Sharing Risks and rewards Risks and Rewards

Is there a case for performance-based director compensation in Australia? asks Eric Jansen.  Sharing Risks & rewards

Is there a case for performance-based director compensation in Australia? asks Eric Jansen.

It would be a great pity if the recent board experience at NAB sent other Australian public company boards back into their conservative corner, fearful of any risk-taking behaviour.

It is rare to find non-executive directors (NEDs) with a significant portion of their wealth tied to company performance. Purely as an illustration, a review of the top 20 publicly-listed companies on the Australian Stock Exchange reveals that NEDs have a median equity interest of $194,000 in the companies whose shareholders they represent. For the large majority of these NEDs, this interest equates to but a small fraction of their personal wealth.

The "normal" or conventional practice, which has gained increasing support since the collapse of Enron in 2001, is to remunerate NEDs with a fixed cash component, with any non-cash component limited to standard equity only. This is in line with Principle 9 of the ASX publication Principles of Good Corporate Governance and Best Practice Recommendations.

Given the intense focus on corporate governance in relation to directors' responsibilities, it is certainly true that a key requirement of company directors is a well-developed understanding of their duties and obligations to shareholders; as well as to other important stakeholders - creditors, employees and government agencies.

Unfortunately, this requirement has virtually become the raison d'etre for NEDs on company boards.

In the past year, almost in unison, regulators and commentators have moved with alacrity to concentrate on compliance before anything else. Boards are being subsumed in meeting standards as opposed to setting direction and directors are now being asked to focus on procedure more than ever before.

One could argue that the end result of this compliance focus is a deeply conservative board _ fundamentally risk-avoiding, with a collective inclination to retard rather than reward sensible and much-needed commercial risk-taking. This way of thinking stifles the company's ability to engage in responsible "entrepreneurial" behaviour.

Moreover, one could ask if this reactionary approach is consistent with the driving imperative of all boards of publicly-listed companies - to increase the value of shareholder wealth. Should not most of directors' time be spent growing the value of the company, rather than fulfilling statutory duties and obligations?

And pursuing this line of thought, would it not be logical to presume that directors will perform more effectively in the interests of shareholders, if their reward contains a meaningful "performance component"?

Non-executive directors do require a fixed fee component in their compensation to recognise the mandatory skills needed to perform on a public board. In addition, without compromising fiduciary duty, there is room for a variable component that is directly related to the performance of the company as a whole. How better to align the interests of directors with the shareholders they are representing.

The historical objections to performance-based pay for NEDs have been:

• NEDs should not be rewarded using schemes designed for the remuneration of executives.
• NEDs should not be involved in the "operational decision-making" of companies and therefore should not be expected to participate in its relative financial success (or otherwise).
• The principal focus for NEDs is to ensure adherence to good corporate governance standards and compliance with statutory requirements.

To balance this approach of risk-avoidance and to encourage an entrepreneurial mindset, it is time to challenge the current aversion to performance-based pay for NEDs.

The private equity and leveraged buy-out (LBO) market offers an interesting contrast to public companies in this regard, with NEDs who have both a large wealth exposure and medium- to long-term focus.

Under a private equity structure, the majority of directors are appointed directly by the lead investor to ensure board control. These directors are predominantly employees of the lead investor and their pay is typically highly contingent on the performance of the company they are collectively responsible for guiding. It is important to note, however, that their rewards are not only performance-based, but also are contingent on the sustained performance of the company over a number of years, until the company is listed through an IPO or sold to a trade buyer.

The director of a company which is under the control of an LBO must still adhere to the statutory requirements to which all other company directors are required to conform; their rewards, however, are ultimately determined by the sustained financial performance of the company under their control.

The powerful effect of this type of governance structure has been evidenced many times in recent months, with the successful "re-birth" of Pacific Brands and Repco being prime examples.

The drive by regulators and others to restrict directors' remuneration to solely fixed fee compensation will increasingly encourage risk-avoiding behaviour. In line with shareholders' expectations, directors have not only a responsibility, but a duty, to seek out appropriate risk-bearing opportunities in order to maximise shareholder wealth.

The notion of "pay-at-risk" is especially important for the chairman, who ultimately has significant power in relation to how quickly, and in which direction, the company grows. A risk-avoiding chairman may steer the company away from the very opportunities that shareholders expect the company to take for long-term wealth creation.

A new model might see the majority of directors having their fees in shares, locked in for three to five years, which would also require a commensurate raise in directors' remuneration to compensate for the additional risk inherent in holding equity (i.e. their pay would no longer be largely guaranteed, as it is now).

The best way of ensuring that directors are motivated to seek out valuable, risk-bearing opportunities on behalf of the companies they represent, is to ensure they share the risk that shareholders are taking, and also have the potential to share in the rewards generated by their entrepreneurial endeavours.

Despite the inevitable fallout from the NAB's boardroom battle, we must hope that chairmen and their boards do not retreat to positions of inertia, if only for the sake of investors in search of growth in their investment.

Disclaimer

The purpose of this database is to provide a full-text record of all articles that have appeared in the CDJ since February 1997. It is aimed to assist in the research and reference process. The database has a full-text index and will enable articles to be easily retrieved.It should be noted that information contained in this database is in pre-publication format only - IT IS NOT THE FINAL PRINTED VERSION OF THE CDJ - therefore there might be slight discrepancies between the contents of this database and the printed CDJ.