The Australian government released its response to the Productivity Commission’s (PC’s) inquiry into executive pay on Friday 16 April 2010.  While, as expected, it agreed with all but one recommendation, it added an additional action item for good measure.

 

The intent is to action all government legislative items for effect from 1 July 2011.

 

The government will support or act on all recommendations except removing the tax on unvested equity at cessation of employment.  Where their “support” is not sufficient for the ASX or ASX Governance Council to act, they will legislate to make it so.

 

In addition, the government proposes a new law not countenanced by the PC – the recovery of bonuses after financial misstatements, otherwise known as claw backs.

 

This article summarises and comments on the government’s response.

 

Government action so far

 

In its response, the government was at pains to demonstrate the action it has taken so far on executive remuneration.  In particular, the action to limit director and executive termination benefits to 12 months’ fixed pay, unless otherwise approved by shareholders with effect from November 24 last year (see HERE) and the Australian Prudential Regulation Authority’s (APRA’s) new standards on pay in the financial sector with effect from 1 April 2010 (see HERE). 

 

But we have noted before that each of these (and the termination limit law in particular) have issues.  One of these is that APRA is not able to regulate effectively on risk management and pay because the government’s share plan taxation killed any prospect of deferring taxation of equity incentives post employment.  On this occasion the government has taken care to explain why they continue not to rectify this, despite the PC’s recommendations.

 

“No vacancy” regulation

 

The government noted that the “no vacancy” rule is used by some companies via their constitutions to block the election of outside candidates.  The government will implement the PC recommendation that these “closed shops” be disallowed unless specifically approved by shareholders to declare no vacancies.

 

Remuneration committees

 

The government supports the PC recommendations regarding the membership and operation of remuneration committees, but notes that implementation is up to the ASX Governance Council and ASX respectively.  However, if they do not act to implement the recommendations the government will legislate.

 

Key management personnel and voting

 

The voting aspects of the government’s response, along with taxation, are among the most contentious.

 

The government will amend the Corporations Act 2001 to prohibit KMP – both directors and management – voting their own shares to support remuneration resolutions, and will extend the PC recommendation to the closely related parties of KMP.  This is despite objections that there is already a legal requirement on directors regarding conflicts of interest. 

 

Likewise, KMP will be prohibited from applying undirected proxies to remuneration resolutions.

 

In addition, the government will require all directed proxies, including those not associated with remuneration resolutions, to be voted as directed.  In effect, this amounts to compulsory voting by proxy holders. The law does not presently force a shareholder, or person who is appointed as a proxy, to attend the shareholders meeting; nor does it force the proxy to cast a vote.

This measure is also problematic, in that the law does not require the proxy to consent to the appointment.  

 

The issue would be addressed if the facility for electronic voting by shareholders prior to meetings was required, or allowed by company constitutions, rather than requiring shareholders who cannot attend the meeting to appoint a proxy. 

 

Hedging prohibition

 

KMP will be prohibited from hedging unvested equity, or equity subject to a trading lock.  The government will also extend this PC recommendation to the closely related parties of KMP.

 

The interesting aspect here will be one of enforcement.

 

Remuneration reports

 

The government supports the simplification of remuneration reports, but has referred the matter to the Corporations and Markets Advisory Committee (CAMAC) to advise how best to revise the legislation. 

 

Considering the mountains of worthy CAMAC recommendations gathering dust through several years of non-action, a CAMAC consideration of an issue, recommendation and implementation in just 15 months will be a record.

 

Individuals in remuneration report

 

The government has agreed to legislate to simplify whose remuneration is reported.  Disclosure will be limited to KMP in the reporting entity.

 

Remuneration consultants

 

The government will adopt the PC recommendation that companies disclose the advisers used in relation to KMP remuneration, who appointed them, who they reported to, and the nature of other work undertaken for the company, by including these requirements in the Corporations Act (instead of in the ASX Corporate Governance Council’s Principles, as recommended by the PC).

 

But they have not stopped there.  In addition, the government will also amend the Corporations Act to extend to all listed companies (not just the ASX 300 as recommended by the PC) requirements that:

 

1.     For all companies employing an adviser on KMP remuneration, the consultant’s services be commissioned by, and their advice provided directly to the board or remuneration committee, independent of management.

2.     The amount the consultant was paid for the remuneration advice be disclosed;

3.     The amount the remuneration consultant is paid for providing other (non-remuneration related) services to the company be disclosed;

4.     The basis on which the consultant was paid be explained; and

5.     A summary of the nature of the advice received and the methodology employed in formulating the advice be provided.

 

The summary of the nature of the advice would relate broadly to the type of the advice received, such as whether the advice included recommendations related to the quantum of pay.  However, it would not require the content of the advice to be disclosed, as this information could potentially be commercially sensitive.

 

The government claims that this will deliver greater transparency for shareholders, as they will be in a better position to assess potential conflicts of interests associated with the use of remuneration consultants.

 

Items 2 to 5 above are in line with recent changes to disclosures being required of US companies.

 

Item 1 is interesting.  It appears to prevent management employing an adviser on KMP remuneration.  In effect it attempts to circumvent the “advocacy” style of competing consultants employed by management against board advisers often observed in the US and Canadian markets.  It may backfire, in that companies may not hire any advisers (did we hear a “hooray” from somewhere?), requiring the board to rely solely on management advice.  One suggestion is that there be disclosure of who the board advisers were, irrespective of where they were sourced.  UK companies do this already, where it is a formal disclosure requirement.

 

Additional issues include:

 

·        The assumption by many that “remuneration consultants” are, well, remuneration consultants.  They are not recruitment consultants, accountants or lawyers, to name a few. Tosh!  The fact is, most remuneration advisers belong to these firms.

 

·         The assumption that conflicts of interest can be ascertained by disclosure of fees for non remuneration services.  But the adviser could be providing non-remuneration services to the board and not to management.  For example, a lawyer could be advising the board on legal liabilities, an actuary on an independent company valuation in M&A, and an accountant on audit matters.  All these advisers could be advising on remuneration matters as well.  But all these non-remuneration services may be contracted by the board, and not management, and so not present conflicts of interest.  Hence disclosure could be refined to the provision of services to management versus the board and the respective fees to better have an objective test of conflict

 

·        Even multi services to the board may have conflicts of interest.  The obvious example is the search consultant employed to find a director or CEO.  The search consultant may advise on remuneration, but fees for a search placement are a proportion of the remuneration paid.

 

·         Perhaps a better approach is one proposed by Senator Dodds, shepherding the stupendous US Restoring American Financial Stability Act bill through the American political machine.  Under this bill companies would be required to disclose whether the compensation committee retained a consultant and whether the work raised any conflict of interest and how it was addressed.  Simple in concept, and we are sure Australian principle based law could get it through in 1, 135.75 pages less than the proposed 1,136 page US law.

 

Institutional investors reporting how they vote

 

The Government notes that any voluntary disclosure is a matter for each institutional investor.

 

The Government also notes that the Super System Review (the Cooper Review) is considering the exercise of superannuation fund voting rights.  The final report of the review is due by 30 June 2010.

 

Removing cessation of employment as a tax trigger for employee equity

 

The Government does not support the recommendation.  While expected, this is a major disappointment.

 

The government uses the old chestnut that cessation of employment, as a deferred employee share scheme taxing point, has been a feature of the law since 1995.  That does not make it a good law.  It was hopeless then.  It remains so.

 

The government claims that removing the cessation of employment taxing point would increase the concessionality of schemes, providing a disproportionately large benefit to higher-income employees.  This is correct to a degree, but is not a significant item.  Since the last tax changes, removing the ability to elect to pay tax upfront, employee share schemes are taxed at the full marginal rate.  This means eventual post employment vesting may result at a time when overall income is lower, so tax may be lower.  But this is likely to be a marginal saving that would not make a difference to the executives from the top 200 companies.  As the PC pointed out, executives from the smaller listed companies earn about as much as the local accountant.

 

The government also claims that it would reduce the integrity of the tax system, and make it more difficult for the Tax Office to ensure the correct amount of tax was paid.  This is not correct.  The company has the TFN record.  It releases the shares.  It advises the ATO.  How does the timing impact the integrity?  If the government is talking about the difficulty of policing the “real risk of forfeiture” rule, then it is admitting that they cannot enforce it for those in employment as much as post employment.  Again the timing is not the issue.

 

In regard to the employee having to find the wherewithal to fund his/her tax liability for unvested equity on ceasing employment, the government reverts back to illogical reasoning that the company could partially vest some of the equity to pay the tax.  Don’t they understand their own tax law?  As far as we can tell, this would fall foul of the “real risk of forfeiture” provision.  In addition, it might make a mockery of the government’s recently enacted termination law.  Do companies go to shareholders asking for permission to exceed the termination limit because the government suggested it?

 

The government also claims that the proposed change would have a significant cost to Government revenue.  This is the rub, it seems.  In actual fact it should not impact longer term revenue over time.  People will still pay the tax.  And the present value of what is paid would not vary from the current arrangements.  But it will not be soon enough to close the deficit to make the government look better in the short term.  Perhaps if government pensions were paid post employment in accord with deficits associated with programs they implemented while in power they may concede this point.  But good governance for governments is not usually a favourite topic here.

 

The 2 strikes law

 

They will implement the two strikes and re-election resolution process where:

 

 • 25 per cent ‘no’ vote on remuneration report triggers reporting obligation on how concerns addressed; and

 

• Subsequent ‘no’ vote of 25 per cent activates a resolution for director elections within 90 days.

 

While acknowledging issues associated with all directors being removed from office at once, the government will implement this recommendation.

 

A new one – clawbacks

 

The Government will also undertake consultation on the proposal to clawback bonuses paid to directors and executives in the event of a material misstatement of a company’s financial statements.

 

This proposal is aimed at ensuring that, to the extent that pay packets are inflated by incorrect information, that money is returned to shareholders. A discussion paper will be released in coming months. 

 

Fortunately we can learn from the US experience (if the government chooses to), whereby clawbacks law in the Sarbanes Oxley Act were unworkable because it did not provide a mechanism for recovery from individuals.  That is, the law required companies to clawback bonuses, but did not provide the “how” for doing this.  In rare instances US companies have gone to court to recover the bonuses, but only in instances where financial restatements were as the result of fraud.  But the company has to prove the fraud, which raises questions regarding the competence and diligence of board directors.  Suffice to say, there have been very few instances of successful claw back.  New US laws being proposed look like they have a chance.

 

The government’s response can be found HERE

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