Prime Minister Rudd has been a vocal part of the worldwide call for greater controls over executive remuneration as a major element of his response to the global financial crisis. There is little doubt this plays well to many voters but, if previous attempts to regulate executive pay elsewhere in the world are any guide, may be counter-productive.

In Australia, the Corporations Act, the ASX Listing Rules, the Accounting Standards and the ASX Corporate Governance Principles and Recommendations establish a detailed framework for setting and disclosing executive remuneration.

Directors on company boards making decisions about executive pay are under exactly the same fiduciary duties and obligations to act in the interests of the company and shareholders as they are when they make decisions on any other subject.

Our focus here is on the Corporations Act and pay for directors and executive directors, who are all ‘related parties’ under the Act. (As executive directors, the CEOs of ASX-listed companies will also be related parties.)

Section 208 of the Corporations Act requires that shareholders approve the provision of a financial benefit to a related party of a public company, and that the benefit be provided within 15 months of approval. Exceptions to the need for shareholder approval are provided if:

• The terms of the benefit would be reasonable in the circumstances in an arm’s length transaction, or less favourable to the related party than this (section 210);
• The benefit is remuneration as an officer or employee (‘remuneration’ here having the same meaning as under AASB 124) and giving the remuneration would be reasonable given the circumstances of the public company and the related party, including the responsibilities involved in the office or employment (section 211(1)); or
• The benefit is the payment or reimbursement of expenses (section 211(2))

Specific provisions (in sections 200A to 200J) apply to termination benefits, although we acknowledge that these are very generous.

Section 211(1) is the key provision for executive pay. Unless shareholder approval is to be obtained, whenever a board makes a decision in relation to the remuneration of its CEO and other executive directors, the board needs to be able to resolve that providing the benefit is reasonable in the circumstances of both the company and the executive.

Under section 209, contravention of section 208 does not affect the validity of contracts or transactions connected with the giving of the benefit and the public company is not guilty of an offence. A court may, however, order an injunction to stop the company giving the benefit to the related party.

A person contravenes subsection 209(2) if they are involved in a contravention of section 208 by a public company or entity – this is a civil penalty provision.

The related party financial benefit provisions seem to have rarely been considered by the courts. According to R P Austin & I M Ramsay, in Ford’s Principles of Corporations Law (13th edition, 2007, LexisNexus Butterworths, at para 9.540) the standard of what is ‘reasonable’ may vary from industry to industry and depend on the nature and position of the company. We note that while the rewards provided under executive incentive plans should be expected to vary with stock market conditions and company performance, the fundamental structure of executive remuneration and the weighting between fixed pay/short-term incentive/long-term incentive should generally remain relatively constant.

The related party financial benefit provisions were considered in the Victorian Supreme Court case of Orrong Strategies v Village Roadshow Limited [2007] VSC 1. In relation to these provisions, Habersberger J held that the onus of proof was on the party seeking to rely on the exception or qualification to the rule in section 208. The court relied on independent remuneration expert evidence to establish whether the payments in that case were reasonable remuneration, concluding that the payments were unreasonable for the purposes of section 211(1).

This suggests it is likely that a board will strengthen its position if it obtains independent expert remuneration and legal advice before setting executive pay and establishing incentive and termination arrangements.

In the Orrong Strategies case, Habersberger J also held (at para 783) that while under section 209 breach of section 208 does not affect the validity of the contract or transaction and the public company is not guilty of an offence, section 209 does not automatically require that an agreement entered into in contravention of section 208 will be enforced by a court. Further, the court could refuse to enforce a claim arising out of an agreement in contravention of the applicable related party financial benefit provisions.

In our view, the current related party financial benefit provisions are a practical, workable approach to executive remuneration, especially when combined with the scrutiny facilitated by the detailed Australian disclosure requirements and the non-binding shareholder vote on the company remuneration report.

A board needs to be able to choose the CEO it wants to run its company and how much the CEO is to be paid on a normal commercial basis. This is a fundamental part of a board’s role. But it is appropriate to require that the CEO’s remuneration be reasonable in the circumstances of both the employee and the company.

If CEOs do not perform, the board removes them. If the board does not employ a competent CEO and remunerate him or her reasonably, it is open to shareholders in Australia to vote to remove the directors. This has been a little-used sanction to date, but there are signs things may be changing, as recently we have seen examples of shareholder advisers recommending voting against the re-election of individual directors to protest board decisions.

This will generally be a more effective sanction for shareholders wishing to protest against board decisions on executive pay than embarking on the difficult, costly and lengthy litigation process.

The above comments are made in our capacity as specialist remuneration consultants and are not legal advice.

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