In brief - AGM season highlights unpredicted and destabilising impacts of two-strikes rule
Company AGMs in 2011 have demonstrated that "no" votes on remuneration reports can be precipitated by a very small proportion of shareholders. They have also shown that the operation of the two-strikes rule is ambiguous and can produce unexpected impacts such as inflated remuneration.
Change in remuneration practices aims to discourage excessive corporate risk taking
There has been much discussion about executive remuneration and whether it was a contributing factor to the global financial crisis. In Australia, as in the United States, Europe and the United Kingdom, regulatory reforms were undertaken to address concerns raised about remuneration practices that were said to encourage excessive corporate risk taking and excessive remuneration of executives, paid irrespective of a corporation's performance.
The question now is whether those reforms are working - and there is no better place to start that analysis than with a look at the 2011 AGM season.
The following analysis provides an outline of Australia's key regulatory reforms and examines the 2011 AGM season in light of reforms, in particular the two-strikes rule as it is the first of the reforms to have a readily measureable impact.
The Australian regulatory response - APRA Guideline PG 511
The Australian Prudential Regulation Authority (APRA) developed Prudential Practice Guide PPG 511 to provide what Kevin Rudd called "clear incentives to promote responsible behaviour rather than unrestrained greed". This guide is intended to assist organisations regulated by APRA manage risks related to remuneration and to support compliance with various APRA standards and Financial Stability Forum standards (endorsed by the G-20 London Summit in April 2009), as well as provisions of the Corporations Act 2001 relating to disclosure, Principle 8 of the ASX Corporate Governance Principles and Recommendation and Australian Institute of Company Directors' guidelines relevant to remuneration.
Notably the Guidelines intend to place on the Board responsibility to ensure that directors are not placed in a real or perceived conflict of interest and to provide some procedures, controls and oversight of remuneration.
Corporations Act amendments aim to improve corporate governance
In its 2009 report on Executive Remuneration in Australia, the Productivity Commission noted that its recommendations for reform around executive remuneration aimed to "strengthen corporate governance to improve how boards set remuneration and engage with shareholders". For example, the Productivity Commission noted that:
- Remuneration practices should avoid creating conflicts of interest, for example, executives voting on the Remuneration Report at the AGM.
- Companies need to create "well designed pay structures [which] facilitate alignment of interests". For example, Remuneration Reports need to be clear and disclose in greater detail remuneration of key management personnel.
- There should be greater shareholder engagement – "better signalling mechanisms, voting opportunities and processes, and audit trails", along with a need for shareholders to understand how remuneration of executives aligns with their interests through more effective disclosure. This is where the two-strikes rule comes into play.
Regulatory changes in Australia, aimed at achieving the outcomes above, are summarised below. The new rules:
- apply to remuneration of key management personnel (KMP).
- are focussed around remuneration recommendations (defined at section 9(B) of the Corporations Act).
- ban KMP and their closely related parties (defined at section 9 of the Corporations Act and includes spouses, children, dependents, family members (in some circumstances) or companies controlled by the KMP) from entering into remuneration arrangements that hedge KMP's remuneration (see section 206J of the Corporations Act). Significantly, the ban creates a strict liability criminal offence. That is, intention is not relevant. Criminal liability for a breach of the provision extends to a closely related party of KMP such as a spouse or a dependent.
- introduce significant changes in relation to remuneration recommendations for KMP at disclosing entities (see Part 2D.8 of the Corporations Act), including regulation of remuneration consultants and their appointment and provide serious consequences for a breach. Failure to comply with rules in relation to appointment of consultants is a strict liability offence on the part of the company (see section 206K of the Corporations Act).
- reduce the threshold for shareholder approval of termination payments (to payment of benefits of one year's base salary) and broaden the definition of termination benefit to discourage excessive termination payments, or so-called "golden parachutes", being paid to outgoing executives (see sections 200 and 200AB of the Corporations Act).
- build on the non-binding shareholder vote on the remuneration report introduced in 2004 through the two-strikes rule (see section 250R of the Corporations Act). Relevantly, KMP whose remuneration may be disclosed in the Remuneration Report (or their closely related parties) and who hold shares in the company are excluded from voting on a resolution about their remuneration. Again, failure to comply with this regulation is an offence.
How the two-strikes rule operates
If 25% or more of shareholders who vote at the AGM (KMP and closely related parties whose remuneration may be covered in the Remuneration Report and who own shares are excluded from voting), vote down the remuneration report, the next year's Remuneration Report must explain how shareholder comments at the previous AGM have been addressed.
If at the next year's AGM, more than 25% of shareholders who vote again vote down the Remuneration Report, a spill resolution is put to shareholders.
If the spill resolution is passed by 50% of shareholder votes, the directors who approved the second Remuneration Report will have to stand for re-election.
Will giving shareholders a say on pay help bring about change?
Some research supports the two-strikes rule. A recent study looking at CEO remuneration packages post GFC, The impact of corporate governance on CEO remuneration structures in the aftermath of the GFC, found that internal corporate governance (for example independence and expertise of the remuneration committee) did not have a significant influence on CEO remuneration.
Rather it was more powerful groups of shareholders, such as institutional investors, who could influence the structure of the CEO's remuneration. The question remains however: is the two-strikes rule an effective vehicle for shareholders to exert their influence?
Key concern - can the chairperson vote undirected proxies on any resolution to adopt the remuneration report?
It is unclear whether a chairperson is prohibited from voting undirected proxies on any resolution to adopt the remuneration report if his or her remuneration details are included in the remuneration report (see sections 250R, 250BD(1) and 250BD(2) of the Corporations Act).
The Australian Securities and Investments Commission (ASIC) has reported that the Government proposes "to amend the law to make it clear that a chairperson is permitted to vote undirected proxies that have been vested in them, provided there is express authorisation by the shareholder".
This is an area in which the recent regulatory reforms are unclear – companies, and directors, are now in the difficult position of determining how to comply with the new rules, with very little guidance and potentially very serious consequences. ASIC has published some suggestions for dealing with the uncertainty, including the following options:
- The chairperson not vote any undirected proxies on the remuneration report and advise shareholders that their votes will not be counted if they provide an undirected proxy on the remuneration report.
- Altering the proxy form such that a shareholder not voting on the proxy appointment form will not result in the shareholder's vote being undirected and not counted.
- Inserting wording on the proxy form explaining to a shareholder that their failure to vote either "for" or "against" will be taken as a direction to the chairperson to vote in accordance with the chairperson's voting intention.
- Shareholders nominating a proxy for the purpose of voting on the remuneration report.
What happened at company AGMs in 2011?
The table below summarises shareholder "no" votes at some 2011 AGMs1
|Paladin Energy Ltd||39%||Watpac Australia||34%|
|Clean Global Energy Limited||64%||Austock Group Limited||46%|
|Scantech Limited||52%||Cabcharge Australia Limited||40%|
|Ellex Medical Lasers Limited||62%||Fleetwood Corporation Limited||39%|
|GUD Holdings Limited||45%||Tassal Group Limited||37%|
|Crown Limited||55%||Globe Australia Pty Ltd||74%|
|Pacific Brands Limited||53%||Nexus Energy Limited||35%|
|UGL Limited||34%||Sirtex Medical Limited||33%|
|Cabcharge Australia Limited||40%||DEXUS Property Group||28%|
|BlueScope Steel Limited||38%||Perpetual Limited||26%|
|News Limited||35%||Emeco International||26%|
A microcosm of the two-strikes rule in operation can be observed at the Crown AGM. After shareholders voted against Crown's remuneration report, James Packer (Crown casino executive chairman and 46% shareholder) is reported to have told shareholders that in the event that shareholders vote against the remuneration report again in 2012, triggering the two-strikes rule and resulting in a board spill, he "will use [his] votes [as 46% shareholder] to ensure all directors are voted back in immediately"2.
Packer's comments reflect the incongruities of the two-strikes rule - that even if shareholders vote "no" resulting in a board spill, a majority or large shareholder can vote the board back in, effectively neutralising the teeth in the reform - a board spill.
Interestingly, when comments made by Crown shareholders are analysed, it appears that the "no" vote was born of shareholder concerns about Crown's remuneration disclosure standards, rather than the amount or manner in which executives were to be paid.
For example, a representative of Perpetual (who did not vote against the report on the basis that Mr Packer does not take a salary), reportedly Crown's largest shareholder after Mr Packer, commented that "this is an issue of disclosure ... the vote should result in the company increasing its disclosure around these issues".3
Further, the Australian Shareholders Association reportedly took the view that Crown's executive remuneration was not excessive, rather its concerns went to the lack of transparency in Crown's incentive plan because specific performance hurdles, their weightings and executives' performance were not disclosed4.
Another area for concern is the power that the two-strikes rule can give a small percentage of shareholders and the associated potential for destabilisation. This was highlighted at Watpac's AGM where 8.37% of shareholders voted against the remuneration report. This translated into a 34% "no" vote5.
On closer examination, it appears that some small retail shareholders and at least one corporate governance advisor supported some of Watpac's proposed increases in executive remuneration, for example there was support for an increase in the non executive directors' fee pool from $800,000 to $1.1 million. However, other increases were not supported, for example the managing director's remuneration was reported to be relatively too high6.
Kevin Seymour, Watpac's chairman and largest shareholder (holding 15% of shares in the company) was highly critical of the two-strikes policy. In an ASX release shortly after the AGM Seymour explained to shareholders that:
- There had been a reduction in KMP remuneration in 2011 compared with 2010 and no bonuses were paid as performance targets were not met.
- Directors took a voluntary reduction in remuneration during the GFC and their remuneration in 2010 was less than in 2008.
- He makes no apology for the modest payments received by executives and staff, which are fair and, in the case of directors, conservative7.
Watpac had adopted a conservative remuneration policy and was acting to the benefit of shareholders. For just 8% of shareholders to be able to cause a "no" vote reflects the destabilising nature of the two-strikes rule. The potential for instability was also separately identified as a concern by the chairmen of both Stockland and QBE Insurance8.
Patterns and unforeseen effects emerging from company AGMs
The potential for destabilisation was also reflected at Globe's AGM, where the "no" vote resulted from only 8.2% of shareholders votes, 5.8% of which are owned by Solomon Lew. Speculation was that the vote was part of a move by Lew to take control of Globe9.
An area for serious concern is the thought that the reforms may, by the new disclosure requirements, lead to increases in executive salaries. Belinda Hutchinson, QBE chairman, gave the example of a CEO paid a limited amount who "the minute this transparency came in... wanted to be paid what everyone else was being paid"10.
It appears that many of the companies who faced scrutiny over their executive remuneration practices have large boards (ie an average of nine members). This may well be because:
- firms with large boards tend not to perform as well as firms with small boards (ie: average six members)
- large boards are less likely to fire the CEO when the firm isn't performing well (particularly where board members, including the CEO, have substantial shareholdings)
- large boards are less likely to remunerate members using incentive payments
- large boards tend to be cautious (because they need agreement from more members) and take fewer risks, resulting in decreased company performance11
Following the 2011 AGM season, Martin Tolar, director of the Australian Compliance Institute, commented that "recent coverage of shareholder deliberations on executive remuneration packages as part of this year's seasons of [AGMs] highlight the shortcomings of the recently enacted two-strikes policy rules"12.
However, in some cases the reforms appear to have been successful. For example, Transurban, dubbed a "repeat offender"13 following its failure to obtain shareholder approval for its remuneration reports since the introduction of reforms in 2005, undertook reform of its remuneration practices and improved shareholder engagement. Following that reform, Transurban obtained shareholder approval of its executive pay arrangements. Chairman Lindsay Maxsted reportedly commented that "it's good to know if you go about business the right way, and consult and it's appreciated, it's good to get the result"14.
Two-strikes rule can be problematic or ineffectual
Overall, the results of the 2011 AGM season indicate that:
- some companies have moved towards greater transparency around remuneration decisions and have taken steps to ensure that principles and reasoning behind remuneration decisions are more effectively communicated to shareholders15. Proxy advisers are reported as taking the view that the consciousness of company directors has been dominated by developing remuneration policies.
- shareholders are prepared to use a protest vote to send a message to companies about their remuneration practices. However, it will take until next year's AGMs to understand properly the impact of the two-strikes reforms.
- the translation of the two-strikes rule from an idea into action is problematic - it has the potential to be destabilising and may have unpredicted impacts such as inflated remuneration.
- Where executives hold a large percentage of shares, the shareholder vote on the remuneration report has no real impact.
Transparency, communication and shareholder power
The GFC has been described as revealing a failure on the part of companies to pay proper attention to risk in the face of "substantial personal incentives created by performance based pay schemes". As Citigroup's CEO, Charles Prince, famously said "it was rational to keep dancing as long as the music played"16. It is that attitude, along with pay structures that encouraged high risk taking, win-at-all-costs behaviours that many argue need to be addressed by reforms.
However, Australia is in a unique position – the economy has been performing well, and better than the UK, US and Europe. Additionally, Australia has a strong prudential and regulatory framework. Following the post-GFC calls for changes to regulation of executive remuneration, APRA has introduced new guidelines and there have been two waves of reform to the Corporations Act, with more to follow. Each of those reforms is targeted at increasing transparency, improving communication with shareholders and, in the case of remuneration reports, giving shareholders power to communicate their approval, or otherwise, of remuneration practices.
Given the outcomes of the 2011 AGM season, the current two-strikes rule may not achieve those goals.
A longer version of this article was first published in the March 2012 edition of Keeping Good Companies, the journal of Chartered Secretaries AustraliaFootnotes
1 The Australian Financial Review 23 November 2011 Jenny Wiggins "Companies learn the art of communication".
2 The Australian Financial Review, 28 October 2011, Andrew Cleary "Packer comes out swinging after first strike on pay".
5 The Australian Financial Review, 26 October 2011, Patrick Durkin and Jane Searle "Shareholder exec pay revolt bites"
6 The Australian Financial Review, 26 October 2011, Matthew Cranston "Watpac "no" provokes chairman's ire"
7 Watpac ASX Release, 26 October 2011 http://media.wotnews.com.au/asxann/01232912.pdf
8 The Australian Financial Review, 25 November 2011, John McDuling "Two-strikes rile "ridiculous""
9 The Australian Financial Review, 29 October 2011 Patrick Durkin, Directors Strike Out
10 Op cit 49
11 The Australian Financial Review, 27 October 2011, Peter Swan "Big boards invite two-strikes"
12 The Australian Financial Review, 2 November 2011, Martin Tolar "Two-strikes needs key governance tools"
13 Op cit 48
15 Wen P and McIlwraith Top cats on a hot tine roof, Sydney Morning Herald, 8 October 2011
16 Winter, J "The Financial Crisis: does good corporate governance matter and how to achieve it", DFS Policy Paper no 14
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