This article addresses the issues of executive remuneration and whether it was excessive or not.
On 05 August 2015, the US Securities and Exchange Commission (SEC) adopted a rule to operationalise Section 953(b) of the
Statutory enactment of the pay ratio provision provided the impetus to create an index, the Paulo–Le Roux Index, that shows how much executives are paid in relation to how much value they add to the firm.
Paulo and Le Roux (2014) developed an approach to measure the value executives add to the firm, drawing from audited financial statements and thereby demonstrating that the value added by executive management could be measured according to the requirements of sound research methodology and rigorous epistemology. Statutory enactment of the pay ratio provision provided the impetus to create an index, the Paulo–Le Roux Index, that shows how much executives are paid in relation to how much value they add to the firm. The value added to the firm is a composite of the value drivers, sales, growth, capital requirements (CR), operating profitability (OP), and the discount rate in the form of a weighted average cost of capital (WACC).
Discussions that hitherto have been normative regarding executive remuneration, and unrelated to the value created by executives, can now be based on rigorous valuations that draw from audited financial statements.
Numerous advantages accrue from the use of this index for all stakeholders, managers, organised labour, investors, as well as for asset allocation and corporate restructuring, the risk incurred in adding value, and the strategies applied. This index can be used for any enterprise, division, functional area, or project, and for any financial period for which audited financial statements are available.
Using the index ensures sound corporate governance and shed light on assertions that corporate executive remuneration was excessive and detrimental to the economic wellbeing.
On 05 August 2015, the US Securities and Exchange Commission (SEC) adopted a rule that requires public companies to disclose the ratio of chief executive officer (CEO) compensation to the median compensation of its employees. Section 953(b) of the
In anticipation of the pay ratio provision becoming mandatory in the USA, Paulo and Le Roux (
The pay ratio provision focuses on reporting income distribution disparities between corporate executives and the median income of employees and hence can be associated with agency theory. In contrast, the approach under discussion herein establishes the relationship between executive remuneration and the value added by executives to the firm. The many benefits of this approach, for all stakeholders, are presented in this article.
This article briefly presents the background to the pay ratio provision, followed by the debate for and against it. This debate provides a motivation for the Paulo–Le Roux Index, which is then presented and discussed. Even though screening and ranking controls are inherent in the application of this index, it is not the intention of this article to prescribe or even suggest control limit values. That issue requires an extensive empirical survey of corporate executive behaviour followed by an appropriate period of consultation, discussion, and public comment with the nation’s stakeholders and legislature regarding appropriate norms and guidelines. The fraction of value added by executives that can or should be distributed to corporate executives or the way in which such distributions can or should be made through time are not the purpose of this article. These are matters for future study.
The
Valuations drawn from audited financial statements, focusing on the intrinsic value rather than the market pricing of the firm, provide a credible motivation for an alternative approach if financial markets are experiencing high levels of turbulence and excess volatility in security prices. Recourse to intrinsic valuation during periods of financial turbulence can improve corporate governance, in part, by ensuring sound executive compensation practices, especially in light of the widespread public invective that has accompanied executive remuneration, particularly bonuses, during and in the aftermath of the global financial crisis.
Section 953(b) of the
The US Economic Policy Institute found that ‘… from 1978 to 2012 CEO compensation measured with [
Kaplan (
In 2013, within the US Congress, Huizenga (H.R. 1135) sought the repeal of the pay ratio provision, Section 953(b) of the
Outside of the US Congress, the pay ratio provision has been criticised by the business lobby, including the American Benefits Council, American Insurance Association, the Business Roundtable, the National Association of Manufacturers, the National Retail Federation, the Financial Services Roundtable, the Securities Industry, and the Financial Markets Association, IBM, McDonald’s, AT&T, the New York Stock Exchange, the US Chamber of Commerce, and the Center on Executive Compensation (Shorter,
Support for the Dodd-Frank pay ratio provision is based largely on whether the provision will provide material information to investors and other stakeholders, and whether the benefits will exceed the costs. The benefits refer to whether the information provided will be necessary to ascertain the reasonableness or acceptability of executive remuneration. Yet again, it must be emphasised that, in the absence of a financial measure of the value added by executives, it is not possible to evaluate with any semblance of objectivity the reasonableness or unreasonableness of executive remuneration. Although Section 951 of the
The SEC summarised its view on the usefulness of the pay ratio provision as ‘… not quantifiable’ (Shorter,
Annual shareholder approval of executive compensation: Section 951 of Dodd-Frank amends SEA 1934 by inserting after Section 14A regarding annual shareholder approval of executive compensation by means of a separate non-binding shareholder vote. In so doing, shareholders can express and formally record, in a transparent way, their opinions on executive compensation. In essence, this is what then British Prime Minister David Cameron called for in his statements reported on January 09, 2012 (The Guardian, 2012).
Independence of compensation committees: Section 952 of Dodd-Frank amends SEA 1934 by inserting after Section 10B, Section 10C regarding (1) the independence of compensation committees, by prohibiting the listing of any security of an issuer that does not comply with statutory requirements; (2) the independence of compensation consultants and other compensation committee advisors; (3) compensation committee authority relating to compensation consultants that includes
The disclosure of pay versus performance linked remuneration: Section 953 of Dodd-Frank amends SEA 1934 by inserting in Section 14 paragraph (j) regarding disclosure of pay versus performance linked remuneration by:
… including information that shows the relationship between executive compensation actually paid and the financial performance of the issuer, taking into account any change in the value of the shares of stock and dividends of the issuer and any distributions … and may include a graphic representation of the information required to be disclosed …
This statutory requirement therefore necessitates a valuation of the change in the value of the company based on factors such as share price, dividends, and other distributions that, in an efficient market, would reflect the value added by executives to the market value of the company, in order to determine the financial basis for performance linked remuneration. In inefficient or manic-depressive markets, this would not hold. No mention is made of the fraction of the value added by executives that can or should be allocated to a bonus pool from which performance linked remuneration can be distributed. The issues regarding value added by executives, the fractional share of this quantum that can or should be distributed, the way in which such distributions are made, and valuations in which financial security prices do not reasonably correspond to their intrinsic values cannot but constitute an important part of the work of the compensation consultant.
Recovery of erroneously awarded compensation: Section 954 of Dodd-Frank relates to the recovery of erroneously awarded compensation, and amends Section 19 of SEA 1934 by adding paragraph (h), which requires the issuer to disclose the basis of incentive-based compensation that is to be based on the financial information required to be reported under the securities laws. In the event that an accounting restatement is required, due to material noncompliance with any financial reporting requirements, the recovery of erroneously awarded compensation is to be made from any current or former executive officer during the 3-year period preceding the date on which the issuer is required to prepare an accounting restatement.
The disclosure of hedging by employees and directors: Section 955 of Dodd-Frank requires the disclosure of hedging by employees and directors, and amends Section 14 of SEA 1934 by requiring the disclosure by issuers of permission granted to employees, directors, or their designees, to purchase financial instruments designed to hedge or offset any decrease in the market value of equity securities.
In the UK, the FSF 2009 proposed nine principles as part of an effort to ensure the effective governance of executive compensation and accountability. These nine principles are presented, discussed, and compared with Sections 951–956 of Dodd-Frank.
As noted by Paulo (
In drawing a comparison, it is evident that Sections 951–956 of Dodd-Frank and the principles of Category A and C of FSF 2009 have notable similarities and are both substantially procedural in nature. The principles of Category B of FSF 2009, namely principles 4, 5, 6, and 7, that require valuations (unspecified in terms of variables and functional format), so that compensation can be aligned with prudent risk taking, and hence the valuation of the value added by corporate executives, is addressed under Section 953 Dodd-Frank by stating that the basis of incentive compensation, bonuses, are to be factors such as share price, dividends, and other distributions (without stating the functional format, formula, or methodology). In comparison, FSF
Compensation systems
Consider, too, Principle 6, ‘Variable compensation payments
Principles 4, 5, and 6 focus on making compensation sensitive to risk, and in this regard the FSF reported that ‘… In years of losses by the firm as a whole, most employees’ bonuses at most firms have continued as a significant portion of boom-year levels. In other words, the size of the firms’ bonus pools showed much more inertia than did economic performance’ (FSF,
In comparison with Dodd-Frank, FSF 2009 has some worthwhile and specific principles concerning the estimation of executive value added with regard to risk, return, and time horizons. These principles help provide clearer guidelines as to the criteria upon which to base executive incentive-linked remuneration. Moreover, FSF 2009 leaves the door open for other approaches to the estimation of executive value added when determining the potential bonus pool by not linking executive remuneration explicitly to market prices of financial securities – to the extent that the market prices of financial securities, dividends, and other types of distributions may not at all times correspond meaningfully to the intrinsic values of those securities. This has merit in financial markets in which security prices do not correspond reasonably to intrinsic values.
The valuations that are required by Dodd-Frank need to conform to the requirements of Rule 702 of the Federal Rules of Evidence of the USA (Rule 702), the SOX, especially as regards sound research methodology, because of their implications for performance measures such as those of Treynor (
In 2000, with the enactment of the ‘new’ Rule 702 that replaced the
If scientific, technical, or other specialised knowledge will assist the trier of fact to understand the evidence or to determine a fact in issue, a witness qualified as an expert by knowledge, skill, experience, training or education, may testify thereto in the form of an opinion or otherwise if:
the testimony is based upon sufficient facts of data,
the testimony is the product of reliable principles and methods, and,
the witness has applied the principles and methods reliably to the facts of the case.
Thus, in terms of Rule 702, an expert witness needs to provide sufficient supportive empirical evidence and reliable methodology in order to provide a sufficient basis for application to the facts of the case under consideration. The application of unreliable principles and methods that lack empirical validity cannot be applied purposefully or meaningfully interpreted. Apart from Rule 702, the valuations of listed corporations based on unsound research methodology may infringe SOX. It is likely to contravene SOX Section 807, §1348 regarding securities fraud if a person possessed of expert skills and knowledge, by education, training, or practice, has made use of unreliable and invalid methodologies to perform valuations, and accordingly allocated capital, or made financial representations or decisions for listed corporations:
§1348 Whoever knowingly executes, or attempts to execute, a scheme or artifice … to obtain, by means of false or fraudulent pretences, representations, or promises … shall be fined under this title, or imprisoned not more than 25 years, or both.
In terms of §1348 of SOX, theories, models, criteria, and decision rules that are mis-specified, lack empirical validity, are not epistemologically rigorous, and defy sound research methodology, are an abstraction from reality and cannot be satisfactorily operationalised are subject to scrutiny. They may be construed as an attempt to commit a false or fraudulent pretence, particularly in the case of an expert professing specialised knowledge, skills, and competence (Paulo
It is difficult to defend the use of market prices as a suitable and sole basis for the estimation of value 4, given that such approaches fall within the ambit of value added by corporate executives. The market prices of financial securities correspond to their intrinsic values only under constructs such as perfect competition and the efficient market hypothesis, that, by definition, are not operationally valid. Consequently, it is not entirely clear how constructs such as perfect competition or the efficient market hypothesis could be reconciled with either Rule 702 or SOX.
Both Rule 702 and SOX are concerned with sound research methodology, which requires performance and valuation metrics to ethically and accurately report, describe, and explain the phenomena being researched (Cavana, Delahaye & Sekaran,
Paulo and Le Roux (
where: Vop(time N) = the intrinsic value of operations; CaptialN = quantity of capital in place at time N;
At an intrinsic level, value added by corporate executives is reflected in the intrinsic values of the issuer’s investments and their financing. Market prices of issuers’ assets and securities may deviate from their intrinsic values for a variety of reasons such as market frictions, preferred habitats, or market segmentation theory (Fabozzi,
The Paulo–Le Roux Index is defined:
where, using the notation of (1): ER = Executive remuneration; and:
This index, defined as the ratio of executive remuneration to value added by executives to the intrinsic value of the firm, shows how much executives were paid in relation to how much value they added to the firm. It is an expression of a cost/benefit ratio with the costs corresponding to ER and the benefits explicitly constituted in terms of the four main drivers of value based corporate management, namely, growth (g), CR, and the discount rate in the form of a WACC and OP.
The purpose of this Index is to provide a meaningfully measurable basis for analysis and discussions concerning what until now has been an imprecise hermeneutical discussion of the widely reported and publicised assertions and counter assertions of ‘executive greed, reasonableness, acceptability, satisfactory and excessive remuneration’ presented and discussed as part of the debate on the Dodd-Frank pay ratio provision.
The prime function of this Index is to provide a financial valuation to guide resource allocation in a manner consistent with the goals of the firm, the objectives of the company, other statutes, and the requirements of sound research methodology and rigorous epistemology. To accomplish this, in particular since the Dot.Com bubble and the advent of the financial crisis that started in 2007–2008, metrics need to satisfy Rule 702, and important legislation such as SOX, UKCA
The Paulo–Le Roux Index is useful because, in drawing inputs from audited financial statements, it complies with the legislative requirements of financial accounting. This applicability is from the perspective of financial accounting that focuses on reporting externally, and the performance of the firm in a manner consistent with numerous reporting and legislative requirements. The index provides a criterion that relates executive remuneration to the value executives have added to the firm. When re-arranged and disaggregated as [V(op time N) – ER], the value added after ER and retained earnings are revealed and available for workers and shareholders. Retained earnings are an important basis of capital formation. For example, [V(op time N) – ER – Dividends – Retained Earnings = Value added for workers]. Thus, it provides an indication of the income distribution between executives and other employees, and also reveals the distribution to workers, shareholders, and retained earnings. Firms can be screened and ranked cross-sectionally and time-serially in terms of the allocation of value added, on a divisional, functional, or matrix basis, by product line, production unit, and project.
From the perspective of management and cost accounting, where the focus is on internal valuations for resource allocation and pricing, this index provides a guide for a wide range of managerial decisions, including promotion, restructuring, outsourcing, split-offs, spin-offs, and corporate restructuring.
Flexibility: Executive remuneration, ER, within the context of the Paulo–Le Roux Index, can be the total remuneration of a CEO; the aggregate remuneration of all executives; the remuneration of specific executives with regard to the division, function, production unit, or project they head. It thus has considerable flexibility. For illustrative purposes, the value of this index could range from a very low number, such as 5% of value added, to more than 100% of value added. Values in excess of 100% are consistent with asset stripping and corporate raiding. By presenting the values clearly, transparently, and unambiguously in a way that can be widely understood, a more informed and responsible debate on what is happening to income and wealth creation is possible.
The share of value added that should go to the various stakeholders is a matter that requires research, discussion, and informed debate in appropriate forums, including sovereign legislatures. Industry norms and guidelines cognisant of specific circumstances and national needs can be developed and modified through time.
As already noted, it is not the intention of this article to prescribe or even suggest control limit values even though screening and ranking controls are inherent in the application of this index. That requires an extensive empirical survey of corporate executive behaviour, followed by an appropriate period of consultation, discussion, and public comment with the nations’ stakeholders and legislature regarding appropriate norms. It is not the purpose of this article to address the fraction of value added by executives that can or should be distributed to corporate executives, or the way in which such distributions can or should be made through time, though these topics are undoubtedly important.
This article presents and discusses the Paulo–Le Roux Index that measures the relationship of executive remuneration to value added by executives. It is a response to the pay ratio provision in Section 953(b) of Dodd-Frank that the SEC announced on August 05, 2015, regarding the implementation, from 2017 onward, of the mandatory reporting by all public companies of the ratio of CEO remuneration to the median compensation of its employees. The background and extensive debate, in and outside of Congress with roots going back to the 1980s, that led to the 2015 implementation of this provision was an incentive for the Paulo–Le Roux Index. This debate and the preceding discussions of agency theory and corporate governance in the 1980s would have benefited substantially from being anchored in the type of measurement that quantifies in financial terms and can express the ratio of executive remuneration to value added by executives as a percentage. This index has widespread and flexible application because it provides a quantitative basis for managerial decision making consistent with the goal of the firm, sound research methodology, and rigorous epistemology, by drawing from audited financial statements. The next stage comprises extensive empirical surveys, to be followed by discussions and consultations with all stakeholders in the South African economy, including the legislature.
The authors declare that they have no financial or personal relationships that may have inappropriately influenced them in writing this article.
Both authors contributed equally to this article.
Extract from Paulo and Le Roux (
where: Vops = the value of operations; and PV = present value of expected future cash flow.
In other words (Brigham & Ehrhardt,
where: WACC = weighted average cost of capital of all the firm’s financing components; and FCFt = free cash flows for all periods
To accommodate growth, the value of the firm’s operations can be rewritten adapted from Brigham and Ehrhardt (
where: g = the growth rate.
Since FCF is determined by capital already invested, sales and the growth in sales, as well as the profitability of sales in relation to the capital required to generate those sales,
The term:
shows the present value of the growth in sales discounted at the firm’s WACC. Since an increase in sales often necessitates an increase in CR over and above the cost of sales, the term:
is needed because it shows the difference in OP, and the firm’s discount rate or cost of capital, WACC, multiplied by the firm’s additional capital requirement to finance the growth in sales. Thus, this term shows the return over and above the cost of capital earned in relation to the additional capital investment needed to fund the growth in sales.