Andreas Whittam-Smith: Cable needs shareholders to flick switch

W hy do the directors of large public companies pay themselves so much? We must attempt a diagnosis before turning to the cure proposed by Dr Cable, the Business Secretary, on Monday. High pay unrelated to genuine achievement is undoubtedly a fault in the capitalist system. Some of the necessary checks and balances have broken down. If a firm sells shoddy goods, customers will desert it. The fault will have been corrected. It should also be the case that if directors demand excessive amounts of pay, then shareholders would restrain them, thus keeping the system in balance.

But shareholders haven't been doing so. They have been asleep at the switch. Large shareholders, such as pension funds, insurance companies, endowments and the like, became careless when things were going well in the 1980s and 1990s. They started neglecting the most important annual events in their calendars, the annual general meetings of the companies in which they are invested. They allowed shareholder power to wither.

Directors of large companies suddenly realised they could raise their rewards with impunity. As a result, the salaries of chief executives have been increasing at 13 per cent a year, five times faster than the pay of their employees, while the performance of their companies as measured by their prices on the stock exchange has hardly progressed.

In effect, directors' pay began to be driven by greed.

The most striking feature of Dr Cable's remedy is that, for the first time, remuneration committees of boards will be expected to explain their future policy when reporting to shareholders and, in another innovation, shareholders may accept or reject these plans by means of a binding vote. This would immediately bring shareholders back into the game by giving them a veto and it would reinforce the need to look forward rather than backward. Nonetheless, the details of what the Secretary of State is proposing are crucial.

Would shareholders have to approve or reject the remuneration report in toto, or could they say yes, we like this, but no, we don't like that? To illustrate what would be a very new situation, suppose that it is the whole of the report that has to be voted upon – as seems to be the case – and that shareholders in a given company duly rejected it. What then? Suddenly, the company would have no authority to pay directors a penny more than they were receiving under the previous year's arrangements. More than that, shareholders would in effect have passed a vote of no confidence in the board. The obvious way to avoid such a crisis would be for the two sides to negotiate an agreed remuneration report beforehand. That would indeed be an interesting development. Because when you look again at the items that the Secretary of State believes the remuneration report should include, they are nothing less than the company's entire plans for the future.

Big shareholders would raise two objections. First, that they are not staffed up for such demanding work. And, second, they would worry that they might receive information that was not simultaneously available to all shareholders and thus create a false market in the shares. Both these problems would have to be overcome if full advantage was to be taken of the new arrangements.

Yet suddenly the prospect of repairing a defective part of the market economy has opened up. It won't be reached however, unless large shareholders, big companies and the Government now swiftly work together to design an effective way forward.