In the time of COVID-19, boards face a difficult governance challenge as they manage the task of exercising their minds to determine the variable pay outcomes of their most senior executives. At no time in recent history have boards found themselves so 'unguided' on such a key issue for the success of the organisations they lead.
As always, remuneration decisions will be a key focus of the annual reporting and AGM season as investors look to understand how payment decisions are being used to incentivise and retain employees while so much is unknown. For those issuers that have had to reduce, defer or cancel distributions and dividends, the focus will be even sharper.
Many organisations have already reported on variations to the remuneration arrangements for employees, especially those in sectors that have been adversely effected by the pandemic. The adjustments have included a mixture of changes in both base remuneration and variable remuneration.
Boards are dealing with a combination of difficult issues including uncertain earnings prospects, a changing international environment and a highly volatile stock market. In this environment, questions to consider are:
- How do you incentivise and retain employees?
- What is the right mix of fixed and variable remuneration?
- How should equity be allocated when securities are trading at lower than normal levels?
ASIC is well aware of these tensions and released Information Sheet 245: Board oversight of executive variable pay decisions during the COVID-19 pandemic. It seeks to provide guidance to boards on the need for a robust remuneration governance framework, and on specific factors to consider when they are exercising discretion on executive variable pay.
Robust remuneration governance framework
The Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry and now the current circumstances of COVID-19, have highlighted the need for a robust remuneration governance framework to support board decision-making appropriate to the changing circumstances.
Increasingly, there is a desire by ASIC and the investment community for a governance model that is transparent in terms of both the objectives of the remuneration framework and how the organisation's processes are designed to ensure that remuneration determinations are devised to retain employees as well as encourage performance and conduct in a way that is consistent with the long-terms interests of the organisation.
On a practical level this means that the Remuneration Report should disclose both the 'how' and 'why' of any decision to exercise discretions. For example, under incentive schemes (either LTIs or STIs) how, say, is vesting being managed to provide an appropriate outcome in the circumstances? Why has this position been adopted? Boards will need to be particularly aware of sensitivities where there has been a potential or likely improvement of the outcomes for executives.
The uncertain trading environment will also challenge boards as they review remuneration arrangements for the current financial year, with critical considerations being:
- How should a board adjust the mix between equity, cash, fixed
and variable remuneration?
- How will they set performance hurdles, vesting terms and
- Will changes to the terms of the model require new member
- What are the accounting and tax implications?
- Should there be a special plan implemented to deal with the
current trading conditions?
- How will the changed arrangements be communicated to employees and to members?
None of this is to say that there is any problem with exercising discretions in the various remuneration schemes, simply that the board will need to be able to explain the basis for the decisions taken in relatively simple terms which are supported by a robust governance framework. That requires a model that is free from conflicts of interest and which ensures that directors have made their decision in good faith - having properly informed themselves about their decisions - and that they consider that the decision is in the best interests of the organisation.
The outcome of the process should result in decisions:
- based on active, timely and consistent exercises of
- based on structured and contextual information from
- made with the benefit of arrangements to manage
conflicts of interest; and
- that are transparently recorded and communicated.
Active, timely and consistent exercise of discretion
Boards should consider whether the variable pay outcome is consistent with the objectives of the variable pay framework and whether the outcome highlights the executive's responsibility for their conduct and performance.
APRA and ASIC have reprioritised the timetable for the Financial Accountability Regime (FAR). However the boards of APRA-regulated companies need to prepare to ensure a smooth transition. This will start by analysing organisations' corporate entity structure and governance arrangements; in the context of remuneration governance this means, for example, that accountable persons need to be assessed against responsibility for end-to-end management of a given product.
Discretion is increasingly pivotal to the boards' variable pay decisions as the pandemic has shifted companies' priorities and targets. The exercise of discretion must:
- avoid unintended windfall gains; and
- address risk or conduct issues that have occurred since the variable pay award was granted.
Boards may consider:
- Adopting practices or frameworks to prompt the use of
discretion in the company's variable pay scheme. For example,
using targeted information to "determine whether to
exercise discretion at a relevant point in the variable pay
- Applying practices or frameworks that guide the exercise of discretion before variable pay decisions are made. For example, "decision trees can be used to direct the circumstances in which the exercise of discretion (and quantum of adjustment) could be constructed..." (ASIC).
When thinking about KPIs for the 2021 financial year the board will need to source information on various matters. For example:
- What is the likelihood of recovery from the impact of the
- How might that impact KPIs in the current financial year?
- Should KPIs for annual incentive programs be customised to the
time, or retain the structure that has been agreed and approved
over many prior years?
- In organisations where distributions are materially less than anticipated, how should boards consider those circumstances when setting remuneration for employees?
Structured and contextual information from unbiased sources
To effectively support the exercise of discretion, the type of information required and the source of that information must be considered. This will highlight how the COVID-19 related changes have impacted performance measures that were set prior to the pandemic.
For example, regarding balanced scorecard outcomes - "this could include broader information on corporate performance and impacts on stakeholders...to balance an outcome that could be dictated by a scorecard set before the COVID-19 pandemic" (ASIC).
Given the impact of COVID-19, some revenue and profit objectives may not have been met, however the board may still believe that their management team have outperformed their industry peers. The team may have enabled the organisation to prosper but have not achieved the 2019 KPIs. If they have been able to keep the workforce employed by finding programs and solutions, there may be good reasons why they should be incentivised to keep up the good work and be paid to help ensure that those valuable employees are not poached by competitors who have fared less well.
This would represent a significant challenge for many companies and for many boards and lead to a circumstance where it is highly probable that incentives for key management personnel will either not be paid, or be substantially below target or expectations.
Valuable sources of information when making and backing up these decisions might include control functions within the company such as risk, compliance and internal audit and information from independent third-party advisers, or other external information sources.
Whilst cross-committee membership can facilitate information across the company, ASIC suggests that regular joint committee meetings and remuneration committee meetings that provide a voice for cross-committee members are better practices.
Arrangements to manage conflicts of interest
Boards should maintain an independent role in overseeing and making executive variable pay decisions. Conflicts may arise where, for example, executives advise the board on factors impacting their own variable pay outcomes, such as decisions on the size of bonus pools.
Remuneration committees should have enough time to exercise discretion so that independent judgment is properly considered and applied - this requires forward planning and scheduling of relevant meetings. There should also be an accurate record of how those determinations were made, as outlined by Andrew Lumsden in a piece titled The Art and Science of Company Minutes.
Transparent recording and communication of decisions
More than ever, there should be a strong narrative in corporate disclosures regarding the 'how' and 'why' for board decisions on executive pay. This will assist in maintaining investor confidence.
Boards should consider including the following matters in remuneration reports:
- the overall rationale to ensure consistent and active exercise
of their discretions and that they are commensurate with the
organisation's long term results;
- when and why discretion has been exercised, or not exercised,
in final pay outcomes;
- the governance process and principles adopted in making
executive variable pay decisions; and
- how the company's specific circumstances were considered in the decision making process.
Remuneration determination is incredibly challenging for boards and is clearly a maturing area of development in corporate governance. That is made even more difficult in the time of COVID-19 when it is challenging to determine what represents appropriate reward in the context of significantly diminished enterprise values and what represents fair reward to executives under long-term incentive plans where their organisations may, in relative terms, have outperformed their peers but where shareholders have suffered a significant loss in the value of their investment.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
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