On 19 December 2009 the Productivity Commission (PC) delivered its report to the government on director and executive remuneration. The government released the PC’s report to the public on 4 January 2010 (see HERE for the government’s press release and HERE for the full report).
The report’s recommendations have significant implications for executive pay governance structures and processes for listed companies. In particular, it elevates the importance of executive pay governance among board deliberations, adding to increases in non-executive director workload, skill and knowledge requirements, and “professionalisation”.
Our summary of the report follows.
The PC concluded that while there had been rapid growth in executive pay (prior to the financial crisis), the evidence does not indicate widespread failure in remuneration setting across Australia’s 2,000 listed companies, nor significant adverse impacts on the performance of the corporate sector as a whole. Nevertheless, the PC recognised that some trend and specific remuneration outcomes appear inconsistent with an efficient executive labour market:
− poorly designed remuneration arrangements that lead to inappropriate risk taking or short-term behaviour, especially in the finance sector, can have wider economic impacts
− loss of shareholder and community confidence in executive remuneration could also have adverse consequences for the corporate sector and the wider economy
The PC rejected imposing caps on total pay or on bonuses or other elements of executive pay, or tax arrangements designed to have similar effects as impractical and costly. The Commission also considered that a binding shareholder vote on the remuneration report would be unworkable given the report’s complexity and coverage, and would compromise the board’s authority to negotiate with executives.
According to the PC, given the board’s central role in determining remuneration for the chief executive officer (CEO), senior executives and directors, a well-functioning board is fundamental to achieving the most appropriate remuneration outcomes for a company. In particular, the independence from management of board decision-making, as well as the capacity of boards, is important for executive remuneration decisions.
The PC concluded that “The only practicable means for the many thousands of diverse shareholders of a public company to achieve a remuneration structure that promotes the company’s long-term interests is for them to ensure that they have an able and properly motivated agent — the board.”
The PC has determined that the “… more appropriate and proportionate response [to concerns that executive pay had got out of hand] is to improve corporate governance and enhance the effectiveness and credibility of boards, as well as to make boards more accountable in relation to pay setting, taking into account the need to minimise potential costs and the scope for unintended consequences.”
The PC recommended that the corporate governance framework should be strengthened by:
− removing conflicts of interest, through independent remuneration committees and improved processes for use of remuneration consultants;
− promoting board accountability and shareholder engagement, through enhanced pay disclosure and strengthening the consequences for those boards that are unresponsive to shareholders ‘say on pay’
The PC recommended that reform should be pursued in five areas:
- Board capacities: as directors need a mix of skills and experience, undue impediments to board diversity and renewal should be addressed.
- Conflicts of interest: conflicts exist which are inimical to efficient outcomes and call for more transparency or, in some cases, prohibitions.
- Remuneration principles: well-designed pay structures facilitate alignment of interests, whereas poorly designed schemes can deliver the opposite.
- Disclosure: shareholders need to be able to understand more clearly how remuneration practices align with their interests.
- Shareholder engagement: more effective engagement will require better signalling mechanisms, voting opportunities and processes, and audit trails.
One of the interesting features of the PC’s recommendations is the differentiation in treatment between ASX 300 companies from other listed companies in several areas.
Some of the key recommendations made by the PC are:
(a) On an ‘if not, why not’ basis, remuneration committees to comprise at least three members, all non-executive directors, with a majority and the chairman independent (Recommendation 2)
(b) For ASX 300 companies, executive directors to be prohibited from sitting on the remuneration committee (Recommendation 3, via listing rules)
(c) The information content and accessibility of remuneration reports to be improved by requiring
• A plain English summary of remuneration policies
• Reporting of “actual” (by this they mean taxable) remuneration received and total company shareholdings of individuals in the report
(d) Remuneration disclosures to be required only for key management personnel (Recommendation 9)
(e) Companies to disclose executive remuneration advisers, who appointed them, who they reported to and the nature of any other work undertaken for the company (Recommendation 10, on an ‘if not, why not’ basis)
(f) For ASX 300 companies, advisers on executive remuneration to be commissioned by, and their advice provided directly to, the board, independent of management (Recommendation 11, via Listing Rules)
(g) Remove cessation of employment as the taxation point for deferred equity subject to risk of forfeiture (Recommendation 13)
(h) ‘Two strikes and re-election resolution’ (Recommendation 15)
• 25% no vote on remuneration report triggers reporting obligation on how concerns addressed
• subsequent ‘no’ vote of 25% or more activates a resolution for elected directors to submit for re-election within 90 days (requiring a majority vote outcome)
A link to a summary of all of the PC’s recommendations and findings appears at the end of this note.
The Commission acknowledged that its proposed reforms may require boards to pay more attention to executive remuneration than some have done in the past. In the Commission’s view, this is called for and will complement rather than compete with other key board responsibilities. Appropriate remuneration structures for executives not only reflect on board competence, but are integral to the successful implementation of corporate strategies and thus the creation of shareholder wealth.
The PC believes its proposed reforms should reduce the likelihood in future of inappropriate remuneration outcomes, especially those that shareholders would find objectionable, and help secure greater public confidence in the corporate sector. They would not, however, put an end to high pay for executives of the largest companies where this is warranted to secure the best people and motivate them in line with shareholders’ interests.
The PC indicated that it would be desirable for the Australian Government to conduct a review within five years into the operation, impacts and effectiveness of any reforms flowing from this report, as well as the recently-introduced changes to shareholder approval of termination payments and share scheme taxation.
The government has announced that it will consider the PC’s recommendations and intends to respond during the first quarter of 2010.
The report’s recommendations in full can be found HERE.