Being on the remuneration committee has its challenges.
While it can be subject to the whim (and at times whimsy) of changing fashions (see our article on remuneration fads and fashions HERE), it can also be intellectually stimulating absorbing for applying new knowledge and methods to get the most out of complex human systems.
There has been a lot to learn from events in 2019. Surprisingly, some problems companies encountered and uncovered by investors did not make it to the broad based media.
For those boards seeking improved performance, and/or avoid a strike in 2020, we have provided a remuneration committee checklist.
If there is to be a key focus for remuneration committees in 2020, “consequence management” would be it.
There have been multiple cases of poor behaviour, omissions, or lack of oversight, that have caused material damage and loss in shareholder value.
In many instances, poor behaviour recurred, and was not checked. Boards failed to exercise discretion to limit, forfeit and clawback remuneration. Consequences failed to materialise.
This has been noticed by regulators, proxy advisers, investors, news media, the man in the street, and, alas, politicians.
Some companies have already moved to remove the uncertainty associated with the application of discretion with structured, well considered, consequence management systems. Most have not.
(a) Review the circumstances in which malus is to apply. Most ASX 200 companies limit it to financial misstatement, which is rarely applicable to any ASX listed company
(b) With the audit and risk committees, insist on an effective process that identifies and elevates incidents through to the remco with individual accountability maps attached. Decide on a structured process that determines the consequences, such that discretion only be needed not to apply consequences, rather than the other way around.
Relationship with the risk committee for annual malus review
Consequence management cannot be effectively undertaken without risk committee input. Most companies rely on “cross-pollination”, where directors who sit on both committees inform the remuneration committees of any relevant matters. Consider formalising the relationship and have the risk committee refer matters to the remuneration committee as a regular feature that has room on the meeting agenda. Create agenda items to consider if any deferred remuneration should be forfeited. In the great majority of cases forfeiture would not occur. But the world has changed to an extent that remuneration committees should formally consider it as part of the governance process.
Identify the process the remco uses to collect, review, assess and action risk management issues.
The picture painted in the remuneration report is ideally a reflection of thoughtful board processes that follow governance principles. Where the remuneration outcomes do not match the business reality or reflect the shareholder experience, the drafters of the remuneration report may be faced with the task of “putting lipstick on a pig”.
Investors and proxy advisors will always ask for more clarity rather than less. Obfuscation can only go so far in disclosures – remuneration committees will do well to think about a sound reasoning behind the headline decisions taken and how that will be communicated.
Proxy advisers, in particular, are now well practised at looking through the obfuscation and will respond accordingly.
When making those remuneration decisions, ask yourself are you equally happy to explain the rationale in the remuneration report. If not, have another think about the remuneration decision.
Remuneration effectiveness reviews
Though still only proposed, and though only strictly applying to the financial services industry, CPS 511 (see HERE) will ultimately impact all industries.
Key areas of focus in the proposed CPS 511 are longer deferral periods and clawback. These may not be appropriate for all companies.
However, one requirement that is relevant to all boards, no matter the industry, is for a review of the effectiveness of the remuneration policy framework by “operationally independent, appropriately experienced and competent persons at least every three years”.
Only a few financial services companies have undertaken remuneration effectiveness reviews. Still fewer have been undertaken in companies in other sectors. Yet they have been remarkable in providing factual, statistical insight into what works and what does not.
Ask if remuneration framework is actually delivering the intended outcome. Require evidence. Undertake an independent effectiveness review at least every 3 years.
While it seems unlikely that APRA’s CPS 511 restrictions on financial measures will be implemented in their current form, the proposal is the culmination of a series of inquiries and reviews highlighting risks stemming from non-financial performance failures and regulators’ desire that remuneration not solely be based on financial considerations.
The issues most investors have with non-financial measures are that:
1 . They can pay out even when the company’s financials are poor, and shareholders are not seeing a return on their investment .
2 . They are often described with words such as “soft” or “personal”, because they are difficult to measure and justify.
Where non-financial measures are a modifier or a gateway rather than applied to a proportion of variable remuneration, the first point is moot, since incentives are only paid if financial measures are met.
The most difficult point to challenge is the second. Therefore, a key board action for 2020 might be to investigate the board’s risk appetite statement and consider and test non-financial measures so that they remain on the radar. They need not be used directly in determining remuneration at this stage.
Consider the non-financial measures that are critical to the company’s sustainability, the extent to which they can be measured and whether they should be reflected in remuneration. If viable, consider testing the measure, subject to review in the next financial year for remuneration purposes.
Climate change risk is required to be considered by directors with exposure to these risks. All ASX 100 companies with this exposure are now being targeted by activists. Activist resolutions on climate change and related matters are being supported by a growing proportion of institutional investors.
In association with the audit and risk committee, consider exposure to climate change related risks. Consider the extent that reliable and valid measures can be defined, data collected in a timely and useful way, and applied. Does it make sense to reflect directly in the remuneration framework, or are these risks adequately reflected in executive equity plan values?
Alternative remuneration frameworks
The Australian listed-company landscape is now littered with former alternative remuneration structures, hastily replaced following shareholder protest.
Much of the investor response has been appropriate, as the alternatives did not appear suited to reflect the nature of the company’s business, or its longer-term strategy.
Ironically, US and UK investment bodies have intensified their support for remuneration frameworks that do not conform to the traditional Fixed Remuneration, Short Term Incentive, Long Term Incentive framework (see HERE and HERE) . If boards are considering such frameworks in 2020, the question of whether such frameworks reflect the nature of the company’s business, or its longer term strategy is key.
Does the current remuneration framework suit the nature of the business and its longer-term strategy? Backward test the alternatives. Is an alternative framework better? How well do you understand your investors and their expectations? If an alternative framework is a better fit for purpose, have you worked up the engagement strategy for supportive investors?
The Royal Commission
Following many companies’ hurried responses to the Hayne Royal Commission report (see HERE), 2020 is likely to be a year of digestion and more action.
ASIC will publish it report on larger company remuneration governance early in 2020. Banks will consider whether their actions have been enough after this year’s investor feedback, and new APRA regulation with effect from 1 July 2020. Non-financial services companies will be wondering if they are next, either in terms of regulation or better ASIC enforcement of existing regulation.
Plan to implement your own self-assessment in response to ASIC’s forthcoming report. Seek management and independent advice.
Many ASX companies are likely to become “performance challenged” in a year of low economic growth. Investor scrutiny intensifies in such times as they have been feeling the pain. At the same time, management is typically pedalling harder to improve performance in a tough market.
Criticism is directed at boards exercising discretion to be fair when the first stop should be reference to a clear definition of the performance measure(s) the subject of the discretion being exercised, and the performance ranges to be applied.
If managements’ grants of relative TSR LTI “almost” vest but not quite, the remuneration committee needs to have a clear understanding of the rules that dictate vesting (see HERE) . How is your comparator group defined, and adjusted for changes? How are dividends taken into account? Do you apply a period of smoothing? What about new entrants or exits from indices or peer groups? What about financial performance measures, what adjustments are above the line or below the line and why?
Consider the definitions of the STI and LTI performance measures – how clear and unambiguous are they?© Guerdon Associates 2021 Back to all articles