Thursday, 8 December 2011

Corporate governance consequences - unintended, intended and unrealised

One piece of conventional wisdom you regularly hear invoked in the corporate governance world is The Law of Unintended Consequences (LUC). It is usually, though not always, aimed at government intervention over a given policy issue as is (in my experience) usually believed by the user to be a logical smackdown. You might think that if the Government does A to B then C will happen, but actually perhaps D will happen instead. And D is usually Very Bad Indeed.

The LUC has often been prayed in aid of conservative positions on PLC executive pay. You may think that trying to rein in pay is a laudable aim, but what you don't realise is that it could actually cause problems. It could cause executive talent to move into the private equity world or worse move out the UK, taking potential tax revenue with them.

A more sophisticated claim in recent years, that is widely believed in corporate governance world, is that greater disclosure of executive remuneration has served to exacerbate the problem by fuelling the war for talent. Greater disclosure was meant to lead to pay being restrained but in reality, apparently, it had the opposite effect of that intended. It all sounds plausible. And indeed it would be a mistake to not consider how "purposive social action" might result in outcomes other than those intended. Life is very complex and billiard ball models of causation may only rarely fit the facts when humans are involved.

However, there are several problems with regularly invoking the LUC as an argument againbst reform. For one, at the risk of stating the obvious, there are plenty of examples were the consequences of a particular policy intervention are those that were intended. For example, I have yet to hear a plausible negative unintended consequence of the introduction of pensions. Yes, we have to deal the consequences of people living longer, but that is not a result of the provision of pensions. This was a big social reform that has touched millions of lives. What are the big negative results?

Second, there are, of course, positive unintended consequences. It's interesting to note that "unintended consequences" are so often portrayed as a threat or negative outcome that when we hear the term we probably all immediately think in these terms. That is an indication, in my opinion, of how often this argument is invoked in defence of conservative positions. And yet isn't a commitment to free markets rooted in the possibility of unintended positive consequences? After all, It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. Unintended consequences, no?

In policy terms perhaps we could describe the "automatic stabilisers" in the economy as positive unintended consequences. For example, unemployment benefits were largely introduced to address a social problem, but, by maintaining a level of demand when people lose their jobs, they also began to play a role in the economy that wasn't initially part of the plan. (Obviously this will be disputed by some people!)

Thirdly, as Albert Hirschman pointed out, the flipside of unintended consequences is unrealised expectations. By undertaking reform X you expect Y to happen, but it doesn't. It doesn't lead to unintended consequences, but it doesn't have the intended consequences either.

So let's consider executive pay reform in the UK again. Actually greater disclosure of pay was combined with shareholder empowerment - the introduction of an advisory vote on remuneration policy. The intention was that, armed with more information and greater powers, shareholders would act to restrain unjustified executive reward, because it would be in their own interest to do so. Therefore perhaps the bigger story of the last round of major reform in this area - the Directors Remuneration Reporting Regulations - is less the alleged unintended consequence of greater disclosure, and more the unrealised expectation of shareholders exercising restraint over directors in respect of pay.

If greater disclosure of executive pay added to upwards pressure, then why didn't shareholders use their new rights more effectively? Remember, for example, that no remuneration reports at all were defeated in 2007 and 2008. I'm prepared to accept that disclosure may have fanned the flames, though I think the argument is overdone, but then the question for me is why shareholders didn't protect their own assets. Perhaps it's because shareholders don't consider the extra costs to be excessive in the total scheme of things, or even consider that it is simply a cost of doing business in order to attract the best talent. But then can it really be claimed that disclosure has caused unjustified pay growth?

If you do think both that disclosure is a major driver of executive pay growth and that there isn't much that shareholders could have done any different (and these are the implicit propositions some in the investment industry are putting forward, even if they are unaware of it) then this, again, raises a question about shareholder oversight of pay. That in turn may lead policymakers to conclude that an alternative approach is required, a more regulatory approach, or stakeholder model of governance, perhaps.

The thing is, I'm sure this isn't the outcome that those invoking the LUC to oppose public policy intervention expected. One might even argue that it is the unintended consequence of warning about unintended consequences.

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