of alignment of interests in executive pay. Re-evaluation of measures of performance, in determining pay for performance. Income inequality (Walker Committee).

11. Some Regulatory Techniques for the Control of Executive Pay Pay cap Pay oversight person or body with ability to disapprove contracts eg US “Pay Czar”; FSA role under Financial Services Bill (UK); Asset Protection Agency (UK). Stricter capital, liquidity and leverage requirements. Clawback provisions (eg s 304 Sarbanes-Oxley; current Australian government proposal). Shareholder voice – say on pay (further strengthening eg by “two strikes rule”). Structural reforms for board and pay-setting procedure to control conflicts of interest (Walker Review; AICD proposals). Structural and design reforms to executive contracts to enhance accountability and sustainability (Bebchuk & Fried 2009; Bhagat & Romano 2009) Increased disclosure (eg Walker Review proposal for banded disclosure) Tax (eg temporary UK bank payroll tax) (December 2009); Henry Review, Australia (May 2010). Stricter controls for remuneration consultants

12. Commercial Pushback re Executive Remuneration Regulation as a dynamic and relational process (Milhaupt & Pistor 2008). Recent examples of commercial push-back re executive pay in the US:- Escape from the US federal funding net Renewed upward pressure on executive pay eg Goldman Sachs (Bebchuk & Cohen, 2009; Joseph Ackerman) Long-term cultural shift re executive pay?

13. References • Bebchuk, “Regulate Financial Pay to Reduce Risk-taking”, Financial Times, 4 August 2009, 7 • Bebchuk and Cohen, “Back to the Good Times on Wall Street”, Wall Street Journal, 31 July 2009 • Bebchuk and Fried, “Paying for Long-Term Performance” (Harvard Law and Econonomics Paper No 658, 1 December 2009). • Bebchuk and Spamann, “Regulating Bankers’ Pay” (2010) 98 Geo. L. J. 247 • Bhagat and Romano, “Reforming Executive Compensation: Focusing and Committing to the Long-Term” (Yale L & Econ Research Paper 374/2009 (available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1336978) • Black, “Empirical Legal Studies in Financial Markets: What Have We Learned?” (2010, Law Society Economics Working Papers 4/2010, London School of Economics, 28) • Bratton and Wachter, “The Case Against Shareholder Empowerment” (2010) 158 U Pa L Rev 653 • Chandler and Strine, “The New Federalism of the American Corporate Governance System: Preliminary Reflections of Two Residents of One Small State” (2003) 152 U. Pa. L. Rev.953 • Coffee, “What Caused Enron? A Capsule Social and Economic History of the 1990s” (2004) 89 Cornell L Rev 269

14. References (Continued) • Conyon and Murphy, “The Prince and the Pauper? CEO Pay in the United States and United Kingdom” (2000) 110 Econ. J. F640 • Core and Guay, Is There a Case for Regulating Executive Pay in the Financial Services Industry?, 12-13, Working Paper, Jan. 25, 2010 (available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1544104) • Dew-Becker, “How Much Sunlight Does it Take to Disinfect a Boardroom? A Short History of Executive Compensation Regulation” (2009) 55 CESifo Economic Studies 434 • Fahlenbrach and Stulz, Bank CEO Incentives and the Credit Crisis, Charles A Dice Center Working Paper No. 2009-13 (July 2009) (available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1439859) • Ferrarini and Moloney, “Executive Remuneration in the EU: The Context for Reform” (2005) 21 Oxf. Rev. Econ. Policy 304 • Ferri and Maber, “Say on Pay Votes and CEO Compensation: Evidence from the UK” (June 2009, available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1420394) • Frydman and Saks, “Executive Compensation: A New View from a Long-Term Perspective, 1936-2005” (June 2008, NBER Working Paper 14145) • Gabaix and Landier, “Why Has CEO Pay Increased So Much?” (2008) 123 Quarterly J of Econ 49

15. References (Continued) • Gordon 2009a, “Misperceptions about the Magnitude and Timing of Changes in American Income Inequality” (September 2009, NBER Working Paper 15351) • Gordon 2009b, “‘Say on Pay’: Cautionary Notes on the UK Experience and the Case for Shareholder Opt-In” (2009) 46 Harv J on Legis 323 • Hill, “Regulatory Responses to Global Corporate Scandals” (2005) 23 Wis. Int'l LJ 367 • Jensenand Murphy, “CEO Incentives – It’s Not How Much You Pay, But How” (1990) 68 Harv. Bus Rev 138 • Milhaupt and Pistor, Law & Capitalism: What Corporate Crises Reveal About Legal Systems and Economic Development Around the World (U Chi Press, 2008) • Paredes, “The Proper Limits of Shareholder Proxy Access”, The Harvard Law School Forum on Corporate Governance and Financial Regulation (June 2009) (available at http://blogs.law.harvard.edu/corpgov/2009/06/30/the-proper-limits-of-shareholder-proxy-access/) • Piketty and Saez, “Income Inequality in the United States, 1913-1998” (2003) 118 Quarterly J Econ 1 • Sheehan, “Is the Outrage Constraint an Effective Constraint on Executive Remuneration? Evidence from the UK and Preliminary Results from Australia” (March 2007, available at http://ssrn.com/abstract=974965) • Veasey, “What Would Madison Think? The Irony of the Twists and Turns of Federalism” (2009) 34 Del J Corp L 35