Andreas Whittam Smith: Buy a share, cast a vote, solve the problem

Why do the directors of large public companies pay themselves so much? We must attempt a diagnosis before we can then turn to the cure proposed by Dr Cable, Secretary of State for Business, Innovation and Skills, in the House of Commons on Monday. High pay unrelated to genuine achievement is undoubtedly a fault in the capitalist system. What have broken down are some of the necessary checks and balances. If a firm sells shoddy goods, for instance, 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 that they could raise their rewards with impunity. There was no need any longer to link them closely with performance. 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 rather than by anything more elevated. So despite the many speeches that have been delivered criticising high pay and the many articles written along the same lines, the practice has continued unabated. It is as if boardrooms are hermetically sealed and the windows blacked out so that those inside are cut off from ordinary society. As with any addiction, reason has been unable to reach them.

The most striking feature of Dr Cable's proposals 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? This difficulty arises from the large number of issues Dr Cable believes should be covered: which benchmarks have been used and why; how employee earnings have been taken into account; the extent to which employees have been consulted about directors' pay; how the proposed pay policy reflects company strategy; how performance would be assessed and how it would translate into rewards under different scenarios.

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.

That is not what happens now. Investment analysts constantly visit companies and meet senior management. But that is part of their unending quest to decide which shares to buy and which to leave alone. It does not take the form of a constructive dialogue. And that is what seems to be in the offing if the Cable plans are put into effect.

Big shareholders would raise two objections. In the first place, they are generally not staffed up to engage in 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.

a.whittamsmith@independent.co.uk