The AICD has a go at fixing remuneration report complexity
23/06/2010
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On 5 June the Australian Institute of Company Directors (AICD) released a position paper on company remuneration reporting. 

The AICD does not release position papers very often (this one is number 15), so when it does it is a big deal, given that the AICD represents the views of company directors.  Its release is also timely, given that CAMAC has been given the brief by the government in May to recommend ways to simplify remuneration reports (see HERE).  The AICD is recommending some quite fundamental changes to how remuneration is reported.

This article provides a brief summary of the AICD’s paper, and suggests areas that may need some hard thinking before progressing too far down a reform track in an era where companies and their shareholders are suffering from perhaps too much regulatory “stimulus”.

A summary of the AICD paper

The AICD supports a principles based remuneration report that overviews the company’s remuneration arrangements for key senior personnel, in four broad areas:

1. The governance structures in place for determining the remuneration of key senior personnel;

2.  The company’s remuneration philosophy and policies for key senior personnel;

3.The remuneration outcomes for key senior personnel in the reporting period (i.e. the remuneration received by the key senior personnel in the current year in “actual pay” terms);

4.   The current entitlements of key senior personnel to future remuneration. 

The most significant aspect appears to be that the remuneration report should be framed in “actual pay” terms only.

The AICD does not support:

·    A black letter law requirement for Remuneration Reports to be in “plain English”, or a mandated “plain English summary”; or

·    An increase in the number of detailed prescriptive requirements in addition to those that currently exist.

 

Specifically, actual pay should be reported in the categories of:

·    Fixed remuneration;

·    Cash bonuses, realisable equity;

·    Termination benefits;

·    Post employment benefits; and

·    Other benefits.

But the AICD does not stop there.  It also suggests that current entitlements to future remuneration be disclosed, including:

·    Future short term bonuses and their conditions;

·    Future long term bonuses and their conditions;

·    Termination payment arrangements;

·    Post employment benefits; and

·    Time remaining in service contracts.

The AICD recommends an exemption to allow directors not to report the performance conditions for performance contingent payments if they may materially prejudice the company’s operations (similar to Section 299A(3) under the Corporations Act).

Guerdon Associates’ comments

The input from the AICD is a welcome addition to the debate, and timely, given CAMAC’s requirements to report to the government on executive pay reporting.  It is also a response to the many issues associated with current requirements pointed out during the Productivity Commission inquiry into executive pay (see HERE)

While much of the recommendations is related to a re-emphasis of items that currently feature in remuneration reports, we particularly support the requirements to report actual remuneration, and describe the governance processes applied to arrive at an equitable remuneration policy.  These aspects are new, notwithstanding that several companies currently and routinely report these.

The AICD also took a bold step, not taken by many others, in saying what should not be reported.  This must be done in order to slim down the compliance burden.  Among these was its suggestion that the accounting standards revert to the basic requirements of IAS 24, something we have long advocated. 

The AICD also suggests that the audit requirement of the directors’ report be omitted, given that this causes unnecessary duplication of effort as lawyers advise on remuneration report content.  We do not know quite where to start with this suggestion.  Firstly, the current requirements of 300A, while convoluted, are not rocket science.  A simple checklist is what most preparers need to see that their remuneration report complies.  Lawyers are unnecessary.  In fact, as more than one director has said to us, lawyers should not be involved if remuneration reports are to be simplified!

Secondly, most auditors are not doing their job anyway.  Well over 80% of remuneration reports fail to comply, according to our latest research.  We seriously wonder what other aspects of company disclosures that are audited have issues.

The AICD sensibly suggests that there be an allowance for not reporting the details of performance conditions if this prejudices the company.  This currently does not apply to remuneration reports.  Despite this, and to support our prior point, companies do not tend to report the detail of performance conditions in any case, and neither auditors nor the corporate cop (ASIC) enforce this.  So, while we support the AICD suggestion, what is lacking is decent enforcement to ensure that these matters are reported if there is no material harm to shareholders.  The US SEC embarked upon enforcement actions on a similar basis in 2007 and 2008 with excellent results for transparency as well as compliance.  Numerous submissions to the Productivity Commission, including ours, noted the absence on enforcement in Australia.

However, we suggest that some AICD suggestions be approached with caution.  Firstly, the AICD suggests that “actual” remuneration be reported.  This is the realisable value of remuneration that vests.  For equity, this is the net gain before tax of the market value of equity less any exercise price.  Hence any options that are underwater would not have an “actual value”.  Pity that the Australian Tax Office (ATO) does not share this view, as it would deem in most instances that underwater options have a value at vesting for taxation purposes (see HERE for example).  In addition, underwater options can be hedged, and we have not yet encountered a company that prohibits hedging of underwater options after vesting.  So an executive can still realise value from underwater options. It may be for this reason that the Australian Productivity Commission suggested that taxable value was an appropriate method to define “actual pay” for reporting purposes.

We note that the AICD proposes that this actual pay be further broken down for reporting purposes. Specifically, actual pay should be reported in the categories of fixed remuneration, cash bonuses, realisable equity, termination benefits, post employment benefits, and other benefits.

Unfortunately, the breakdowns and reporting method suggested by the AICD bear no relation to how companies actually manage pay.  This makes it difficult for shareholders to decide how competent directors are in managing pay for the purposes of the remuneration report vote.

Companies manage pay in terms of fixed, STI and LTI.  Most ASX300 companies allocate LTI on the basis of expected value.

Neither the AICD approach, nor the current approach in the Corporations Act, require this type of reporting.  Yet if companies are to describe their philosophy and policy in these terms, will they have to volunteer another set of figures to layer on top to illustrate how they apply their policy?  This would make remuneration reports even more confusing.

We have thought long and hard about this, and suggest that with “actual” pay as suggested by the AICD there is no prescriptive method through which a further breakdown can enlighten shareholders, unless this prescription takes the breakdown down several more layers.  For example, realised value of equity could be attributable to equity that was granted 4 years prior, 2 years prior and 18 months prior for different service and performance conditions.  For shareholder voting purposes, the directors who signed off on the remuneration report may not have been around when some of the precursors to this actual pay outcome were established. 

To prescribe a breakdown to one lump value of “equity” would not be particularly transparent or helpful.  Either go the whole hog, or just report one top line figure for all remuneration, irrespective of payment vehicle.  Given the AICD favours principle based rather than black letter prescription, the simple top line figure should suffice.  That is, “actual” pay received during the fiscal period was $x.  Under the principle based regulation, a company is compelled to explain this in terms that shareholders should be able to understand. 

Then the AICD suggests that future entitlements be reported and broken down. But they suggest that the breakdown of equity based remuneration need not incorporate probability based accounting valuation.

Somehow, it seems we are getting to a level of regulation that is not only as comprehensive as the regulation it replaces, but also bears no relation to the financial expense incurred by the company, or to the way the company manages pay.

Recognising the different facets, Guerdon Associates tried its hand at drafting new reporting regulations, in association with Allens Arthur Robinson, Regnan and CGI Glass Lewis (see HERE).  The result was submitted to the Productivity Commission.  It was during this process that we realised just how difficult it was to ensure simple, concise and relevant remuneration reports.

 

The AICD has made valuable points which should be incorporated into CAMAC outcomes.  But we need to tread carefully to avoid yet another regulatory quagmire. 

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