Is Good Pay Governance Applicable to NED’s?
In this article, we share lessons learnt on factors to consider when setting Non-Executive Directors (NED’s) pay, and propose a transparent approach in defining competitive and defensible remuneration rates for NED’s.
The pressures of today’s business environment, along with high-profile governance failures in recent years, demand for greater diversity and specialisation for Non-Executive Directors (NEDs), as businesses become increasingly reliant on the capabilities of people on their boards.
As part of the recruitment and governance process, companies need to ensure that NED’s have sufficient capacity to devote additional time to the needs of the business in times of crisis. This view is supported by Proxy Advisors and is even more critical for small capitalised listed companies and junior miners (small-cap companies). Consider the volatility and disruption West Australian businesses have endured over the past five years. This has been even harder for small cap companies and further highlights the need for NED’s to be vigilant in effectively guiding their businesses through tumultuous waters.
Small-Cap Companies Verse Large Cap-Companies
Notably, small-cap companies have less access to financial resources as compared to large-cap companies. These limitations can strongly impact decision making, where efforts to secure funds for bridging short term cash flow concerns take priority over skilled recruitment.
Financial constraints and absence of required skills increase the vulnerability of small-cap companies when market conditions are tough. In addition, increased scrutiny by the public and regulatory boards, as well as exposure to legal liability, calls for NEDs to be ‘on their game’ at all times. The law is explicit, directors and officers who breach the law, or their fiduciary responsibilities to the companies they represent, can be held personally liable for causal loss or damages, and this personal liability can in fact be unlimited.
Time and Effort!
The annual financial statements’ Remuneration Report of most companies’ states that NED’s are appropriately and fairly compensated for the time and effort required to fulfil their obligations. The definition of “effort” however can be subjective and is often attributed to performance, whereas “time” is a quantifiable element which can be measured.
In our experience working with small-cap companies, the number of formal and sub-committee meetings recorded within a specific peer group (identified for remuneration purposes), can vary significantly. Despite this disparity, the total fees paid to the NED’s within this peer group are in many instances uniform.
How can this be if NED’s are being remunerated for their time as stated in the Remuneration Report?
Quite simply, they are not, and it does not take a remuneration specialist to know that something is amiss in the way these fees are calculated. Companies advocate that they pay for time, however there is a tenuous link with the actual time the NED affords to the company versus the fees received for discharging his/her duties.
What do we know?
Many small cap NED’s will testify that not all the time they dedicate to companies they serve are formally recorded. The risk of delayed or incorrect advice can impact upon a small cap company’s solvency and sustainability. As such, time attributed to travel, late night calls, urgent emails demanding immediate action and the like, remains un-documented. Whilst these activities are critical for a NED to perform the required obligations to the company, the time aspect can be difficult to quantify, highlighting the misalignment of pay and actual time expended.
What does this mean?
The process many small cap companies use for calculating NED fees needs to be reviewed. It is unfair to the incumbent and contradicts good governance principles of remunerating “fairly and responsibly”. In some cases, the process may also represent a departure from the company’s remuneration policy.
Consider this; process and outcome are the substance of an equitable pay structure. ‘Process’ outlines how remuneration is determined and ‘outcome’ is the result of this process. If the process lacks transparency or credibility, then the outcome cannot be deemed as fair.
“Fair and responsible” remuneration is critical to the process and outcome. An objective remuneration process should be reflected in the company’s remuneration policies that serve to guide its actions and decisions. Establishing sufficient and reasonable remuneration amounts can only be achieved through fair and responsible remuneration processes.
In summary, if the remuneration process is not “fair and responsible” then the outcome achieved cannot represent “sufficient and reasonable” remuneration for NEDs.
Where’s the ‘Silver Bullet’?
It is encumbered upon NED’s to understand the company’s short to medium term challenges and what is required to manage them effectively. Allowances for unexpected events, should be considered in any planning process, and is an implicit part of the NED role. The planning process demands a strong understanding of the business. This knowledge, in conjunction with extensive business experience should allow the NEDs to reasonably calculate the time that may be required to perform their duties. As the basis of any effective workforce planning process, this principle should also be applied to small-cap boards more methodically.
Does this means we should pay NED’s by the hour?
No. If we bluntly apply the principle of ‘time’ in setting NED pay, the result may lead to NEDs devoting excessive and/or unreasonable hours to the business. There must be ‘checks and balances’ to stop this from occurring.
BDO Approach
BDO have an approach that calculates an annual fixed fee cognisance of the ‘individual’, ‘role’, ‘company’ and ‘market’:
- The individual’s reputation, track record, experience, expertise, industry understanding and network reach;
- The role which is to be performed by the individual i.e. main board chairperson, committee chairperson, committee member etc.
- The company’s dynamics i.e. size, complexity, competitors, ‘footprint’ etc.
- The market which is represented by a valid and reliable peer group.
As part of our process, we are able to:
- Determine what is ‘reasonable time’ for a NED to perform their duties based on the size and stage of the company’s development; and,
- The time the client company believes it will take to discharge their duties.
In some instances, there can be a marked difference in time between what is required by the NED’s of the client business as compared to our benchmarked model results. In this instance, the company would need to ask a number of questions, including;
- Is this amount of time required by the business from its NED’s?
- Is their workload and our expectations unreasonable?
- Why does the incumbent believe so much time is required for these duties?
- What is he/she spending time on – are these board issues? Are they reflected in their role descriptors?
- Do we have the right operational management and leadership team in place?
Once the aforementioned factors have been considered, we apply our BDO methodology, in addition to input from the company’s board, to determine a total fixed annual fee.
Seems Complicated?
It’s robust. If you wish to embed a fair and transparent pay structure which is credible and can be defended, then you must be willing to accept some complexity. The alternative is to ignore what is fair and reasonable, and adopt a “one size fits all” NED pay approach. Some companies may choose to do so, however this can lead to less than favourable results as it fails to support the company’s unique circumstances and critical requirements from their NED’s.
Proxy groups and institutional investors are not averse to a company paying seemingly ‘top dollar’ for their NED’s if the rationale and reasoning for doing so has been considered, is defensible and can be substantiated. Small-cap company NEDs are entitled to be fully and fairly compensated for the time, effort and expertise they bring to a company because it makes good business sense to do so. If affordability or other constraints limit a company’s ability to remunerate appropriately, the board must be made aware so that they can effectively manage this risk with the resources available and to the best of their ability.
Conclusion
A well-paid, alert and competent board is the cheapest form of insurance and most effective comfort for investors. It is not only fair, but makes commercial sense to adopt policies that deliver ‘fair pay for a fair day’s work’ – this includes NED’s!