The credit crisis and the collapse in the share price of many companies during the current financial year will impact executive remuneration for the 2008 reporting season and require new approaches to be implemented during the new financial year.

Lower share prices directly reflect shareholder expectations of performance, and also have a big impact on executive remuneration programs.

Depending on the extent that peer group selection validly reflects a company’s competitors for capital, talent, customers and suppliers, a LTI using relative total shareholder return can either cope with the vagaries of volatile market movements or totally negate the relevance of the incentive for effective attraction, retention and motivation.

The incentive value of equity-based LTI plans is reduced where executives expect the share price will stagnate or fall.  And there is a risk that in-demand executives will effectively “re-price” their LTI themselves by changing jobs. But, as an offset, lower share prices mean more rights or options in new LTI grants for each dollar of LTI remuneration value – valuable for those with a longer term focus.

So what issues does the Remuneration Committee need to be focusing on now for implementation this year?  What executive remuneration questions are likely to be raised by shareholders as they consider their vote on the 2008 remuneration report?  The following issues are a good start for directors wanting to make sure their management team is in good shape for the tumultuous times ahead.

1.  Review incentive plan performance measures and hurdles

Investor expectations have changed in line with the economic situation.  For most companies this means a review of incentive plan performance measures and requirements is necessary.  Last year’s 15% EPS growth target may be this year’s impossible dream.  For incentives to be motivating, targets must remain reasonable.

We presented a check-list for reviewing LTI performance targets in our March newsletter (available HERE)

That advice remains current.  Key points include

• Make sure a change to performance targets is justified

• Consider the validity of the relevant sector’s outlook before moving to amend management performance targets – it is essential to consider the extent to which a reduced share price is a function of general market sentiment (the ‘beta’ component of share price) or management competence (the ‘alpha’ component of share price)

• Investors need to be realistic about what management can be expected to achieve.  Performance hurdles need to be at levels that motivate executives without being soft

• LTI and STI plans must incorporate adequate risk controls – boards need to ensure that management is not encouraged to take an excessive punt to boost their annual remuneration to levels that would be “unreasonable” to an informed and rational person

• Balance the interests of management and shareholders

2.  Review the comparison group for benchmarking CEO and direct report remuneration

Executive remuneration should continue to be regularly benchmarked to ensure remuneration levels are valid and fair.  But, given that there is a strong correlation between executive pay and company market capitalisation, careful thought will have to be applied to ensure there is a valid comparison company selection for each of the executive positions being reviewed. 

Realistically, fixed pay cannot be reduced from current levels – apart from the fact that attempts to cut fixed pay could amount to constructive dismissal, executive jobs do not immediately shrink with a falling market capitalisation when the business fundamentals remain the same.  If your company’s market capitalisation is falling as a result of general market or industry sector sentiment, it is likely that so, too, are your competitors’.

Apart from market capitalisation, revenues, turnover and other sizing factors may need to be taken into account for comparison company selection and position benchmarking.

Paradoxically, jobs are likely to be even more demanding in tough economic times.

For more detailed information, see our Remuneration Committee checklist for balance in executive pay, from our February 2008 Newsletter, HERE.

3.  Benchmark and adjust board remuneration

While executive remuneration growth is slowing, director remuneration growth is likely to remain robust. 

The demands on directors’ time and commitment have been increasing for several years and board remuneration needs to continue to reflect this.  But, however justified, directors will generally be reluctant to ask shareholders to sign off on an increase in the fee pool when shareholder value has been reduced.  So manage fees within the existing fee pool, but if this is inadequate, put the case for an increase as a part of the regular, on-going good management of the company.  It is in the interests of shareholders to ensure the on-going quality of the board for the challenges ahead.  And it is our understanding that the two main proxy advisers in Australia will support reasonable pay for directors on boards with a majority of independent directors.

So do not defer a benchmarking review of director remuneration because the market has turned down.  Now, and perhaps more so than in the “good” times, director experience and application in risk management and CEO succession are critical.

Lastly, as with executive pay benchmarking, remember that market valuations have changed.  So make sure that you are being compared to an appropriate peer group.

4.  Check internal equity and implications for succession planning

Is there a potential successor to the CEO?  This is regarded as one of the most critical elements of a board’s ability to add value for shareholders.  Part of this responsibility requires a review of internal pay equity.

Significant pay inequities among executives and between executives and other employees can cause significant strife and need to be remedied, particularly as detailed disclosure makes these obvious to all.  The most obvious issue, and one that should concern all boards and shareholders, is that if there is too large a disparity between the CEO and the next highest paid then there could be no candidate for internal succession. This applies not so much to total remuneration inclusive of incentives, for we know where the buck stops for poor company performance.  But it is certainly very relevant to fixed pay levels.

A checklist for establishing a methodology for dealing with pay inequity was included in GuerdonNews® HERE.

5.  Test executive contracts and change in control outcomes

Market volatility presents more challenges and opportunities for mergers and acquisitions than the “good times”.  The extent that management is retained and focused on maximising value to shareholders may come down to what is written in their contract of employment, especially when it comes to change in control provisions.

Written contracts provide certainty for executives and employers and help to prevent nasty surprises for shareholders.  Payments on termination and in the event of a change in control must be reasonable and appropriate to the circumstances.  For CEOs, you can expect that any termination payment entitlements in excess of 12 months’ worth of fixed pay (plus pro rata STI and LTI subject to performance hurdles being met) will be subject to detailed scrutiny.  On change in control, automatic full vesting of outstanding awards will also attract attention – a good starting point is to pro rate and performance test awards, but with the board retaining the discretion to ensure that the outcome is fair to all parties.  In the US, it is becoming more common for change in control payments to be made only if the for change in control payments to be made only if the executive’s employment is terminated (in Australia, ASX Listing Rule 10.18 prohibits paying or increasing termination payments as a consequence of a change in control).

Outside of the contract, the board needs to be cognisant of what other action may be necessary in the event of a prolonged and bruising control battle.  On occasion, special retention provisions may be necessary to see the battle through to a successful conclusion.

For information on UK standards for executive contracts and severance guidelines, see HERE.

6.  Require remuneration report clarity and directness

Remuneration reports receive more public scrutiny than many directors say they warrant.  But they can be a powerful means to communicate that a board and its management have got it together.

Producing the desired clear and understandable remuneration report is easy when remuneration policy, strategy and practices have been carefully set to support the business plan.  They also need to be aligned with reasons for executive director equity grants in proxy documents.  Lastly but importantly, they are important investor communication documents demonstrating that executive remuneration is integrated with company business strategy, and that business strategy will create shareholder value. 

Keep in mind that many companies are moving away from prescribed governance guidelines to remunerate in a way that directors believe will add value, irrespective of the non-binding vote outcome.  Directors should consider whether their company’s situation warrants this.  If so, do what is right for shareholders and use the remuneration report as a platform to explain why.  In our experience the proxy firms and institutional investors are more open-minded than many think.

Previous GuerdonNews® articles have provided a primer on remuneration reports and commented on the complexity of many remuneration reports and on how difficult they are to understand (see HERE and HERE).

7.  Seek independent pay advice for effective corporate governance

Executive remuneration arrangements that are specifically tailored to the needs of the company but differ from the ‘norm’ will be more much more easily sold to shareholders and proxy advisers if good corporate governance processes are followed.  Maximum credibility requires only independent non-executive directors be on the remuneration committee. 

Directors also need to be in control of the issues on their agenda, must fully understand executive remuneration programs and have access to adequate information and independent consulting advice as required.

A matter that is likely to be given more attention in Australia as part of the federal government’s review of executive remuneration regulation is the independence of remuneration consultants (see HERE).  Does your remuneration consultant provide other services for the company? Are these disclosed? Is there a conflict of interest? 

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