The Australian Productivity Commission’s Inquiry Into Executive Pay

The government response indicated the government will support or act on all recommendations except the recommendation about removing the tax on unvested equity at cessation of employment. In addition, the government proposes a new law not included in the Productivity Commission recommendations – the recovery of bonuses after financial misstatements, otherwise known as the claw back provision.

 

This article summarises and provides an iHRDirEx view on the government’s response to the Productivity Commission’s recommendations.

 

Progressive Government action on executive pay 

In its response, the government listed the actions it has taken so far on executive pay. These actions included:

 

- action to limit director and executive termination benefits to 12 months’ fixed pay, unless     otherwise approved by shareholders with effect from November 2009, and

 

- the Australian Prudential Regulation Authority’s (APRA’s) new standards on pay in the         financial sector which can into effect from 1 April 2010

 

The government noted that the “no vacancy” rule is used by some companies via their constitutions to block the election of outside non executive directors not proposed by the Board. The government indicated that it will implement the Productivity Council recommendation that these “closed shops” be disallowed unless specifically approved by shareholders. 

The intent of this recommendation is supported by iHRDirEx. However it is at odds with the typical role of the Board Nomination Committee. In our view, the ability to nominated external non executive directors should remain the right of all groups of shareholders whose numbers are sufficient meet clearly defined nominating thresholds.

 

The government supports the PC recommendations regarding the membership and operation of remuneration committees. However it, acknowledged that implementation is up to the ASX Governance Council and ASX respectively. There was a clear indication that if the ASX do not act to implement the recommendations the government will consider legislation to compel these changes.

 

The government indicated it will amend the Corporations Act 2001 to prohibit directors and management voting their own shares to support remuneration resolutions. It will also extend the PC recommendation to the votes of closely related parties. It should be noted that there is already a legal requirement on directors regarding conflicts of interest. 

 

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

 

These changes are supported by iHRDirEx.

 

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

 

Under the recommendations directors and key executives will be prohibited from hedging unvested equity, or equity subject to a trading lock. The government will extend this Productivity Council recommendation to the closely related parties. This recommendation is supported by iHRDirEx as we have seen instances where these hedging provisions have been used to effectively circumvent performance based vesting conditions and bring reward payments forward. Where the performance targets were subsequently met any structural concerns dissipated. When the performance conditions were not met the Board Remuneration Committee was forced to fund a messy and expensive “unwinding” to save the executives concerned from financial ruin.

 

The Board’s role in enforcing Hedging prohibitions must be clearly defined in all Incentive Plan Rules.

 

The government supports the simplification of remuneration reports. In the iHRDirEx view, Remuneration Report structures have taken on an overly legalistic view to the detriment of the overarching communication and transparency intents. The government has referred the structure and content of Remuneration Reports to the Corporations and Markets Advisory Committee (CAMAC) to advise how best to revise the legislation. 

 

The government has already agreed to legislate to simplify whose remuneration is reported. Disclosure will be limited to Directors and Key Executives in the reporting entity.

 

The government will adopt the PC recommendation that companies disclose the remuneration consultants used in relation to Director and key Executive remuneration. The report must specify who appointed the consultants, who the consultants reported to, and the nature of other work undertaken for the company by that consulting organization. The government, intends to include these requirements in the Corporations Act (instead of in the ASX Corporate Governance Council’s Principles, as recommended by the PC).

 

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 Productivity Council ) requirements that:

 

1. For all companies employing an adviser on Key Management Personnel 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, as we understand it, 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.

 

These apparently simple changes raise many additional issues which include:

 

- The assumption by many that “remuneration consultants” are solely remuneration consultants. These recommendations cover not only recruitment consultants, but accountants or lawyers, etc. The fact is, most remuneration advisers belong to the multi service firms. In our view It is the quality and particularly the independence of the remuneration advice that is in question, not the nature of the firm from which that advice is sourced.

 

- The assumption that conflicts of interest can be ascertained by the simple disclosure of fees for non remuneration services is illogical. Where one adviser could be providing non-remuneration services to the board and not to management, we see little conflict. For example, a lawyer from the same firm could be advising the board on legal liabilities, an actuary on an independent company valuation in a M&A situation, and an accountant on audit matters. All these advisers could be, in part, commenting on Key Management Personnel remuneration quantum matters as well. If all these non-remuneration services are contracted by the board, and not management, then in our view not present conflicts of interest occur. 

 

- In our view the disclosure requirement should be re- refined to the situation where the provision of services to both management and the to board might be required to meet 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.

 

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

 

The Government also notes that the Superannuation 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.

 

The Government does not support the recommendation. 

 

This is an area of significant concern to iHRDirEx.

 

The government argues 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 robust or appropriate law. 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 benefit 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 employee’s TFN record. It releases the shares upon vesting. It advises the ATO of this release. How does the timing impact the integrity? If the government is arguing the difficulty of policing the “real risk of forfeiture” rule, then it is no more difficult to enforce for those in employment than in the  post employment situation. 

 

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. We don’t understand the logic of this position 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 cap. Do companies go to shareholders asking for permission to exceed the termination cap because the government wants the tax?

 

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 has indicated that it will implement this recommendation. We agree with the AICD view that this change is inappropriate and potentially damaging to business stability.

 

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. 

 

We await this discussion paper with some interest.