The executive pay checklist

Most companies that suffered an executive remuneration first strike under Australia’s two strikes law were first time “offenders”.  In many, if not most, the vote outcome was a surprise. This experience behoves boards to ensure that executive pay does not arise as a surprise issue that can be used to divert board attention from oversight of more material matters impinging on company value.

The following is a checklist to ensure that the board has in place processes for dealing effectively with executive remuneration:

1. Establish a remuneration committee of only non-executive directors. In fact, ASX Listing Rule 12.8 requires this for ASX300 companies. However, we have noted that despite this listing rule, some companies relatively new to the ASX300 still retain executive directors on the remuneration committee. To avoid conflicts of interest, do not have executives involved in the setting of their own remuneration. If relying on internal company resources (such as the human resources manager), be aware of their own conflicts of interest.
2. Have in place board processes that incorporate independent opinion, expertise and transparency. Have a board remuneration committee chairman who is not the board chairman. Meet in non-executive director-only sessions, where no company executives are present, for a frank assessment by non-executive directors.  Seek the input of external advisers, shareholders, and other stakeholders as well as management. Canvassing input will almost guarantee a diverse range of views.  Take note when there is consensus.
3. Seek independent expert advice. Minimise conflicts of interest by ensuring that your advising firm does not also work for management.  Ideally, utilise a firm that does not provide services that could be used by management, i.e. they only provide services to boards. The mere potential to provide more lucrative services to management at some later date gives rise to a conflict of interest.
4. Stress test proposed incentive structures and payments. Is there a maximum or cap? What could be the maximum earned, and under what conditions? Could an incentive be earned if results are poorer than the prior year?  Is there a profit gateway before any bonuses are awarded? Can incentives payments be made under the plan that are material as a proportion of overall company profit?
5. Check that overall remuneration levels are reasonable. While the pathway that arrives at a remuneration outcome may seem reasonable, does the overall level make sense relative to competitors and general market standards?  If you know how the company has performed relative to other companies, the overall executive pay level could be aligned to this same relative rank.  That is, 25^th percentile pay for 25^th percentile performance, or 75^th percentile pay for 75^th percentile performance.  Is there a disconnect?
6. Realistically assess the potential for executive turnover because of pay. If pay is fair, the prospect of executive loss is unlikely.
7. Ensure that executive pay does not promote excessive risk taking. Consider using multiple measures of performance in incentive plans instead of one to diversify the risk of unintended consequences arising from excessive attention to just one measure of performance. Consider deferral of part of the annual STI to make sure annual results were not achieved in a way that gives rise to excessive risk of poor outcomes later. Consider ensuring long term incentive plans remain “on foot” post employment for good leavers, to ensure that they focus on leaving behind a sound legacy.
8. Do not change performance hurdles mid-stream. To be sure, external events beyond the control of management do happen. But these impact shareholders as well as management.
9. Make it clear that the board has the right to exercise discretion. So, while uncontrollable events may happen, this does not mean the board remuneration committee cannot exercise discretion at the end of the performance period. Providing outcomes are just and fair, and the reasons for it are adequately communicated, the exercise of discretion should be accepted.
10. Clearly communicate the board’s approach to remuneration, and the company’s policies. The advent of the Australian two-strikes law (see HERE) has resulted in an upsurge in board engagement with shareholders and their advisers.  After some hard work and more than a bit of nerves, the experience so far has been well received. The extent of overall “no” votes on remuneration matters is down from the period before the two-strikes law, with the exception of smaller companies owned mainly by retail shareholders, with significant KMP shareholdings that could not be voted on the remuneration report and where chairman were denied the right to vote undirected proxies due to a drafting flaw in the legislation (see HERE). But make sure communication is not restricted to just external stakeholders. Make sure management knows the rules so that a difficult conversation at the end of the year is not made more difficult.
11. Undertake an annual review. Do not restrict this to the annual check on remuneration levels.  As a matter of course, review whether the structure of executive pay met objectives. Review external stakeholder comments. Review the adequacy of the remuneration structure’s alignment with strategy.  If company strategy has changed, it is highly likely remuneration should change to support it.
12. Keep abreast of external developments. Executive pay was not “put to bed” with the Productivity Commission enquiry. The government did not wait for its completion to legislate on executive termination benefits (see HERE). Tax laws were changed on equity plans (see HERE). After the review and the announcement of government laws, further reviews were made by CAMAC (see HERE). Further legislation is to be introduced (see HERE). Other countries have taken slightly different paths, providing new ideas for governments to imitate in more laws in pursuit of the populist vote (for example, see HERE). Meanwhile, many boards have been caught short, rushing to catch up to comply and engage internally and externally. If you have not already, consider subscribing to the only newsletter and alert service focusing exclusively on executive remuneration matters (see HERE).