Don't get caught by a second strike

John Egan provides pointers on how directors should approach executive pay this reporting season.

Whether directors believe the “two strikes” rule has been a necessary addition or an unwelcome imposition to governance, its introduction three years ago has changed the board landscape. A survey of directors conducted by Egan Associates earlier this year indicated this change has, overall, been for the better. The survey found that:

• 82 per cent of respondents believed the two strikes rule had been a key driver of boards’ remuneration decisions.
• 63 per cent said remuneration policies had improved since the introduction of the rule.
• 33 per cent stated that although past and present remuneration policies had led to excessive executive remuneration, balance was returning.
• 43 per cent said board and management restraint in setting remuneration was already having positive effects.

A similar survey in the US found only 26 per cent of US directors believed the US’s non-binding say on pay rule had been a key driver of board remuneration decisions. Thus, it would appear the harder-hitting two strikes rule has been more effective. However, not all the Australian survey’s findings were positive. Almost three quarters of respondents believed past and present pay policies had led to excessive executive remuneration. Most believed some companies were failing to align their pay models to strategy and one quarter said the link between pay and performance needed to be strengthened through more transparent and disciplined target setting.

In the light of these findings, directors should examine each element of their remuneration framework and consider whether there are opportunities for improvement. Has the framework been designed with the company’s strategy in mind? Do the elements work well together to reward superior performance? Has shareholder value increased relative to the remuneration executives receive? Some more specific considerations for directors include:

• Fixed remuneration: Are appropriate benchmarking practices being used? Do pay levels reflect the skill level as well as position accountability? Are internal relativities appropriate? Remember that fixed remuneration often acts as a multiplier for incentive pay so changes flow through into the total package.
• Annual incentives: Is the level of deferral appropriate? Does meeting targets require more than a business-as-usual performance? Are stretch targets truly a stretch? Has the board considered incentive outcomes under different scenarios (including a loss)? Is the relationship between financial and non-financial performance measures correct? Has the board taken into account the inclusion of clawback in the latest version of the ASX Corporate Governance Council’s Principles and Recommendations?
• Long-term incentives: Is the performance period the correct length for the business cycle? Do the performance hurdles reflect long-term business goals? If relative performance measures are used, is the peer group appropriate? Is the value of the award opportunity clearly communicated to shareholders? Is the amount vesting to executives for stretch performance in line with the stated remuneration intent? Under what circumstances would the board exercise discretion?
  Regarding the efficacy of the two strikes rule itself, the survey revealed an undercurrent of frustration. Over a quarter of respondents said there was no correlation between remuneration report votes and the organisation’s alignment of pay with performance. Directors noted that the rule could be easily hijacked for non-remuneration purposes. Concerns were also expressed about the amount of board time spent on remuneration since the rule’s introduction, with 32 per cent noting that it took time away from other critical board issues.

With time this is likely to improve, but until then the board can take a number of actions to try and reduce the burden:

• Ensure disclosure is clear, concise and explains the “why” as well as “what” and “how much”. The focus should be on quality information rather than quantity. Respondents believed current disclosures were too long to be valuable. Indeed, 80 per cent would like the complexity of disclosure to be reduced. 
• Waiting for a “no” vote to talk to key investors is false economy. Identify key stakeholders to deal with proactively. A targeted rather than scattergun approach is required to optimise the board’s time.
• Ensure enough information has been provided for key investors to consider your framework on its merits, especially if it has a unique element designed specifically for your company’s strategy and business.
• Consult a remuneration adviser who is willing to provide remuneration recommendations, not just information or informed guidance. This ensures transparency and accountability.

If a board follows these recommendations and a strike still ensues, directors should remember that most investors do not want the board to be thrown into disarray and are likely to be just as keen as the board to engage and avoid a second strike.

What is the two strikes rule?
Shareholders have to vote on whether to spill all board positions if 25 per cent or more votes cast are not in favour of adopting the remuneration report at two successive AGMs.