Commission backs board role in exec pay

ON January 4, the federal government released the Productivity Commission’s report on Executive Remuneration in Australia. Judging by the response to the report, the commissioners largely got it right.

The report concluded that Australia’s corporate governance and remuneration frameworks rated highly internationally, and as a consequence the commissioners looked to ways of strengthening Australia’s existing framework.

They rejected imposing caps on total pay and bonuses, and binding shareholder votes on the remuneration report. Instead, the commissioners held firm to the view that the board plays the central role in determining the remuneration of the executives.

The report concluded that: “The only practicable means for the many thousands of diverse shareholders of a public company to achieve a remuneration structure that promotes the company’s long-term interests is for them to ensure that they have an able and properly motivated agent – the board.”

The first 15 recommendations in the report seek to improve corporate governance and enhance the effectiveness and credibility of boards, as well as to make the board more accountable in relation to pay setting.

The recommendations fall into five areas of reform.

• Board capacities: The board plays the central role in determining executive remuneration. Board members need a broad mix of skills, knowledge and experience to provide independent, well-informed decision making, including on remuneration. Board membership and renewal should reflect merit-based processes that draw appropriately from the pool of available talent. (Recommendation 1.)

• Conflicts of interest: Given the desirability of boards operating independently, any potential conflicts of interests need to be effectively addressed. Some potential conflicts require regulatory constraints, whereas greater transparency will be sufficient in other areas. (Recommendations 2-7.)

• Disclosure: Appropriate disclosure of information is necessary for shareholders to understand the extent to which their interests are being served by the company. This includes understanding executive pay structures and how pay links to company performance. (Recommendations 8-12.)

• Remuneration policies: Incentive pay structures provide a key mechanism for boards to align the interests of executives with those of companies and shareholders. However, such arrangements need to be carefully designed, as inappropriately constructed pay packages can deliver perverse outcomes. (Recommendation 13.)

• Shareholder engagement: Shareholder engagement with boards (their agents) requires appropriate signalling mechanisms and sanctions through effective voting processes and audit trails. (Recommendations 14 and 15.)

The remaining two recommendations are related to implementation issues, including making legislative changes to ensure compliance with recommendations relating to conflict of interest (2 and 3) and disclosure (10 and 11) should the ASX and Corporate Governance Council not make the requisite changes and a review of the reforms within five years.

The report also made two findings. The first noted the continuing under-representation of women on boards and concluded this was an indication that boards were not drawing from the existing wide pool of talent. The commissioners strongly endorsed the ASX Corporate Governance Council’s initiatives of requiring companies to adopt and disclose (on an ‘if not why not’ basis) their progress against gender objectives set by their boards, and encouraging nomination committees to review the proportion of women at all levels in the company and disclose on an annual basis the skills and diversity criteria used for board appointments.

Again, if after a three-year review little progress has been made, it has been suggested that these initiatives be “upgraded” to a listing rule.

The second finding guides boards as to how the commissioners feel they could better explain their remuneration decisions to shareholders by explaining:

• how the remuneration policy aligns with the company’s strategic directions, its desired risk profile and with shareholder interests;

• how the mix of base pay and incentives relates to the remuneration policy;

• how comparator groups for benchmarking executive remuneration and setting performance hurdles and metrics were selected, and how such benchmarks have been applied;

• how incentive pay arrangements were subjected to sensitivity analysis to determine the impact of unexpected changes (for example, in the share price),and how any deferral principles and forfeiture conditions would operate;

• whether any ‘incentive-compatible’ constraints or caps apply to guard against extreme outcomes from formula-based contractual obligations;

• whether alternatives to incentives linked to complex hurdles have been considered (for example, short-term incentives delivered as equity subject to holding locks);

• whether employment contracts have been designed to the degree allowable by law, to inoculate against the possibility of having to ‘buy out’ poorly performing executives in order to avoid litigation; and

• whether post-remuneration evaluations have been conducted to assess outcomes, their relationship to the remuneration policy and the integrity of any initial sensitivity analysis.

The majority of the recommendations were supported across industry and membership organisations, including the Australian Institute of Company Directors, and was seen as a substantial improvement in the position of shareholders by Australian Shareholders’ Association.

The commissioners have trodden the middle ground, receiving praise for recognising the high regard Australian corporate governance is held internationally and by recommending shareholders have greater access to, and say on, remuneration practices of listed companies.

As expected, the two most contentious recommendations relating to ‘no vacancy’ and ‘two strikes’ (1 and 15) remain the most widely discussed.

In relation to the ‘two strikes’ recommendation, some suggest it places too much significance on remuneration (diverting the board away from strategic issues) and others say it allows boards that get executive remuneration wrong too long before they can be ultimately held to account.

No matter which side of the divide you sit, the implementation of these recommendations will require further stakeholder involvement in the review and comment on drafting.

After almost nine months of research, review and public consultation we have the recommendations. Now, we must wait for the Rudd government’s response.

n Pamela-Jayne Kinder is principal of PJ Kinder Consulting – board and executive remuneration governance.