The outlook and issues for Australian director and executive pay and board effectiveness in 2015
14/01/2015
mail.png

This article dusts off our crystal ball and presents our outlook for director and executive pay, and also for board effectiveness, for 2015.

Conditions have changed, and directors need to be aware of the issues likely to arise based on the factors considered below.

Boards need to keep an eye on executive incentive targets as companies gear up

Below trend economic growth, low interest rates, healthy balance sheets and, for a large proportion of ASX listed companies, long-term incentives contingent on EPS growth will all encourage mergers and acquisitions. Particularly for middle-sized and smaller ASX listed companies where market consolidation opportunities exist, executives will seek to leverage up their companies to achieve consolidation in their markets, and to nail otherwise elusive EPS growth targets.

Larger companies may not have such opportunities, but their stock may be good value given longer-term prospects. The ready availability of cheap money may see larger companies buying back stock, which will make achievement of EPS and TSR targets easier than when they were initially set.

While these strategies in these market conditions are probably appropriate, boards should probably review the EPS targets they have set as they approve increased gearing levels. While TSR should, over time, readjust for higher gearing, capital management intiatives will elevate stock prices for a time. Again, boards will need to consider the timing and impact of capital management strategies on TSR outcomes that result in high levels of LTI vesting.

Review change in control provisions

In a year that promises heightened company takeover activity it may be circumspect to review change in control provisions. Be particularly wary if equity could vest on the smell of a merger or acquisition. There have been instances of this in the past, whereby a merger or acquisition did not eventually take place (perhaps because of FIRB intervention, or other uncontrollable factors), but equity vested to executives in full. Boards should retain discretion to consider all factors and decide the timing and extent of any vesting in relation to a change in control.

Two strikes, proxy advisers and allowances for variations from the norm

The number of ‘strikes’ against remuneration reports remained subdued in 2014. However, proxy advisers and some investors continue to raise the bar in terms of expectations. There has been a concerning trend, at least with two proxy advisers, to become more prescriptive. That is, recommending, or threatening to recommend, a “no” vote on the remuneration report if a company does not change the way it pays to a form considered appropriate, even if the actual executive pay delivered appears benign. Most times this occurs if a company has an unusual pay framework, such as no LTI, and does not clearly enough explain why it has this framework. In other words, it becomes a “hanging” offence if a company has a non-conforming framework even if the actual pay delivered is modest. A conforming framework with poor disclosure and modest pay outcomes will, on the other hand, probably receive continued support. The message this sends is that all boards need to do to continue to receive proxy adviser support is continue with a banal, and in many instances less than optimal, remuneration framework, rather than try something that could be more effective.

Good disclosure and effective engagement clearly remain the key to proxy adviser and investor support for companies that want to ensure their remuneration framework best suits their circumstances.

IPO companies still need to shore up their executive remuneration

2015 should continue to see a reasonable number of IPOs, although the number will be down on 2014. 2014 saw some improvement in IPO remuneration, but the greed factor was evident in some cases with excessively generous IPO grants, IPO specific bonuses and high executive remuneration – all signs of poor governance and hence investment risk.

Many prospective investors remain disappointed that so many IPO companies missed an opportunity to provide assurance that the management team will stay on to complete the transition to a public company rather than take the money and run as soon as their IPO stock comes out of escrow.

Boards of prospective IPO companies should consider developing and disclosing in the prospectus a remuneration framework that does not leave an incentive gap between stock coming out of escrow and a performance-contingent long-term equity plan. There should be some overlap so that management retains “skin in the game” at all times.

While many IPO companies made sure executives retained some “skin” well past listing date, we still observed many larger ones that are likely to get into trouble with their second or third remuneration report vote.

Start-ups will now be able to rev-up

As well as prospective IPO companies, experienced directors may be excited to join start-up companies seeking their 3rd round of funding on the path to a trade sale or IPO. There may be good grounds for their enthusiasm. While the wave of technology investment in Australia is a good three to five years behind the US, Israel, the UK and Singapore, the lower $A and many geography specific and therefore proven technology opportunities (e.g. taxis, accommodation, and recruitment) mean the chances of catching the wave are promising. In addition, the government has promised new equity plan taxation that should make it easier to attract and retain talent from board director to programmer. The government’s proposal will permit tax deferral until options are exercised (and shares sold if a company is a “start-up”). The deferral period can now be up to 15 years, with the gain subject to capital gains tax rather than regular income tax.

However, as a result established companies may find it even more difficult to attract and retain the directors currently most in demand i.e. those who are able to contribute to board considerations of disruptive technologies.

Equity taxation and plan review

The changes to equity plan taxation announced by the government (see HERE) will permit many companies to consider equity plans that are better suited to the nature of the business, attraction and retention, and/or governance. For example, “blue-sky” technology and bio-tech companies may again consider option plans at executive and director levels to reduce cash expense while fostering entrepreneurial cultures. Share rights may be able to feature exercise restrictions post vesting to encourage management to retain ‘skin’ and reduce excessive risk taking. Director fees could be paid in the form of rights or options to better attract off-shore directors and ensure more alignment with shareholders.

Once the new equity plan taxation rules are finalised, board remuneration committees would be well served by seeking a comprehensive review of the implications and opportunities for company remuneration frameworks.

Board renewal and board fees

The debate regarding diversity is maturing at a rapid rate. For many it has moved beyond the need to attract qualified women directors.  The emphasis now is on attracting people with, for example, knowledge of disruptive technology or international markets – the former are one, or even two, generations younger than most current directors, while the latter may not be white, or protestant or permanently reside in Melbourne’s inner east or Sydney’s lower north shore.

It may be an indictment of prior management that there remains a supply problem with qualified women directors, but it remains to be seen whether there is a supply problem for potential directors with technology or Asia experience. And while the lower A$ reduces the attractiveness of director fees for potential recruits residing in Hong Kong or Singapore, Australian director fee levels still comfortably exceed those being paid in the rest of Asia. More likely, there may be issues associated with the willingness of established company boards to accept more “adventurous” board renewal. In these cases, boards should consider external facilitation of their next board review.

Pressures on the supply of the new directors needed for IPO companies, private technology companies and superannuation funds are likely to be offset to some extent by mergers and acquisitions among both companies and superannuation funds.

Overall total board fees remain historically low relative to CEO remuneration. Despite this, we expect increases in base board fees will remain relatively flat, at about 3%. However, it is likely there will be more committee fees paid, as companies form and pay for technology committees, while others are still considering splitting out risk oversight into a separate committee. Some companies may also consider increasing the number of NEDs to add technology expertise. This, and the inclusion of superannuation in fee pool allowances from 1 July last year (see HERE) may see an increase in the number of companies seeking shareholder approval to increase the director fee pool. In this regard, note that proxy advisers would rather see more frequent resolutions for smaller fee pool increases than less frequent resolutions for larger pool increases.

Board skills matrix disclosure and board renewal

An ASX Corporate Governance Council recommendation applying for company financial years commencing on or after 1 July 2014 is to disclose information on the mix of skills and diversity that the board is looking to achieve in its membership. A board skills matrix can help with this.  However, disclosure of such information could open a can of worms because, if you have developed the skills matrix properly, it may telegraph new areas of focus that you would prefer the market and your competitors not to know about just yet. Such disclosure here is in its infancy, and we can learn from US and UK companies that have progressed further down this track.

Executive remuneration increases

The rate of increase in executive pay moderated from 2013 to 2014, with median incumbent CEO fixed pay increasing by 3.3% (see HERE).

The rate of increase for 2015 is likely to be similar, with an expected median fixed pay increase of 3% to 3.5%. However, this masks what we expect to be significant variation by industry and company.

Concluding remarks

2015 will be an interesting year for the board nomination and remuneration committee, and for institutional investors. Boards will need to be rigorous in setting incentive targets to ensure they reflect expectations for M&A activity, share buy backs, and other capital management strategies. Board renewal will be a focus at many more companies, driven in part by the need to diversify due to technology and market imperatives. Director supply issues will be impacted on the one hand by continuing IPO activity and start-up maturation, and on the other by M&A activity. Sourcing qualified women directors remains an interesting challenge for many boards.

© Guerdon Associates 2021
read more Back to all articles