The two strikes law has the potential to seriously disrupt the smooth functioning of listed companies and materially reduce shareholder value because a small minority of shareholders can work havoc.  That is, 25% of votes on the remuneration report that are cast two years running will result in a board spill and election for all non-executive directors.  Given that only about 60% of shareholder votes are cast, that means 15% of votes are needed each of 2 years for this to happen.

 

Directors, however much they disagree either with the principle or the details of legislation, need to be pragmatic.  They need to make sure that more than 75% of votes cast support their remuneration report.  The following is an extract of an opinion piece published in the Australian Financial Review promoting better mutual understanding between stakeholders for this to happen.

 

Critics and criticism of executive pay continues to receive plentiful media coverage. But the reality is that since the non-binding vote on remuneration reports was introduced in 2005, the annual average number of majority rejection votes has been less than a half a percent of the 2,200 ASX listed companies.

 

Some of the criticism may stem from the base motive of envy. But some of the criticism of executive pay is also founded on misunderstanding because of poor disclosure.There is also evidence that other critics do not carefully read disclosures to fully understand company pay policy. Few of these critics appear to be owners or proxy advisers, and so they do not play a direct part in the voting process. But they can still have an undue influence on popular opinion.

 

The annual general meeting season which kicks off on Monday will be a challenge for directors due to the new two-strikes rule which triggers a board spill if investors twice reject remuneration reports. Directors have to explain pay and performance outcomes to their shareholders, and this will be especially difficult if executives have received higher bonuses despite a lower share price or profits.

 

Failing to adequately disclose and clearly explain these outcomes in plain English does not endear company boards to legitimate critics who are motivated by genuine governance concerns.

 

It is not enough to comply with Corporations Act requirements on disclosure. It is not enough to say that a company has complied with ASX good governance standards. Shareholders need, more. They want pay to be explained.

 

It shouldn’t be that hard. Most ASX300 company votes are lodged by sophisticated institutional shareholders. But they are not psychics. They need to know what is being paid for and why. If they see an increase in total pay, including a big bonus, and share prices going the wrong way, they want to know why.

 

This is where many companies and their boards fail. Some cannot explain the outcomes because the numbers are, in fact, wrong. In a “blind Freddy” moment, a good many smaller companies show bonus amounts for the wrong year. Bonuses are shown in the year they are paid, and not for the year that the performance was assessed. This is a basic accounting concept that a surprisingly large proportion of companies get wrong, and that auditors fail to pick up.

 

Even companies that get the basic disclosure right often fail to put it in context. They may receive a blast from critics upset that a bonus is high while share price is down. But share prices are forward looking indicators of future earnings. Bonuses are typically paid on lagging indicators, such as the last year’s profit growth.

 

Some companies make it even harder for themselves by paying a portion of the bonus on lagging indicators, like last year’s profit growth, and another portion on achievements that should improve future earnings and hence share price. They confound shareholders’ understanding further by being coy about what those achievements were.

 

There is a case for directors in these situations to heed shareholders’ calls to simplify remuneration. Short of that, at least clearly state what was paid for last year’s financial performance, and what was paid for positioning the company to perform better this year.

 

But directors will need to explain more – for example, why they do not wait until the promised performance, from positioning the company for greater things, actually transpires, before they hand over the money.

Critics focus on the total pay number. But often almost a third of this is an estimate of equity value that an executive may or may not receive. It would be clearer to show what the executive actually received. Some boards are now disclosing this, but most are not.

 

Apart from improving disclosure and ensuring they are written in simple and plain English, there is also the issue of engagement. The report on institutional share voting and engagement released by the Australian Institute of Company Directors carries the complaint from a minority of directors that institutional shareholders and their proxy advisers are not available in the period just prior to their company AGM.

But this lack of availability is hardly surprising. This period is the busiest for these stakeholders as they work their way through hundreds of companies’ disclosures in order to lodge or advise on votes.

 

The time for directors to engage with shareholders and the proxy advisers is in the quiet times, not the time between publication of annual results and the AGM. Listen to the owners regarding their concerns, test possible changes to pay policy, explain company pay governance and performance linkages, and note what they want to know from disclosures.

 

This does not mean that boards should slavishly adopt the prescriptions of a few intransigent stakeholders. But engagement and the explanation of executive pay by boards of directors are crucial to influence the opinions and judgments of informed owners.  In the majority of cases, this results in shareholders affirming confidence in their directors.

 

It was important for the misunderstood to do all these things this year, the first year of the two strikes law.

 

Early indications are that some of these companies have left it one strike too late.

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