Although a central factor to business’ success or failure, the issue of corporate governance has not historically tended to excite great passions amongst policymakers beyond the usual party-political posturing. However, over the past two years it has become a more contested area of reform, with a rash of policy proposals from both sides that will interest and potentially concern investors. Changes being brought by government will impact how companies report and are overseen, while more radical proposals from the Labour Party represent a further risk for investors, given they would alter the way companies are owned and managed at the top level.
In Theresa May’s 2016 leadership speech, she pledged to implement “changes in the way that big business is governed”. This included mandating places for workers on company boards and making shareholder votes on corporate pay binding, instead of advisory as they are currently.
Encountering the political reality of governing with no overall majority and resistance from Philip Hammond’s Treasury, which was concerned about upsetting business, May’s proposals have been watered down. Instead of the stronger proposals suggested by the Prime Minister before the election, companies reporting on financial years starting after 1 January 2019, will have to adhere to several new lesser requirements:
These measures follow a similar pattern to other new reporting requirements brought in by Theresa May, such as gender and ethnicity pay gap reporting, where public databases of performance have been created. We are likely to see similar stories in the press highlighting the worst offenders with high CEO-worker pay gaps, or the most clashes with shareholders over pay, such as those at Direct Line, and housebuilder Persimmon.
There are particular problems with the CEO-worker pay ratio which may distort who receives bad coverage by emphasising where CEOs are paid significantly more than workers. Some industries such as financial services tend to have limited numbers of well paid employees, so their ratios will be small, while retailers employ larger workforces on smaller salaries so will have considerably worse ratios. For example, McDonalds’ CEO was paid 3,101 times the average worker in 2017. In addition, because the ratio is based on CEO to average worker pay, changes in CEO pay year-on-year will have a large effect on the ratio. Because CEO pay tends to vary significantly with performance the ratio will also jump around, rather than showing clear trends.
These issues may prove a boon for private equity looking to take listed companies private, as they will not be subject to the same level of scrutiny. This has led to wider concerns the proposals will accelerate the trend for companies to go private, or not to list as they grow, meaning they are not subject to the same level of shareholder scrutiny.
Not to be outflanked on the left, Labour leader Jeremy Corbyn and Shadow Chancellor John McDonnell came forward with proposals of their own for corporate governance at their 2018 Party Conference. If elected, Labour said it would ensure both public and private companies with a workforce of over 250 set aside at least one third of their boardroom positions (a minimum of two) for representatives elected by the workers.
While on the surface this idea seems extreme, the model exists in other countries and we can look to Germany for an example of the actual effect such a policy is likely to have on assets. German companies operate a two-tier system, with a management board made of the senior executives and the CEO, and a non-executive supervisory board, consisting of shareholder and employee representatives.
The model has been quite extensively studied around the world. One troubling finding is that the system reduces the market-to book ratio of companies by 31 per cent on average, likely meaning a loss for shareholders as the model is implemented. There is also evidence such companies have higher staffing levels which can negatively impact profits. Shareholder and employee interests align in other areas which may provide benefit. Both are incentivised to ensure the company is a going concern by limiting risky management behaviour and executive pay.
Any potential benefit in the long term, however, is likely to be wiped out by Labour’s other eye-catching policy for company structures. For example, large companies would have to hand over ten per cent of their equity to workers. There will be a cap on the earnings received by workers and the state will take the rest, so there are questions over whether the policy is really a cooperative model. Whoever benefits, it is clear shareholders would take a ten per cent cut on the value of existing shares – no doubt the most hard-line left wing policy put forward by Corbyn’s Labour Party.
While May’s reforms will lead to public recriminations for the companies with the most egregious pay structures and a shakeup of some boardrooms, the greater risk clearly comes from Labour’s attempts to redistribute corporate power. It is this which investors must keep a watchful eye on.