1. that the board should create a1. that the board should create a


General idea – to highlight how the existing system of
remuneration mixed with the shareholder value approach results in a
catastrophic level of short-terminism. Furthermore, how this affects other
stakeholders, especially creditors.

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Specifically – this paper will focus on the banking sector and the
results of the 2008 mortgage crises, as it is arguably one of the sectors,
where the results of the above described policy are most visible.


When appropriate the paper will also discuss the differences between
common and civil law systems with regard to the remuneration problems.1



The core idea –
agency problems

Although – as we will see in the chapters below – there are many
theoretical problems surrounding the issue of executive remuneration, agency
problems are at the heart of this topic.


Berle and Means were the first to highlight that managers often can have
different interests than those of the shareholders.2
However, it was Jensen and Meckling, who defined this type of situations as
agency problems.3
In their definition the agency relationship is “a contract under which one
or more persons (the principal(s)) engage another person (the agent) to perform
some service on their behalf which involves delegating some decision making
authority to the agent.”4
If the interests of the agent and the principals are different, then the
principal will have to use additional tools to

monitor the actions,

align the interests of the agent,

cover residual costs.5
Remuneration predominantly falls into the second category, although in the case
of performance-based remuneration it could be seen also as a monitoring device.


There are two approaches on how agency problems and executive
remuneration are connected:

the optimal contracting approach

the managerial power approach.6

The optimal contracting approach – preferred by financial economists –
sees compensation as a remedy to the agency problems. The suggestion is that
the board should create a contract which would maximize the incentives to
favour shareholders` interests and does so with minimal costs.7
The managerial power approach highlights the fact that frequently the level of
remuneration is more likely to show the level of agents` power over the
company. Bebchuk and Fried, the advocates of this approach show in their work
that instead of solving the agency problem, remuneration has become a tool for
managerial rent-seeking and the part of the problem.8


value approach

The issue of whether the shareholder value approach is the most fitting
and useful for the modern development of corporate governance has attracted a
great deal of attention.9
In the UK the enlightened shareholder value approach is established in the Companies
Act 2006 (hereinafter: CA) S172. The section provides a non-exhaustive list of
values (e.g. long-term consequences, stakeholders interests, environmental
impact, etc.) that should be taken into consideration by the management in
addition to the primary goal of “promoting the success of the company for
the benefit of its members as a whole”10.


From a remuneration perspective, if the executive compensation is
performance-based, then the shareholder value approach dictates the managers to
create financially positive results on a quarterly basis. In Gunningham et al11,
this was described as the “tyranny of quarterly returns”. Furthermore,
the management is also under pressure since quarterly reviews are generally the
indicating documents for investors and markets, thus stock prices are largely
dependent on the numbers presented in those reports, as highlighted by Jackson
& Petraki12.


The existing
rules regarding remuneration


The regime

The existing UK legal regime could be described as a colourful mixture
of hard and soft law regulations.


The general rule is that there are no limits or compulsory structures with
regard to remuneration of executives. The exception from this rule are certain
financial institutions that fall under the jurisdiction of the Capital
Requirements Directive and FSA Remuneration Code.13


A comprehensive set of rules regarding remuneration can be find in the
UK Corporate Governance Code (hereinafter: CGC)14,
section D. However, it must be taken into consideration that those rules are
operating based on the comply-or-explain principle. The main principle of
section D is that remuneration should promote the long-term success and must
heavily rely on performance-based elements.  It also states that the procedure of determining
the compensation should be transparent, formal and no director should be
involved in deciding his or her own remuneration. The application of this
framework is complemented by sector-specific guidelines from such organisations
as Association of British Insurers (ABI)15,
National Association of Pension Funds (NAPF)16,
and Pensions Investment Research Consultants (PIRC)17,
that attempt to give more specific benchmarks.


CA S420 requires directors of quoted companies to provide a remuneration
report each financial year. The Large and Medium-sized Companies and Groups
(Accounts and Reports) Regulations 2008, R11 defines the content of that
report. Companies that receive premium listing on the London Stock Exchange
have to comply with a higher level of disclosure requirements according to the Listing
Rule 9.8.4R.18


CA S439 gives shareholders the right of approval of directors’
remuneration report. However, according to subsection (5) of this Section the approval
is strictly advisory, since the company is not bound to take action based on
the results of the approval.



The existing legal framework of remuneration in the UK was
unsurprisingly heavily criticised.19
It is apparent from the above presented legislation that the main tool in terms
of accountability are the financial reports. However, the complexity of these
reports could easily serve as a major obstacle in terms of accountability of remuneration.
A good example of this could be the HSBC Holdings plc Annual Report and
Accounts 201620
and the complementing Directors’ Remuneration Policy Supplement 201621.
Even after a short look three issues could be recognised:

both the Report and the Supplement
provide rather vague evaluation points;

although the remuneration of top
executives is easy to assess there is no description of how those numbers where
calculated; and

naturally, the performance-based
elements should be judged based on the description of the annual performance,
but this a rather complex task. The report is 246 pages long and includes
highly technological descriptions that might become an obstacle.

Overall, it appears that the current system of tying up the report on
remuneration with the overall financial report could be one of the main
obstacles to transparency and objective decision making.


The fact that except some basic provisions in the CA, the general rules
for reports are in CGC is also troubling. Given the fact that remuneration is
arguably the most important tool for aligning the shareholder and agents`
interest it seems questionable, whether it is a good idea to regulate this
issue in a soft law source, which works on a comply-or-explain basis.

Finally, when evaluating the current remuneration regulation, it should be
highlighted that all those rules must comply with the described above ultimate
goal of the current UK corporate governance – the maximization of shareholder
value. Therefore, even if Section D of CGC articulates the importance of
long-term success, it is in my understanding (similarly to the enforceability of
enlightened values in CA S172) limited within the goal of shareholder value.


The banking
sector and the 2008 crises

The banking sector and the events of the 2008 financial crisis present
themselves as a perfect example to demonstrate the above discussed issues. It
demonstrates excessive risk-taking, managerial rent-seeking, potential harm for
other stakeholders, and the general reluctance to consider any other
overarching corporate governance ideology than shareholder supremacy.


The 2008 crisis started as a subprime mortgage crisis, but ultimately had
vast effects on the whole banking sector. Murphy argues that the one of the defining
causes of the crisis was the mispricing of credit default swaps.22
Murphy thoroughly examines the tools that made this – arguably intentional –
mispricing possible, e.g. “by applying purely statistical credit scoring
procedures using a limited number of factors that didn’t incorporate the
effects of requiring no documentation for the inputs to the models and having
no human credit analyst to provide a subjective judgment”23.
However, when examining the reason for such behaviour Murphy emphasises the following24:

mortgage-backed securities were
widely insured,

commissions were based on the sheer
volume of originated securities,

comparatively high profit margins.

Arguably, it is incorrect to define such behaviour as excessive risk
taking, since retrospectively it is clear, that this type of financial
operations was destined to fail. However, it does provide a very clear example
of how excessive risk-taking and managerial rent-seeking are interconnected. In
case if in a bank the executives` remuneration is performance-based, it is easy
to understand how such business model could become as widespread, as it was
before 2008. With regard to the potential harm to other stakeholders it is
probably sufficient to say, that the estimated cost of this crisis – only in the
US – could be around $22 trillion, out of which $13 trillion materialised in losses
in economic output and $9 trillion loss bared directly by households.25


Johnston in his comprehensive overview of the regulatory changes in the
European Union inducted by the financial crisis26
 highlights that although a lot policy
documents and academic papers acknowledge the impact that the executive
compensation had on the crisis, there is no explanation of why and how
remuneration became a problem.27
Johnston demonstrates that the current EU legislation does not address the core
problem – the ideology of shareholder primacy, but rather tries to keep at bay
the banks` risk-taking abilities.28
Johnston explains the reluctance of legislators to intervene into the operation
of financial markets based on two reasons29:

the inherit uncertainty of
financial markets makes it difficult to differentiate between “normal” and “excessive”

shareholder primacy approach is so
deeply rooted as the overarching ideology of corporate governance that even the
dramatic events of 2008 could not force regulators to start searching for




shareholder value

As we could see in chapter 3 of this paper it would erroneous to state
that the legislators are completely unaware of the problems created by the
shareholder primacy approach. However, the provided so far responses show a
lack of either the ability or willingness to genuinely tackle the issue. The
introduction of the enlightened shareholder value was followed by heavy
The interests that are supposed to enhance the quality of corporate governance –
basically CA S172 – have been defined within the ideological framework of
shareholder primacy and only as secondary to it. Furthermore, the
non-exhaustive list includes interests that could easily collide and there is
no guidance how to prioritise if such collusion happens.


In the new Government response to the green paper consultation regarding
corporate governance reform31
the British government maps out a plan for action which mainly focuses on increasing
the shareholder democracy and transparency within the reports. This can hardly be
described as anything else than a slight fine-tuning of the already existing



Bebchuk and Fried presented performance-based remuneration as the
desirable way of allocating executive compensation and the managerial power
approach as the way of separation the pays from the results.32
Although the shareholders` desire to align their interests with those of their
agents is understandable, today it seems unequivocal that performance-based
remuneration is one of the key reasons for short-terminism and excessive








Variable pay cap





As we could see in previous chapters both the academia and the current
hard and soft law regulations are trying to solve the problem of remuneration
by introducing ideas behind quantification of executive compensation. With
regard to this – although it is arguably on the verge of this paper`s scope – I
would like to highlight the fact, that according to some research in modern
behavioural economics and psychology, money is not the only or even the best
motivational tool. In their study33
Ariely et al. show through a series of experiments that money is an effective
motivational tool only when it comes to mechanical tasks, but fails when it
comes to creative tasks. They also argue that “the results of the
experiments reported here suggest, at a minimum, that high payments cannot be
relied upon to produce optimal behaviour.”34
Thus a potent question arises, whether money should be relied at all as the
primary tool for solving the problem of aligning the agent`s and principal`s


1 Given the author`s
educational background the Hungarian corporate governance legislation will be
used as an example for a civil law system.

2 Berle, Adolf A. Jr. and Gardiner C. Means – “The Modern
Corporation and Private Property”, (1932), New York: Macmillan Company.

3 Michael C.Jensen and William H.Meckling – “Theory of the firm:
Managerial behavior, agency costs and ownership structure”, Journal of
Financial Economics 3 (1976) 305-360.

4 Ibid. 308.

5 Ibid.

6 Lucian Arye Bebchuk and Jesse M. Fried – “Executive Compensation
as an Agency Problem”, The Journal of Economic Perspectives, Vol. 17, No. 3
(Summer, 2003), pp. 71-92.

7 Ibid. 73.

8 Ibid. 72.

9 See: Andrew Johnston – “After the OFR: Can UK Shareholder Value
Still Be Enlightened?” (2006) European Business Organization Law Review 7:
817-843.; Andrew Keay – “Tackling the Issue of the Corporate Objective: An
Analysis of the United Kingdom’s ‘Enlightened Shareholder Value Approach'”
2007 SydLawRw 23; (2007) 29(4) Sydney Law Review 577.; Sjåfjell, B., &
Richardson, B. (Eds.) – “Company Law and Sustainability: Legal Barriers and
Opportunities.” (2015), Cambridge University Press.; Joan Loughrey, Andrew
Keay & Luca Cerioni – “Legal Practitioners, Enlightened Shareholder
Value and the Shaping of Corporate Governance”, (2008), Journal of
Corporate Law Studies, 8:1, 79-111.; Collins C Ajibo – “A Critique of
Enlightened Shareholder Value: Revisiting the Shareholder Primacy Theory”,
(2014), Birkbeck Law Review Volume 2(1), pp. 37-58.

10 CA S172.

11 N Gunningham, RA Kagan and D Thornton – “Shades of Green:
Business, Regulation and Environment”, (2003), Stanford University Press.

12 Gregory Jackson & Anastasia Petraki – “Understanding
Short-termism: the Role of Corporate Governance”, (2010), Report to
the Glasshouse Forum 2011, 56.

13 Peter King, Lauren Pau and Rebecca Grapsas – “Disclosure of
executive remuneration in the UK: recent developments and US comparison”,
Practical Law UK Articles 1-523-1863,  www.practicallaw.com, date assessed: 24
January 2018

14 Full text of the UK Corporate Governance Code: https://www.frc.org.uk/getattachment/ca7e94c4-b9a9-49e2-a824-ad76a322873c/UK-Corporate-Governance-Code-April-2016.pdf

15 Association of British Insurers (ABI) Principles of Executive
Remuneration (29 September 2011), see here: https://www.ivis.co.uk/media/5887/ABI-Principles-of-Remuneration-2013-final.pdf

16 National Association of Pension Funds (NAPF) 2011 Corporate
Governance Policy and Voting Guidelines (November 2011), see here: http://www.plsa.co.uk/portals/0/Documents/0201_Corporate_Governance_Policy_Voting_Guidelines_Nov_2011_COMPLETE.pdf

17 Pensions Investment Research Consultants (PIRC) UK Shareholder
Voting Guidelines (24 February 2012), a review could be assessed here: https://uk.practicallaw.thomsonreuters.com/w-008-3567?transitionType=Default&contextData=(sc.Default)

18 FCA Handbook, LR Listing Rules, see here: https://www.handbook.fca.org.uk/handbook/LR/9/8.html#D1506

19 Among others: Charlotte Villiers – “Controlling Executive Pay:
Institutional Investors or Distributive Justice?”, (2010), Journal of
Corporate Law Studies, 10:2, 309-342.; Jackson & Petraki (n 12); King et al
(n 13)

20 See full text here: http://www.hsbc.com/-/media/hsbc-com/investorrelationsassets/hsbc-results/2016/annual-results/hsbc-holdings-plc/170221-annual-report-and-accounts-2016.pdf

21 See full text here: http://www.hsbc.com/-/media/hsbc-com/investorrelationsassets/hsbc-results/2016/annual-results/hsbc-holdings-plc/170221-directors-remuneration-policy-supplement-2016.pdf

22 Austin Murphy – “An Analysis of the Financial Crisis of 2008:
Causes and Solutions”, (November 4, 2008), 11. Available at SSRN: https://ssrn.com/abstract=1295344

23 Ibid.

24 Ibid.

25 See the full version of the relevant article here: http://www.huffingtonpost.co.uk/entry/financial-crisis-cost-gao_n_2687553

26 Andrew Johnston – “Preventing the Next Financial Crisis?
Regulating Bankers’ Pay in Europe”, (2014), Journal of Law and Society,
Vol. 41, Issue 1, pp. 6-27.

27 Ibid. 8.

28 Ibid. 9-18.

29 Ibid. 22.

30 See (n 9) and (n 19).

31 See the full text here: https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/640470/corporate-governance-reform-government-response.pdf

32 Bebchuk and Fried (n 6) 72.

33 Dan Ariely, Uri Gneezy, George Loewenstein, and Nina Mazar – “Large
Stakes and Big Mistakes”, Review of Economic Studies (2009) 76, 451–469

34 Ibid.