The 2016 laureates of the Swedish National Bank’s Prize in Economic Sciences in Memory of Alfred Nobel were Oliver Hart y Bengt Holmström, for their research on how contracts help us manage conflicts of interests.

Dr. Hart’s work stems from discerning that contracts are incomplete manuals of instructions that are unable to specify what appropriate actions should be taken in all possible cases. According to him, that is why contracts should focus on defining how to make decisions, identify what is known as the contract’s spirit, instead of a mere always incomplete listing of possible cases.

Nevertheless, we want to highlight Dr. Holmström’s contribution, since it has a greater impact in an aspect that all shareholders find ourselves at least once a year: the approval of the directors’ compensation plan proposal in the General Shareholder Meetings.

One of the conclusions of Dr. Holmström’s research is that it makes sense to retain part of the compensation during a period to enable the evaluation of the results achieved by a director’s work. In fact, most quoted companies already have some differed compensation aspects, especially in the case of directors’ compensation, and it is considered an excellence-geared practice to align directive interests with those of shareholders.

However, the current compensation system has a limited impact. Dr. Holmström argues that companies tend to condition these evaluations to the stock performance of their peer companies in the same sector, instead of to the director’s own company performance. According to Dr. Holmström, this practice makes little sense because directors can be compensated or penalized for aspects outside their control.

Taking Telefónica to illustrate, part of its director’s remuneration at short and medium term is conditioned by the quoting evolution of a comparison group including Vodafone Group, America Movil, Deutsche Telekom, BT Group, Orange and Telecom Italia, among others. As pointed by one of the main consulting companies specialized in the subject, one of the reasons for the sharp accretion in directors’ compensation in recent years has been the adverse psychological effects on directors due to applying high discount factors to their differed income. Following these procedures, according to Dr. Holmström’s research, directors studied in the United States tend to have, on average, half of their differed remuneration discounted. As such, a US$ 1,000 differed remuneration would be perceived by directors as a remuneration equivalent to US$ 500.

Another factor in the steep rise of such director’s compensation is that the majority is conditioned to variable aspects as well as both financial and qualitative objective achievements. Indeed, a Pandora’s box is revealed in the case of variable objectives, particularly in times when shareholders’ and directors’ interests do not seem to be fully aligned.

This is what happened in the 2016 General Meeting season to companies like the BP oil corporation, the AngloAmerican mining corporation or the management company Schroders, among others, an episode known in the British press as the shareholder rebellion. It was not unprecedented however, as in 2012 several of the main British companies suffered strong rejection to their directors’ compensation proposals, a phenomenon then called the “shareholder spring”. Yet, this year’s BP case has called particular attention, given that 60% (59.29% to be exact) of the shareholders voted against the juicy compensation proposal to their directors in a year in which the company reported historical losses of US$ 6,500 million, mainly as a consequence of the raw oil prices drop and sanctions due to the Deepwater Horizon platform accident in 2011.

As we can see, directors’ compensation is a complex subject, with no single solution. Notwithstanding, we expect that the Swedish National Bank recognition of these two experts for their research on principal-agent problem management will contribute to a revision of all contracts modulating the shareholder-director relationship and favour a better interests alignment, pursuing to promote the long term value of both shareholder and society. Congratulations to the laureates.