Welcome to Guerdon Associates’ September newsletter. This month's highlights include a review of the issues associated with share ownership requirements; problems we have observed in companies complying with disclosures on how they are valuing equity plans and the latest on accessing executive and director remuneration details online.

What Price Ownership? Issues With Executive Share Ownership Requirements.

Most respected governance bodies in Australia do not prescribe shareholding requirements for executives in the companies they run, in contrast to similar bodies in the UK and the USA.

On balance, this is a good thing, as we will conclude at the end of this article.

In the UK, the Combined Code states that it is desirable that executives hold shares after vesting or option exercise for at least 12 months. Several US governance bodies recommend that executives own company shares. For example, the NACD Blue Ribbon Report On Executive Compensation And The Role Of the Compensation Committee (available at http://www.nacdonline.org/publications/pubDetails.asp?pubID=223&user=4DCA3F5E24714AC98C0851DB6DA89B3F) recommends that companies require executives to buy or own shares and create disincentives to selling them. However, the report cautioned that “commitment, not dependency, is the goal” and that committees should avoid requiring executives to have too much of their net worth tied to company shares.

The US Business Roundtable’s Executive Compensation: Principles and Commentary (available at http://www.businessroundtable.org/publications/publication.aspx?qs=2806BF807822B0F13D142) recommended that executives also acquire and hold a “meaningful” amount of shares. In addition, it suggested that they acquire some of this holding through part of their incentive based awards.

Partly as a result of these governance requirements, the number of US companies requiring senior executives to hold shares in their companies continues to increase, although holding guidelines remain fairly constant, with median CEO holding requirements at a little over 5 times salary for the 82% of public S&P 500 companies that have holding requirements.

Outside of the financial services sector, Australian companies, in contrast, rarely have executive shareholding requirements.

Should Australian companies change? What is the effect of these holding requirements?

On the whole, these holding requirements would encourage a tendency to be more risk averse. The extent would depend largely on the two primary factors of share volatility and the proportion of personal wealth tied to company ownership. The breadth to which these factors range in the real world requires remuneration committees to question in more depth recommendations for adopting a policy of median practice.

For example, care should be taken if shares are highly volatile, and the company has very high revenue and earnings growth potential. That is, it may be unwise to encourage the CEO of, say, a high potential technology company to be more risk averse through shareholding requirements when shareholders expect entrepreneurship. It may also be difficult to attract a capable CEO required to have a significant proportion of his/her personal wealth locked into a relatively risky investment. In this case it may be not only fairer but also prudent to define holding requirements as a proportion of profits on option or SAR exercises, rather than as a multiple of salary. With adequate analysis, the executive’s holding requirements could be adjusted to the likely maturity curve of the company’s shares over time.

The converse also applies. A mature company with low volatility and slow revenue growth prospects may consider establishing executive ownership requirements substantially higher than median standards. Typically, such companies may seek higher dividend strategies to deliver improved shareholder returns. These may be sought through better operational earnings and prudent acquisitions with resultant cost savings. A high ownership requirement will help focus these executives on delivering better shareholder value.

So, on the whole, Australia is fortunate that the main governance guidelines do not prescribe executive share ownership because the effectiveness of such a requirement would vary with company capital and business strategies.

Disclosure and Compliance Issues: What Option Plan?

This is the second in a series of issues raised from our continuous review of public company disclosures.

Almost 80% of the ASX 300 companies have in place an existing employee or executive share option plan. In the annual financial reports so far published since June 30 2004, all the companies with an executive option plan have disclosed the annualised fair value in executive remuneration tables more or less in accord with the Australian Accounting Standards Board (AASB) 1046 standard. But most of these companies have not specified the details for valuing employee equity compensation. The valuation method details are required to be disclosed as part of Australian's adoption of international accounting standards (in particular, IFRS 2) from January 1 of this year. From this point, at a minimum, companies are required to disclose the following inputs into and outcomes from employee share option valuation for each option plan still in existence:

• Estimated fair value of each share option granted;
• Method used to estimate fair value (e.g. a binomial option pricing model);
• Model input value of the share price at grant date;
• Grant date;
• Model input value of the exercise price;
• Model input value of the expected volatility and how this volatility was determined;
• Model input value of the expected dividends;
• Model input value of the contractual life of the option;
• Model input value of the risk-free interest;
• Model input value of the early exercise assumptions; and
• Model input value of the share price volatility and its basis.

If the option valuation model was a complex lattice model using more variables, then more model inputs may need to be disclosed.

Companies have, so far, tended to state the method used, but we have been surprised at the proportion of companies that fail to disclose the values of all material variables.

Guerdon Associates readily acknowledges there is currently a very limited knowledge and skill base in Australia for option valuation. Given the liability issues, directors on the audit and compensation committees probably need to take affirmative action to verify that their company comlies with these new standards.

GuerdonData™ Goes Online!

At last, Australia has a database of executive and director remuneration disclosures.

GuerdonData™ is now online. But access is restricted, at the moment, to subscribers who pay for access on an annual basis. Annual subscribers receive discounts. We are currently considering allowing the database to be accessible to ad hoc users later in the 2005-2006 financial year.

Subscription enquiries can be made to info@www.guerdonassociates.com.

Latest GuerdonData™ Updates

Do you recognise any of these ASX codes?

ALS, AIX, AMC, API, ASX, BBG, BDG, BOL, BSL, CGF, CNP, DRT, EXL, FMG, GSA, HSP, LLC, MCG, MGR, MTS, PPT, RCD, SGP, UGL, UTB, WAN, WOR

The peak of the reporting season is upon us, and these companies were the first to report results for the June 30 financial year. Guerdon Associates updated their data on our GuerdonData™ executive and director remuneration database within hours of their results being published. Further executive and director remuneration data will be added as fast as ASX 300 companies can disclose it. Look out for the majority of ASX 300 remuneration disclosures over the next 2 months appearing on GuerdonData™.

Executive and director remuneration data from all ASX 300 companies on GuerdonData™ is available to any subscriber. More information on GuerdonData™ can be found by clicking on the More Info button below.

Guerdon Associates in the News

McNicoll, D 2005, ‘Paying price for lack of bonuses’, The Australian, 5 August.

Rolfe, J 2005, ’Incentive to perform’, The Daily Telegraph, 6 August, pg 95.

Rolfe, J 2005, ‘Lowy has the most money on the line’, The Daily Telegraph, 6 August, pg 95.

Disclaimer

The information, analysis and opinion in this e-mail and attachments are intended to be for informational purposes only. Analyses are based on information taken from public documents or private surveys, and we do not represent to its accuracy. Guerdon Associates assumes no liability for the use or interpretation of information contained herein. This publication is provided "as is" without warranty of any kind, either expressed or implied, including, but not limited to, the implied warranties of marketability, fitness for a particular purpose, or non-infringement of third party rights.