Three Approaches to Regulating Corporate Governance: State Regulation Through Law; Market Regulation Through Mandatory Transparency and State Intervention as an Active Shareholder--The Example of Capping Executive Pay

(Pix (c) Larry Catá Backer 2013)

States and the international community have been moving toward one of three distinct approaches to regulating corporate governance.  The first and most traditional involves direct regulation through  the domestic legal order of states.  It is the most effective, but only to the extent that the regulated community is trapped within the territory of the regulating state. The second involves control of corporate governance indirectly through state control of markets for information.  The idea here is that investor tastes will determine the viability of corporate behavior and states may signal approval or disapproval through mechanics of disclosure. The last escapes the public regulatory sphere in favor of markets.  Here the state becomes a private investor in enterprises in which they assert the ordinary rights of influential investors to change corporate behavior like an ordinary owner. This approach privatizes regulation or inserts the state into the private sphere in new and innovative ways. 

The resulting fracture in approaches suggests the complications of regulation in the 21st century and suggests the ways in which multiple layers of overlapping regulation, each with distinct boundaries, may be shaping a polycentric governance universe in this century. More importantly, this fracturing of approaches is having real time effects in contemporary controversies over the regulation of corporate conduct with respect to specific issues. One of the hottest issues of corporate governance in recent years has been that of the growing gap between the pay of the highest and lowest paid employees of enterprises.   

This post considers how the emerging "schools" of corporate governance management, direct control through state law, indirect control through mandatory transparency regimes, and private control through active shareholding may affect the current debates over the regulatory intervention of the state in the market for corporate talent, and specifically in the context of the current debate about controlling executive pay.

The issue of executive compensation has been quite controversial virtually everywhere. On one side of the debate stands forces that argue that enterprises, and their shareholder/stakeholders no longer exercise sufficient monitoring and accountability for the excesses of corporate control that produces what appears to be an abuse of the corporate enterprise in which the highest executives control both the company and its compensation mechanisms to their own benefit.  As a consequence state intervention is  necessary to avoid the corruption inherent in a system of governance that itself is flawed. On the other side of the debate are those who argue that labor markets are independent of corporate governance at every level and that it is in the best interests of the corporation to participate in labor markets in order to hire the best talent for which market prices must prevail.  Just as markets for labor at the lowest levels tend to be pushed down by greater supply than demand, and is distorted by governmental and other regulatory interventions, so markets for the most talented executives tend to be pushed up as companies become more complex and the number of people sufficiently talented to run these enterprises effectively tends to diminish. Governmental interventions at either level of labor markets tend to produce distortions that can only produce absurdities and inefficiencies that will hurt economic actors, including labor, more than help them. 

Both sides have sought to use governments and investors to push for their vision of appropriate corporate governance constraints on pricing labor at the highest levels of corporate employment. Governmental efforts have sometimes sought to apply caps, though thus far unsuccessfully.  But government efforts have also applied different tactics as well, including indirect regulation through control of markets for information, and private market efforts through state intervention as a shareholder.

1.  Direct Regulation--Switzerland.

Ironically, perhaps, one of the most potent recent efforts for direct regulation of executive wage labor markets originated in Switzerland.  Swiss voters have considered two approaches, one of which received wide popular support, the other of which was recently defeated.  The first broadened the scope of shareholder democracy in Swiss corporate governance.  

In March [2013], Swiss voters approved by a wide margin an initiative that broadened shareholders’ power to limit executive pay. Popular support for the measure was perhaps surprising in a generally conservative country that has one of the highest standards of living in the world and unemployment of just above 3 percent. While Switzerland is not a member of the European Union or the euro zone, it has close ties to both. Still, its economy has been resilient despite the crisis surrounding it.

Switzerland also has a long history of social equality, and many citizens were offended by cases like that of Daniel Vasella, the former chief executive of the pharmaceutical company Novartis, who this year demanded a $78 million severance package in return for a promise not to share his know-how with any competitors. In the face of a public outcry, Mr. Vasella withdrew the demand and has since retired. (Jack Ewing, Swiss Voters Decisively Reject a Measure to Put Limits on Executive Pay, New York Times, Nov. 24, 2013).

This is the sort of traditional adjustment in the respective rights of shareholders and board members relating to the governance of the corporation that is the stuff of national corporate law and policy. The only difference now is that the standard for governance at the root of this action is international rather than national in origin and expression.  In effect, the great issues of corporate governance hjave, like corporate activity in general, gone global.  National law and political debate now reflects international conversations about corporate governance, norms, behaviors and expectations. Of course, , national application of international conversations about corporate policy affects the character of the international conversation.  Thus Swiss action may have significant effect on similar actions across Europe and in the United States.

The second effort was more radical but still well within the tradition of invoking government power to affect the power relations between stakeholders in economic activities. It did not seek to cap executive pay so much as make the now segmented labor markets coordinated by requiring a direct relationship between the floor of the lowest tier labor market segments and the ceiling for the highest.  "As anger at multi-million dollar payouts for executives has spread around the globe since the financial crisis, Swiss voters forged ahead in March by backing some of the world's strictest controls on executive pay, forcing public companies to give shareholders a binding vote on compensation." (Swiss govt urges voters to reject cap on executive pay, Reuters/CNBC, Sept. 17, 2013) The result, the so-called 1:12 Movement sought to cap the pay of the highest paid employee to no more than what the lowest paid employee earned in 12 months.  "The 1:12 initiative was proposed by the youth wing of the Social Democratic Party and supported by the Green Party. As recently as October, the measure appeared to have a chance of passing, but support flagged during the last month in the face of determined opposition by business groups." (Jack Ewing, Swiss Voters Decisively Reject a Measure to Put Limits on Executive Pay, New York Times, Nov. 24, 2013).

Indeed, the 1:12 effort failed this time. "Swiss voters rejected a proposal on Sunday to cap the salaries of top executives at 12 times that of a company's lowest wage, heeding warnings from industry leaders that the measure could harm the country's economy." (Swiss voters reject proposal to limit executives' pay, CNBC, Nov. 24, 2013 "Opponents to the proposal had warned it would harm Switzerland by restricting the ability of firms to hire skilled staff, forcing firms to decamp abroad, resulting in a shortfall in social security contributions and higher taxes.").  

Play Video

Swiss vote on salary cap for executives

Luke Hildyard, head of research at High Pay Centre, discusses the upcoming Swiss referendum on the 12:1 pay ratio, and says that executives whining about the pay cap is "a bit vulgar."

But this may not be the last word: "Sunday's vote is just one of several initiatives being put to Swiss voters to try to address the widening income gap in the country. Switzerland will also hold a vote on whether to introduce a basic living wage of $2,800 per month from the state, though a date has not yet been set." (Swiss govt urges voters to reject cap on executive pay, Reuters/CNBC, Sept. 17, 2013).  Thus bottom up and top down controls appear to be in the future of the political debates, at least in Europe.

2.  Regulating Conduct Through Control of Markets for Mandatory Reporting--The U.S.

The Americans have taken a different approach, one more in line with their business culture model and one that seeks to provide incentive for private markets--investors mostly, to assert private pressure to suit their investment tastes for enterprises with appropriate policies on executive compensation. They have sought to apply a transparency model through legislation.  In effect, the American approach privatizes the Swiss approach.  Where the Swiss sought to impose  compensation ratios more directly, the Americans would report compensation ratios and leave it to the market to determine the consequences.  (the theory is discussed, e.g., in Backer, Larry Catá, From Moral Obligation to International Law: Disclosure Systems, Markets and the Regulation of Multinational Corporations. Georgetown Journal of International Law, Vol. 39, 2008)  Its form, content and effectiveness remains elusive.  Consider the recent informative post for the Conference Board prepared by Branden Rees, Acting Director of the AFL.-CIO's Office of investment, reproduced here:

CEO-to-Worker Pay Ratios Are Material To Investors
By Brandon Rees, Acting Director, Office of Investment, AFL-CIO; Guest Blogging for The Conference Board Governance Center Blog

A long overdue executive pay provision of the Dodd-Frank Act will finally go into effect in the near future. As required by Section 953(b), the Securities and Exchange Commission has proposed rules to require public companies to disclose the median pay of all employees, and the ratio of pay between the median employee and the CEO.

The SEC has received over 100,000 comments that are overwhelmingly in support of this disclosure provision. Investors who have come out in favor of the rule include pension plans such as CalPERS and NY State Common, socially responsible investors including Walden and Trillium, and international investors like Railpen and Amundi.

Many of these investors’ letters express concern that existing CEO pay practices are flawed. At most companies, CEO pay levels are set based on a peer group analysis of what other CEOs are paid. While the CEO’s final payout may vary based on performance, the targeted amounts are based on these peer group studies.

The problem is that peer group benchmarking leads to CEO pay inflation. Not every CEO can be paid above average, yet no company wants its CEO to be “below average.” Some companies explicitly target their CEO’s pay above the median, while others cherry-pick their peer group with higher paid. Year after year, the average rises.

While peer group data is relevant for setting CEO pay levels, it shouldn’t be the only factor taken into consideration. Pay ratio disclosure will encourage board of directors to consider the relationship CEO pay levels relative to other employees. Investors will also use pay ratios as a metric to evaluate the appropriateness of CEO pay packages.

Why are these pay ratios material to investors? High levels of CEO pay relative to other employees can reduce company performance. Employees are well aware of how much their CEO is paid. Employee productivity, morale, and loyalty suffer when workers see that the CEO is taking more while those same workers do more for less.

In contrast, a reasonable pay ratio sends a positive message to the workforce that the contributions of all employees are valued. Accordingly, the Council of Institutional Investors recommends that compensation committees consider “the relationship of executive pay to the pay of other employees” as a factor when setting executive pay.

Pay ratio disclosure will help investors allocate capital to companies based on human capital considerations. There is no one-size-fits-all answer for the ideal ratio of CEO-to-employee compensation. Rather, disclosure will permit investors to compare the employee compensation structures of companies over time and to their competitors.

Lastly, pay ratio disclosure will help constrain further growth of CEO pay levels. Over the past two decades, average CEO pay at large U.S. corporations has increased at twice the rate of average worker pay. Had CEO pay grown at the same rate as worker pay, the average large company would have paid its CEO $5 million less in 2012.

Pay ratio disclosure gives investors an additional metric to consider when voting on “say-on-pay” votes and other executive compensation matters. This is important because the siren song of high pay can tempt CEOs to take on excessive risks. That’s why pay ratio disclosure is integral to the Dodd-Frank Act’s executive pay reforms.

About the Guest Blogger:

Brandon Rees, Acting Director, Office of Investment, AFL-CIO

Brandon Rees is the Acting Director of the Office of Investment for the American Federation of Labor and Congress of Industrial Organizations (AFL-CIO). Brandon Rees joined the AFL-CIO Office of Investment in 1997. He received his B.A. in Economics and J.D. from U.C. Berkeley.

3. Active Shareholding and Corporate Regulation--Norway.

The Norwegians have been trying a third approach--active shareholding.  Effectively, the Norwegian state is seeking to influence corporate behavior by seeking shareholder action to adopt corporate policy limiting executive compensation--one enterprise at a time.  And at the same time, the Norwegian SWF is seeking to use its position as a "private" shareholder to lobby local governments to seek to mange, directly or indirectly, corporate executive wage labor markets. (theory discussed in Backer, Larry Catá, Sovereign Investing and Markets-Based Transnational Legislative Power: The Norwegian Sovereign Wealth Fund in Global Markets (November 18, 2012). American University International Law Review (forthcoming 2013). Richard Milne, reporting for the Financial Times has reported that the Norwegian Sovereign Wealth Fund is investing more aggressively in this strategy, to the benefit of Norwegian State policy, international norms (including the U.N. Guiding Principle son Business and Human Rights) and the development of global customary practices among businesses. In particular, Yngve Slyngstad, chief executive of Norges Bank Investment Management will be joining the nominating committee of ther board of a Swedish company in which the NSWF has a large interest, putting the SWF in a position to participate in the direct nomination of directors for the first time. (Richard Milne, Norway’s oil fund to become active investor, Financial Times, April 25, 2013).  Milbne also quoted Slyngstad as suggesting that with respect to all of its investments in which it holds a "top 5" stake, it would expect to assert an appropriate influence on corporate policy; a policy that is directed by the Norwegian state and reflecting Norway's taste for internationalizing its domestic approaches to corporate governance and behaviors, especially in identified key areas. Thsi represents a change form the SEWF's position in 2011. 

Norway's sovereign-wealth fund, a big shareholder in some U.S. companies, is pushing to make it easier to replace directors at firms, including Wells Fargo WFC +1.46% & Co., over concerns about financial performance and governance. . . .
Norges Bank Investment Management screened the fund's more than 2,000 holdings in the U.S. and selected six companies with unsatisfactory returns on capital or other factors.
For those six, it has filed proposals to give shareholders the right to list competing candidates for board seats on official company ballots, which currently only list management's choices. The fund hopes making it easier to replace directors via so-called proxy access will eventually improve returns by forcing boards to be more responsive to shareholders' concerns.
"We are an active investor, not an activist investor," Ms. Kvam said. Norges Bank Investment Management isn't demanding board changes or its own representation at the companies just yet, Ms. Kvam said. Nor is it demanding strategic or business changes. But if the boards aren't becoming more accountable to shareholders, "we will nominate directors. We are not planning that now; we would much rather have a good dialogue with the board." (Mattias Reiker, Norway Fund Targets Firms, Wall Street Journal, Dec. 6, 2011).

The NSWF has identified key corporate governance issues that it will focus its active shareholding: "Shareholder’s right to vote, Board of Directors, Anti-takeover measures, Capital structure and corporate transactions, Executive remuneration, Social and environmental issues, and General issues." (nicely summarized in the PowerPoints of a presentation by Director General Pål Haugerud, Corporate Governance: Norway's Pension Fund Global, presentation to the IFSWF  Annual Meeting, Mexico City, Sept 2012).  And it believes that its approach is arguably within the constraints of the soft law framework for the behavior constraints of Sovereign Wealth Funds, the Santiago Principles, though that is debatable.  (on the IFSWF compliance with the Santiago Principles, see, e.g., Sarah Bagnall and Edwin M. Truman, IFSWF Report on Compliance with the Santiago Principles: Admirable but Flawed Transparency, Peterson Institute for International Economics, Policy Brief No. PB11-14, Aug. 2011).

More importantly, the NSWF's active shareholding is meant ot both transpose a variety of international norms into Norwegian law, and then to transpose that law and policy into the approach of the Sovereign Wealth Fund as a "private" equity investor in companies through global markets. In its 2012 Report to the Norwegian Parliament, the NSWF reported:

Thee Bank has decided to focus active ownership on six strategic areas:

– equal treatment of shareholders;
– roles and responsibilities of the board;
– well-functioning financial markets;
– children’s rights;
– climate change; and
– water management

The strategic focus areas shall be financially justifiable, since Norges Bank is acting in its capacity of investor. Norges Bank also notes that it is committed to engage with individual companies, where its relationship with a company is based on long-term objectives and the process runs for many years. Such engagement seeks to communicate the expectations of the Bank and assist companies in evaluating and improving their own corporate governance processes. Confidentiality considerations and the need for ensuring good and effective processes mean that Norges Bank will not normally publish details of such contact with individual companies. (Norwegian Ministry of Finance, Meld. St. 27 (2012–2013) Report to the Storting (white paper), The Management of the Government Pension Fund in 2012  ¶4.4.2, p. 73).

These active ownership strategies reflect Norwegian understanding of the implications of the U.N. Global Compact, the OECD Guidelines fr Multinational Enterprises, and Principles of Corporate Governance and the UN Principles of Responsible Investment. (Ibid., Box 4.3 Basic Responsible Ownership Principles).

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Taken together, these three approaches suggest the ways in which regulatory frameworks, approaches and conceptions are multiplying and fracturing.  It also suggests the way that state borders have become both permeable and fluid.  But the approaches remind us as well that while globalization has made the state less central to the project of controlling behavior and setting legal or normative frameworks, it remains an important source or nexus point for such regulation. (theory at Backer, Larry Catá, The Structure of Global Law: Fracture, Fluidity, Permeability, and Polycentricity (July 1, 2012). Tilburg Law Review 17(2) 2012).  The future is likely to see more of efforts of these sorts simultaneously applied by stakeholders seeking to develop norms driven governance structures in and through the state, or through private markets. The strategies and politics of these efforts, and the effects of their intermeshing in global strategies of companies (e.g., Gunther Teubner, "The Corporate Codes of Multinationals: Company Constitutions Beyond Corporate Governance and Co-Determination," in Conflict of laws and Laws of Conflict in Europe and Beyond: Patterns of Supranational and Transnational Juridification (Rainer Nickel, ed., Oxford: Hart, 2009)), will mark much of the coming decades and determined the aggregate effect of these measures on the ground.