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Shortening executive contracts is short-sighted

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Few could argue against the logic that highly performing executives deserve to be well-paid. Where to draw the line between well-paid and over-paid is a discussion for another day. But paying executives generously for mediocrity, or even failure, is difficult for investors to swallow.

A clean break

Too often, it seems remuneration committees find themselves in this position. The chief executive is underperforming or, as in the situation at Tesco earlier this year, there are allegations of wrong-doing. In these cases, a clean break from the executives is the best option. So it is somewhat inconvenient that senior executives routinely have year-long employment contracts. The price of showing them the exit door early is a handsome pay-off.

Pressure for shorter contracts

But changes may be on the horizon. According to some institutional investors, big payments for failure will become a thing of the past and executive contracts will be reduced to six or even three months. So convinced are they of the logic of this approach that they intend to vote against companies that do not fall into line and refuse to shorten executive service contracts to less than twelve months as soon as 2016.

Undeniably, the argument has some merit. It seems unfair that executives enjoy many times more job security than their workforce. Shortening contracts is a small step on the road to addressing some of the inequalities of the labour market and restoring public confidence in big business. As for arguments about continuity, perhaps snappier exits will be the push boards need to dust off their succession plans more regularly.

Measured approach

However, at Hermes EOS we are not yet convinced that this is the right approach. In an era of short-termism, reducing notice periods seems to send exactly the wrong message to companies about the expected tenure of chief executives. Investors may seek to wield the axe after far shorter periods of underperformance, to the detriment of long-term corporate decision-making. And what sort of compensation will directors who are being asked to cut their contracts – increasing the already high risk of taking on a senior role – expect?

We will continue to question remuneration committees to ensure that they will not over-pay departing executives who have underperformed. This would include imposing a duty to mitigate, if the individual in question obtains alternative employment during the notice period. But more particularly, boards must have the discretion to claw back or withhold payments if appropriate. At Tesco, there was insufficient evidence to establish gross misconduct by the individuals in charge, so, despite an ongoing investigation, the company was obliged to make payments in lieu of the 12-month notice period to the CEO and CFO.

Shortening contracts across the board looks heavy-handed. It is far better for remuneration committees to have the tools they need to take sensible decisions in exceptional situations.

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