Trying to simplify executive remuneration disclosure is unlikely to be successful.
THIS submission has been structured to consider a number of the common complaints directed against remuneration reports apparent from submissions to the Productivity Commission and other public commentary. These responses have been written on the basis of our company’s detailed review of more than 1,300 remuneration reports at S&P/ASX 300 entities since the introduction of the remuneration report for reporting periods ending on or after June 30 2005.
In its final report the Productivity Commission notes the views of participants in its inquiry that remuneration reports are overly long and complex. The views of participants cited by the commission were largely those of the management of listed companies.
From ISS Governance’s experience of reading remuneration reports prepared by large Australian companies, report complexity is driven by company approaches to disclosure and remuneration rather than disclosure requirements, with the exception of share-based payment disclosures.
Many remuneration schemes now adopted by Australian companies have considerable complexity in terms of the measures against which executive performance is assessed and describing these schemes in a simple fashion is difficult.
It is clear from submissions to various reviews of executive pay legislation and practice in Australia that there is little support for firm rules on how companies should pay their executives.
Despite the length of remuneration reports, there is widespread non-compliance with the existing disclosure requirements. The length of reports is driven in part due to the complexity of company remuneration practice and also by the widespread use by many companies of ‘boilerplate’ disclosure. It is apparent from reading hundreds of reports that many companies follow similar templates, often with identical or near-identical wording. From discussions with listed companies and their advisers it appears these templates are provided by professional advisers such as law firms.
This boilerplate discussion, often used for remuneration policy or how fixed pay levels are set, is of minimal use to shareholders and simply adds to the length of reports without providing information. Anecdotal evidence suggests, however, that over the past two years more listed companies are seeking to take ‘ownership’ of their remuneration disclosures and are discarding templates.
Remuneration consulting firm Guerdon Associates has estimated that less than 20 per cent of ASX 300 listed companies comply with the Corporations Act requirement for listed companies to provide a ‘detailed summary’ of the performance conditions attached to senior executive bonuses, and ISS, from its review of remuneration disclosures, estimates similar levels of non-compliance.
Another area of frequent non-compliance is entitlements on termination under service contracts disclosed under s. 300A(1)(e)(vii) of the Corporations Act. ISS notes companies in disclosing termination payments made to senior executives routinely note that benefits were provided in accordance with contractual terms without these entitlements having been disclosed in prior remuneration reports.
In a recent example, Downer EDI disclosed that its departing CEO Geoff Knox had received 243,013 unvested shares on departure as part of his employment contract. Disclosures provided in the 2008 and 2009 remuneration reports on his termination entitlements were silent on any entitlement to unvested equity incentives.
ISS acknowledges, however, that certain aspects of the formal disclosure regime provide minimal information to shareholders and should be abandoned or modified.
Much of the commentary on the problems of remuneration disclosure, including through submissions to the Productivity Commission inquiry, has focused on the disclosed value of share-based payments.
It is notable that this criticism has arisen since the onset of the credit crisis at the beginning of 2008 and has grown during a period in which the disclosed fair value of equity incentives has routinely overstated the value received by executives. There was minimal criticism of the current share-based payments disclosure requirements prior to the sharp downturn in equity markets at the start of the credit crisis.
This may have been because disclosure regimes based around the grant date fair value of equity incentives amortised over the vesting period often significantly understated executive pay during bull markets because the fair value estimates of equity incentives granted are typically significantly lower than the realised vested value of such incentives during periods of high share prices.
Even during bear markets, the disclosed fair value of equity incentives is often substantially lower than the derived value.
It is clear that the estimated fair value of equity incentives granted to senior executives and disclosed in remuneration reports invariably is either much higher or much lower than the actual value received by the executive. This is in part a function of the difficulties in valuing equity-based incentives,
ISS does not consider that remuneration valuation and disclosure requirements should be driven by short-term considerations from issuers concerned at over-reporting of remuneration when such concern has been absent during periods when remuneration disclosures have consistently under-reported actual pay.
Remuneration disclosures and financial reports generally should also not be driven by the ‘lowest common denominator’. There is no obstacle to listed companies providing so-called ‘shareholder friendly’ concise reports, including simplified remuneration disclosures, in addition to statutory reporting.
There is also no obstacle to listed companies providing both realised (ie. cash pay and the value of equity incentives actually vested) and statutory remuneration disclosures, as many have done over the past two years (usually in cases where realised remuneration is lower than statutory remuneration).
There are, however, several aspects of the current valuation and disclosure regime for share-based payments under Australian International Financial Reporting Standards that could be improved.
Companies are also not required to disclose the extent of any discount they apply to equity incentives to take account of the probability of vesting, while other assumptions used in assessing fair value are disclosed.
There does not appear to be any compelling reason why the discount applied in determining the fair value should not be disclosed to shareholders, especially if fair values are used to determine the number of equity incentives granted to executives.
In summary, ISS recognises there is room for relatively minor modifications to existing law but changes designed to substantially simplify remuneration disclosures are unlikely to be successful unless they materially reduce the quality and quantity of information disclosed to investors. This is unlikely to improve the ability of investors to determine whether remuneration policies and outcomes are aligned with their interests.
• Martin Lawrence is head of the Australian operations of ISS Governance, the world’s largest governance advisory body. This is an extract from its submission to CAMAC’s inquiry into executive remuneration disclosure.