APRA published its review of CBA culture, governance and remuneration on Tuesday 1 May 2018. Its observations and recommendations provide a useful insight into APRA’s expectations of prudentially regulated companies. They also have implications for other ASX listed companies, as the practices of Australia’s banks tend to permeate through to all other companies over time. Examples of this include the majority ASX 200 practices of short term incentive (STI) deferral in equity, and the provision for malus to be applied to these deferred amounts.
We have developed a board remuneration checklist based on APRA’s CBA review that can be used by all APRA-regulated entities, as well as other ASX-listed companies, with additional commentary as it may relate to the APRA review.
1. Are the remuneration incentives linked to the long-term financial soundness of the company?
GA commentary: APRA found that the CBA’s LTI had no explicit link to long term financial soundness. However, this observation by APRA can apply to the majority of companies as the CBA’s LTI has features common to most ASX 300 LTI plans. The CBA LTI was mostly weighted to relative TSR performance. APRA and the governing body of global prudential regulators (the Financial Stability Board), have never been keen on relative TSR. One of the reasons for this is because the LTI outcomes tend to be based on how badly a company does just prior to the beginning of the performance period, and bad behaviours may be encouraged at performance testing time. And, as it is applied in almost all ASX listed companies, TSR takes no account of risk. While there are ways to tackle this (see HERE for example), remuneration committees would be well served to question whether relative TSR measures are appropriate. If the conclusion is yes, further consideration can be given to whether the measure is suitably balanced by other measures, or means, to ensure longer term financial soundness.
2. Is there an excessive weighting within incentive plans on financial outcomes?
GA commentary: APRA’s view is that an excessive weighting on financial outcomes can contribute to “conduct risk”. That is, to make a quick dollar, some companies may take short-cuts or reduce product quality that, for example, may harm the present value implicit in the company’s customer franchise, or brand.
3. Have you considered the inclusion of positive reward for more sound risk management in the incentive plan structure?
GA commentary: APRA-regulated entities typically look to punish poor risk management by the application of malus. Few provide positive incentives for more sound risk management. The value of all companies would be enhanced if sound risk management resulted in less earnings volatility, all else being equal.
4. How are individuals held accountable for their responsibilities? Is the board accepting and tolerant of accountability being diffused, excused, or undetermined.
GA commentary: Most companies reward KMP executives on corporate performance outcomes, given that the top team has collective accountability for results. It is reasonable to expect that if individuals are properly accountable for their areas of responsibility, more variability of incentive outcomes may be warranted and will be apparent. This will generally require a more focussed effort by the remuneration committee in critically reviewing the incentive outcomes for executive KMP to ensure direct and individual accountability for positive and negative outcomes. It may also require a review of the level of the incentive that is determined by personal versus corporate outcomes.
In determining individual accountability, the remuneration committee will firstly need to determine the extent to which issues are clearly owned.
5. Are the incentive outcomes being justified on the basis of ‘good intent’?
GA commentary: Poor outcomes cannot be excused by an executive having ”good intent”. The role of the remuneration committee includes ensuring competence is rewarded, and incentive outcomes are reduced for incompetence. The remuneration committee and board have a significant role in giving the CEO spine, and in ensuring a remuneration framework inclusive of performance assessment is rigorously applied.
6. Is the incentive structure rigorous or does it rely on the board exercising negative discretions to achieve appropriate outcomes? Has the board provided comprehensive guidance on how reductions to STI and LTI outcomes should be determined so there are clear expectations by all stakeholders?
GA commentary: The board may be reluctant to exercise negative discretion to reduce pay or apply malus. Yet most malus systems require negative discretion. Behavioural economics shows that by implementing a well thought-out “choice architecture”, the incentive and malus systems can be more effective. This approach was popularised by Nobel laureate Richard Thaler (see HERE).
This choice architecture acts as a “nudge” that alters people’s behaviour in a predictable and easy way without forbidding any options. In this case, implementing a nudge might involve specifying defaults on which malus is to apply. This may involve particular levels of financial damage or inputs from whistleblowing policies, auditors, regulators or customer complaints.
The nudge is not a mandate, in that the board can still apply discretion, although in this case it would be positive discretion to override the application of malus, rather than negative discretion to apply malus.
Consideration might be given to the creation of a template to help managers exercise their discretion on malus in a consistent manner.
7. Has consideration been given to a “clawback” provision and its application?
GA commentary: Clawback is the recovery of remuneration that has been awarded and received. Most ASX 200 companies mistakenly label their malus policies as clawback. Malus is the forfeiture of earned, but unvested remuneration (e.g. deferred STI).
There are practical difficulties in clawback that may require litigation for an uncertain outcome. To an extent, these can be overcome by ensuring an executive employment agreement permits recovery of what has been paid from other, unpaid remuneration (e.g. accrued long service leave, future incentive payments, annual leave accrual etc). It is argued by regulators that clawback policies and practices will ensure better behaviour.
8. Does the board cross pollinate committees for better understanding of risks that can impact remuneration outcomes?
GA commentary: It is difficult to set defaults where malus should apply, or set risk aware performance conditions without a thorough understanding of the risk appetite, situation and auditing. Having board members who sit on the remuneration committee and the audit or risk committee will aid in this understanding.
9. Is the remuneration committee provided with sufficient information to enable it to carry out its duties and effectively challenge remuneration outcomes and make appropriate adjustments to variable remuneration?
GA commentary: the remuneration committee needs quantitative and qualitative information covering current and past performance to assist it in understanding the range of outcomes it should be anticipating for the variable remuneration. If there is not a structured process to deliver the data it needs, it will not be in a position to effectively challenge.
The APRA report can be found HERE.
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