Late last week, on Thursday 26 February 2009, the UK Financial Services Authority released its “Code of practice on remuneration policies”. Despite its origins (i.e the UK) and its focus (i.e. financial services providers), this is important for all Australian listed companies.

The FSA guidelines are the first guidelines published reflecting the views likely to be pushed by all the regulators of financial services providers globally, including Australia. (In fact, APRA is a participant in the working group set up under the G20 Action Plan dealing with executive remuneration, with which the FSA guidelines will comply). And while they will apply to financial services providers initially, we expect that it will not be long before the guidelines are universally referred to by proxy advisers, governance groups and institutional investors for all listed companies (including companies that are not capital intensive, and to which many of the guidelines are actually ill-suited).

This article summarises the Code, considers whether this is reasonable for most situations, and provides a checklist for companies and their remuneration committees to critically assess the extent of compliance.

The FSA guidelines can be found HERE.

What is evident in the FSA Code and, confirmed in a speech given by APRA head, Dr. John Laker last Thursday 26 February 2009 (see HERE), is that board remuneration committees will need to be engaged in remuneration framework and policy setting for employees below the top management team. APRA’s Dr. Laker said:

“… boards should extend their stewardship of remuneration matters to all groups of personnel whose performance and activities can materially affect the institution’s overall performance. Generally, the relevant groups would include the senior executives of the institution, risk management staff, commissioned sales employees and agents, and traders and other operators where incentive remuneration can be material. The larger and more complex the institution, the more the board will need to consider remuneration arrangements beyond the senior executive group.“

The Code requires that companies not overemphasise remuneration comparisons with other, presumably similarly sized, companies. Rather, boards should primarily take into account their own financial situation, then make a comparison to others.

In effect, this opens a Pandora’s box of possibilities. For example, the small banker can make as much as the big banker if total pay was based on a percentage of risk adjusted profit, irrespective of market capitalisation and job complexity. This one aspect of the new Code turns on its head a decades old basis of remuneration setting.

The Code also requires companies to base their bonus incentive payment plans on risk-adjusted profit, such as “economic profit” (EP). Put simply, economic profit is cash earnings (such as EBITDA) less a charge for the cost of capital. The cost of capital is comprised of the weighted long term average cost of debt and equity.

The problem with this approach, apart from its complexity (when you get into the nuts and bolts of it), is that the cost of these elements is determined by reference to the market. In the years leading up to the credit crunch the market grossly underestimated risk, and debt was so cheap given the money pumped into the global system by Dr. Greenspan (the US Federal Reserve Board head for most of the 90s and 2000s) that poorly regulated overseas banks already using economic profit as a key performance measure leveraged up and got the world into trouble. Hence extensive use of this method may exacerbate a credit crunch.

The key message to capital-intensive companies considering this approach is for their boards not to be lulled into a false sense of security because you think you have priced risk appropriately into your financial profit measures.

Another key consideration is that there are several simpler measures of profit in relation to capital that take into account risk than the economic profit method cited. Simplicity is a key requirement for executive and board comprehension and acceptance, excutive motivation and board control.

To an extent this could be balanced by the Code’s requirements that boards take into account non-financial performance metrics to over-ride the financial metric outcomes. Again, this opens up a Pandora’s box of possibilities. However, in the Australian Corporations Act 300A requirements, companies are required to disclose whether they can apply discretion to amend pay outcomes otherwise determined by financial (and other) measures. It is likely this key aspect of pay regulation will remain in the government’s review (see HERE).

Another key aspect of the Code is the heightened role the risk management function has in advising the board on the remuneration framework, and the need to ensure that these employees in the company are not remunerated on the same basis as others in the company to avoid conflicts of interest.

Surprisingly, if somewhat belatedly, the Code recognises that long term TSR and EPS growth measures can induce excessive risk taking: something that Guerdon Associates has been noting repeatedly to our clients and in our newsletters over the years. While Guerdon Associates has developed various ways to ensure these methods can still be applied validly on either a risk-adjusted approach, or in ways that do not encourage excessive risk, the Code does not offer alternatives.

The Code also requires fixed pay to be high enough to allow variable pay to be reduced in hard times. That is, the company’s employees will not experience too much of a sag in their hip pocket when shareholders are doing it tough.

Well, pardon us, but isn’t one idea behind variable pay to make the company cost base more able to cope with bad times? The fact that some poorly disciplined, weakly supervised banks receiving government bail out money continued to pay high bonuses is more a function of poor governance, weak boards under an imperious CEO, and the tolerance of moral hazard in remuneration structures with upside and no downside. We suggest that his aspect of the Code needs review.

One aspect of the Code that sounds good in practice, but impractical in execution, is the requirement that two thirds of bonuses be deferred, and presumably contingent on sustainable performance. The impracticality is associated with the growing propensity for employees (think of gen Y) to take their labour elsewhere. The deferred bonus is already widely applied in Australia at executive and, in financial services, at lower levels. The prospective employer simply re-offers it to make the employee’s package “whole” (i.e. equivalent to the prior employer’s), and usually only requires a service condition to be met before paying it out. If anything, this provision of the Code will encourage turnover and risk.

In addition, Australia’s current tax system requires any deferred pay to be taxed on termination (something that we are asking the Henry tax review to re-consider), so there is nothing to encourage even retiring CEOs to behave nicely and do the right thing for the longer term.

The Code requires that companies take into account where the company is in the economic cycle in assessing performance. Presumably that means the company that loses the least shareholder value and profit in a bear economy gets the biggest bonus. While Guerdon Associates does not have a problem with this, it will not do much to quell the media outrage in tough times.

Notwithstanding the reservations above, here is the checklist based purely on the Code as it stands now:

1. Boards and relevant remuneration committees should have the skills to exercise independent judgment on remuneration matters, including on matters of risk and risk management.
2. The procedures for setting remuneration should be clearly documented.
3. The procedures for setting remuneration should be free of conflicts of interest.
4. The primary factor in setting remuneration is the financial condition of the company, with competitive remuneration relative to a peer group of comparable companies secondary.
5. Staff should not be engaged in processes that set their own remuneration.
6. Control functions, including risk management, should be independent enough to assess the extent that risk adjustment has been factored into data used by the remuneration committee.
7. Risk and compliance staff should have performance metrics that differ from the metrics applicable to other staff on which they need to render an opinion.
8. Bonus pools should be based on profits that take into account the cost of capital employed and the liquidity of the company to meet its ongoing commitments.
9. Companies should not assess performance for remuneration purposes solely on the basis of the current financial year. Longer term performance must be considered, as well as an assessment of where the company is in the economic cycle.
10. Discretion will be applied in accord with an assessment of non-financial metrics if these indicate that reward otherwise determined from financial outcomes alone is inappropriate.
11. Long term incentive plans based in some way on the performance of shares be risk adjusted.
12. The fixed component of remuneration is sufficiently high that the company’s bonus policy can operate with full flexibility.
13. The majority of the annual bonus is deferred.
14. The deferred element of a bonus should be linked to the performance of the business division or the company as a whole.

The FSA will consult on the code and further proposals for remuneration policy in March. Australia’s APRA has said that it will release its version in the first half of 2009. We are hopeful that more details will be released at the Remuneration Forum on 16 March 2009 (see HERE).

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