Shareholders versus employees

For 2009, Goldman Sachs announced, shareholders would get $3.4bn of the $10bn available for distribution from the second-quarter revenues of $14bn and staff $6.7bn. This announcement sparked a debate about the relative entitlements of shareholders and staff.

David Blake of the FT saw no reason for shareholders to get more, as it was the staff who had earned the revenues, and he even quoted the King James Bible: “The labourer is worthy of his hire”. Harry Wilson, in the Financial News, felt that paying out less in bonuses and more in salaries would reduce banks’ flexibility and in a future crisis force more job cuts, damaging the long-term interests of both bank and shareholder.

Euromoney presented both sides of the argument in highlighting the example of an individual who brings in $10m from two IPO deals. In the traditional banking model of paying out half the profits to the individual, this individual would get $5m, the boss might get an extra $1m and the shareholders would be happy as well with the extra $4m they get.

But the other side of the coin is that the model attaches a low value to the brand and infrastructure, which are owned by the shareholders, as well as the equity risk run by the latter. The Economist pointed out that the industry-wide practice of paying about half of net income is less palatable when bad banks are taken into account. The Economist also raises the question of how shareholders can be happy with a 20% return on equity under this model when the partners under the previous ownership structure got more. In the three years before the bank floated in 1999, Goldman Sachs partners earned returns on capital of 50% a year.

Shareholders blamed for bank excesses

Shareholders are being blamed for failing to prevent excessive risk-taking by the big banks. The corollary question of how they should be persuaded to intervene has been occupying the minds of the authorities and other interested parties during this credit crisis. At one time, the emphasis was on telling shareholders (and subjecting them to other pressures) why they had an obligation to be activist and intervene in poorly performing companies.

This approach, which has lain dormant lately, is being pushed again now, the latest manifestation being an interim report by Sir David Walker on bank governance. The report, published in July, emphasises the duty to carry out long-term engagement, rather than selling a company’s shares, and envisages adherence to this being policed through the Financial Reporting Council’s requirement to “comply or explain”.

Lord Myners, a Treasury minister and a long-term advocate of shareholder engagement, has thought of three ways to build on Walker’s suggestion. One of them involves offering a carrot to shareholders by giving long-term company owners extra voting rights. The second envisages forcing companies to publish the remuneration of executives below board level. His third way is to allow shareholders to sell their voting rights to others who are more interested in voting.

All three of these suggestions have met with industry criticism. Lindsay Tomlinson, incoming chairman of the National Association of Pension Funds, pointed out that violating the “one share-one vote” principle by giving extra voting rights to long-term shareholders would involve regressing to the days when there was a problem with controlling shareholders, such as the founding families with special voting rights. This situation is still widely prevalent on the Continent and abused in Japan under the cross-holdings system.

Tomlinson wasn’t enthusiastic about Myners’ second idea either, saying it was a violation of privacy. And his third idea of selling voting rights is opposed by many big investors as well as by the Association of British Insurers. The problem with selling voting rights is that it could transfer the voting power to somebody with an agenda other than company prosperity, possibly with a preference for seeing the company go under.

The Lex column in the FT has come up with yet another possible carrot, suggesting that longer-term shareholders pay decreasing tax on their dividends, with it eventually declining to zero. This idea was attacked by Richard Royden, head of merger arbitrage at a company run by GFI Group. He pointed out the flaw in that long-term holders could benefit from the lower tax rate without retaining an economic interest, by selling shares short in a separate contract or through derivatives.

Principal-agent theory

A key intellectual argument for asserting that institutional investors should vote stems from the principal-agent theory, whereby the company executives, the agents, need to be supervised by the investors, the principals. But the flaw in this argument is that the institutional investors are themselves agents of the ultimate beneficiaries, and therefore there are flaws in the concept of the exercising ownership responsibility. In practice, there are also conflicts of interest.

Unpublicised abuse

An aspect of top executive behaviour that does not receive widespread attention is the topic of expenses. Earlier this year, a large number of MPs in the UK parliament suffered the embarrassment and loss of reputation of having had their expense claims to parliament publicised, with shoddy details ranging from the petty to the unethical and even downright dishonest claims. What is not generally realised is that this abuse by MPs is tiny compared with what goes on at the apex of many public companies. In May this year the Lex column described several instances of shareholder-funded extravagance by the chief executives. This is an aspect of poor corporate governance that receives little attention at shareholder level.

Allowing the real owners to vote

The real owners, who are the ultimate owners on the share registers of most companies, are those who have bought their shares as individuals, but the nominee system means that this community of shareholders is effectively disenfranchised. The shares are not held in their name and there are several other obstacles to their trying to vote.

Conclusion

The Economist’s argument about the former Goldman Sachs partners having cut themselves a bigger slice of the profits pie in the past seems fallacious, as the 50% included not just ownership rewards but also pay, not to be compared with the 20% received by shareholders currently. Furthermore, the partners ran more risk, not benefiting from the limited liability available in a corporate structure.

The question of the split between owners and employees of the total payout pool is unlikely ever to be resolved on a logical basis, as so many subjective variables are involved.

In dealing with the issue of banks not having been restrained by their shareholders, Sir David Walker is threatening to introduce an element of compulsion through the Financial Reporting Council designed to make institutional shareholders vote. Attempts at compulsion would be fraught with many difficulties and adverse outcomes, an issue that needs to be dealt with at length.

The retail shareholder’s disenfranchisement is another serious matter. In this electronic age, there is no reason why companies cannot take the trouble to identify them through the nominee system and then communicate and receive votes electronically. Too much of current thinking is geared towards the larger players.

In addition to the theoretical principles underlying the approach to compulsion, an important practical issue is being overlooked. It was not just the banks that failed to spot the risks, but apart from a small minority virtually the whole of society at all levels. This included house owners, estate agents, politicians, central bankers, regulators and, most relevant to the issues discussed here, asset managers and institutional investors. If the risks had been recognised, there is no doubt that the regulators or the central bank would have jumped in. Indulging in a blame game, rather than accepting collective failure at the highest levels, could have severe consequences in the long run.

References

“Shareholders versus employees” and “Shareholders blamed for bank excesses”, Investment Management Review vol. 5, issue 1, 2009

“Higher salaries = less flexibility”, Harry Wilson, Financial News, 3.8.09.

“From discreet envelopes to mega-bucks: A short history of the bonus”, Harry Wilson, Financial News, 3.8.09.

“Why banking’s bonus culture should be defended”, David Blake, Financial Times, 18.7.09.

“Banks and bonuses – going overboard”, The Economist 18.7.09.

“To cap or not to cap?” Euromoney, June 2009.