19 September 2012

Should Sebi regulate executive pay?

I have a face-off opinion piece in today's Business Standard titled Should Sebi regulate executive pay? I argue, there should be no further regulations on pay given the Indian business micro-structure. Here is the short piece in full:

It is tempting for the government and regulators to try to curb executive pay; it is surely politically attractive to do so in these days of austerity. The idea of curbing runaway compensation is not new. In fact, our current law has extensive regulations relating to pay, such as deliberations by an independent committee of the board, authorisation by shareholders, various disclosures, maximum percentage caps on commissions for profit-making companies and absolute caps for loss-making ones, government approvals for various acts, minimum period of vesting for employee stock option, to name a few.

No further control on executive pay is warranted for four reasons.

First, Indian firms are not orphaned by their owners. In other words, there is typically a large dominant shareholder known as a promoter who controls the company. Now, this promoter has a financial incentive to keep costs low, and, thus, pay as little as he can to a professional CEO, as little as would get him a high quality CEO. Compare that to the western CEO, who has no one over his head to supervise remuneration. In fact, most western countries do not even require a binding shareholder vote on pay. The agency problem becomes clear as the CEO usually picks his own directors and, thus, members of the remuneration committee, which is a child of the board. Given that for a vast bulk of Indian companies this agency problem does not arise, means we are solving a problem that doesn’t yet exist in the country. Most top promoters give themselves well below 0.5 per cent of net profits as salaries, compared to the law that permits them to take away as much as five per cent of profits.

Second, Indian companies including financial companies are not massively leveraged like their western peers. No wonder, the various crises have not required any governmental bailouts of financial institutions. Thus, the western argument that financial institutions through their CEO take large bets, which, till the bet pays off, results in huge profits for themselves and their top management. When those bets fail, the government must bail out the firm, that is, privatising profits and socialising losses. Given this problem, several western countries have mandated claw-back provisions that take away compensation if there are future losses in a company. Given Indian regulations limits on leveraging, this is not a problem and, again, solving it is, therefore, pointless micro-management.

Third, Indian top honchos’ pay packages are nowhere near as outsized as the western ones. The top US CEO makes over Rs 7,000 crore in a single year (source: Forbes). The top Indian CEO, and there are very few in that bracket (only three), takes home Rs 70 crore by contrast (source: SiliconIndia).
Fourth, it is unlikely that the promoter would extract a huge salary as his gains mainly would come from capital appreciation and dividend payouts. Besides, a lower tax incidence on capital appreciation (often zero) and dividends (typically 15 per cent payable by the company and tax free in the hands of the shareholder) would ensure that the promoter does not award himself a large salary. In addition, the benefit of a disproportionately outsized salary is likely to depress share prices in the secondary markets so the promoter loses far more in terms of capital appreciation than he gains in terms of a larger salary cheque.

High executive compensation in a market is an outcome caused by limited supply and high and rising demand for top talent. Attractive as it may sound, the government and regulators should restrain an urge to cap executive pay either in all companies or specifically in financial companies. Problems that exist in the West do not exist in India and are unlikely to find a place in India so long as the promoter-shareholder continues to oversee professional CEO and top managers. 

Increasingly aggressive shareholder scrutiny, especially from institutional investors and proxy advisory firms, has created substantial pressure on executive pay practices. The law should only take action in cases in which a promoter or CEO is seeking to loot the company with strict enforcement action rather than impose absolute restraints on pay packages by way of pointless micro-management.


Mandar Kagade said...

I read the Debate that figured in Business Standard and find myself nearer to your view than Mr. Haldea's. Just to push you further on this issue tho--- Would your views be the same if we were to talk about the structure of executive/Directorial pay? (rather than the quantum of it)? For instance, the new Bill has proposed that IDs may not be paid in anything but cash and no stock options). Wouldn't stock and stock derivatives (with a vesting schedule to curb excessive risk-taking) be a better idea for IDs?

Sandeep Parekh said...

I think stock options are clearly a good way to compensate – since they are valuable only if you make the company more valuable. Therefore permitting their use aligns the interests of the shareholders with those of the directors (whether indep or not). Of course you can argue against this with at least a couple of examples - but I still think IDs should be permitted ESOPs etc.

Mandar said...

Thank you Sir for sharing your views. My views are the same. Though of course, having a mix of restricted stock, and staggered vested options with cash would be closer to optimum. Exclusively cash-based compensation that the Bill aims to usher in, will, the way I see it, do little to curb ID passivity.