The Rudd Government recently issued its response to the Productivity Commission's (Commission) final report on Australia's director and executive remuneration framework, which was commissioned amid the market turmoil caused by the global financial crisis in March 2009 and released on 4 January 2010.
The inquiry was instigated as a result of perceived public concern regarding high value executive remuneration packages at a time when company values were plummeting. The Commission's report examined whether director and executive remuneration trends were inconsistent with an efficient labour market, whether poorly designed remuneration arrangements lead to inappropriate risk taking and/or focus on the short term performance of the company and whether the existing framework for the oversight and transparency of remuneration arrangements was sufficient.
Generally, the Government supported the reforms proposed by the Commission, which include:
- a listing rule requirement for all ASX300 companies to have a remuneration committee comprising only non-executive directors and an 'if not, why not' principle for all other listed companies with respect to such a committee;
- prohibiting key management from voting their shares in relation to their own remuneration arrangements;
- prohibiting key management from voting undirected proxies on remuneration resolutions;
- requiring a plain English summary of remuneration policies and details of actual remuneration received to be included in remuneration reports;
- a requirement that proxy voters cast all of their directed proxies on remuneration reports; and
- the implementation of a 'two strikes' rule (outlined on the following page).
However, significantly, the Government withheld its support of the Commission's recommendation to remove the cessation of employment trigger for taxation of incentives that qualify for tax deferral (which are subject to risk of forfeiture). Further, the Government has added an additional proposal to introduce a 'claw back' provision, requiring directors or executives to repay any bonuses calculated on the basis of financial information that is subsequently required to be materially restated.
A discussion of the more contentious reforms supported by the Government is set out on below.
The "Two Strikes" Rule
The 'two strikes' proposal is intended to strengthen shareholders' current non-binding vote on companies' remuneration reports and provide consequences where companies do not address shareholders' concerns in relation to remuneration issues. Under the proposals, the Corporations Act 2001 (Cth) would be amended to provide that:
- where a company's remuneration report receives a 'no' vote of 25% or more of eligible votes cast at an AGM, the board must explain in its subsequent report how shareholder concerns were addressed and, if they have not been, the reasons why; and
- if the subsequent remuneration report also receives a 'no' vote of 25% or more at the next AGM, the elected directors who signed the directors' report must stand for re-election at an extraordinary general meeting to be held within 90 days.
The 'two strikes' proposal has been widely criticised, as the trigger for re-election disregards the majority view and could lead to experienced directors refusing to stand for re-election, leaving the company without a properly functioning board.
Removal of cessation of employment tax trigger
Under the current tax legislation, employees that have received shares, rights and/or options under an employee share scheme that qualify for tax deferral (which are subject to a risk of forfeiture) are taxed on those rights or shares when they cease to be an employee of the company. The Commission recommended that this tax trigger be removed with such incentives instead being taxed on the earlier of the time that free title to the shares or rights passes to the employee or seven years after the employee acquires the shares, rights and/or options.
The Government has indicated that it will not support the Commission's recommendation. Whilst the Government has stated that it is supportive of employee incentive schemes, it cited various reasons for keeping the tax trigger. These reasons include the fact that it has been a feature of the tax legislation since 1995 and was then introduced to counter tax avoidance under such schemes, that its removal may provide disproportionately large benefits to high-income employees, that the reporting and monitoring rules for employee share schemes would be difficult to enforce after ceasing employment and that its removal would result in less revenue for the Government.
Interestingly, none of the Government's reasons for keeping the tax trigger relate to corporate governance or the objectives of the Commission's inquiry.
The Government's response has attracted criticism from executive pay advisers and corporate governance advisers on the basis that good corporate governance, rather than taxation, should be the primary driver of remuneration design. Others consider that the proposal will result in a 'cash is king' approach to executive remuneration rather than aligning the longer term interests of executives and shareholders under an equity incentive plan.
Companies use a variety of performance measures to determine management remuneration. However, these measures are generally supported by the company's financial statements. Where bonuses have been triggered by overstated results, under the current Australian framework, commencing legal proceedings is generally the only avenue available to shareholders to recover overpaid bonuses. However, the Government is considering going beyond the recommendations of the Commission by introducing a mechanism whereby bonuses paid to management will be recovered by the company (or 'clawed back') if the financial statements on which they were based are subsequently found to have been materially misstated. This approach has also been adopted in the US.
The Government is to release a discussion paper on the introduction of a legislative 'claw back' provision shortly. However, the proposal has already been met with scepticism on the basis that, in light of the risk of unintended consequences facing directors and executives, an overstatement of assets (which may have been a judgment call at the time) should not automatically require clawbacks; rather, clawbacks should require a clear and deliberate intention to misstate accounts.
Legislation giving effect to the reforms is expected to be introduced later this year.
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