by Helen Dent, Chairperson Australian Shareholders' Association

The ASA has good reason to welcome the directions taken in the Productivity Commission's draft report.  There is much in it that we believe has the potential to produce better remuneration practices for companies.  It provides much-needed quantitative evidence in a field that has been far too empty for far too long; and it has thrown a considered spotlight on claims, counter-claims and the odd myth, challenging in the process concepts that stakeholders in this battlefield have spent many years arguing about.  ASA thinks there needs to be a lot more of this.

Based on shareholders' wishes to increase their long term wealth through sustainable growth in profit making by their companies, ASA considers shareholders' chief concerns as regards executive remuneration include:

• Getting the best top executives and retaining them in their companies
• Paying them appropriately to achieve this end
• Not paying top dollars for average or below average performance
• Feeling they can trust their boards to be honest and deal openly with them.

ASA redeveloped its executive remuneration policy with these chief concerns in mind through the second half of 2008 and the first half of this year, announcing the new policy in May 2009. The policy focuses on several critical factors and recommends guidelines for companies in constructing their remuneration policies and reports.

ASA's key factors and guidelines - many of which, gratifying to the ASA, seem to be reflected in the Productivity Commission's draft report - are:

• Transparency and clarity of structure and reporting

o   If shareholders aren't told in language they can understand what, how and why their managers are to be paid, they will assume the board wants, and has something, to hide from them

• It is appropriate for the remuneration package of a CEO to include a substantial "at risk" element

o   Shareholders want to harness the self-interest of their top managers via this approach so that top management interests are  focused on things that in the long run sustainably increase shareholder returns

• Incentive payments in addition to base salaries are only acceptable, however, if they reward superior, as against merely satisfactory, performance

o   and that superior performance must have been proven by the achievement of  predetermined and challenging targets or performance hurdles that shareholders are told about in plain English

• Incentive structures must be properly and demonstrably aligned with the long term interests of shareholders

o   with performance assessed over at least a 4-year period

o   with dual hurdles to reflect the dual objectives:

1.  to reward executives for achieving superior performance shared by shareholders - and thus based on total shareholder return (TSR) or an equivalent measure, not just relative to an appropriate comparator group, but in absolute terms so that negative TSR cannot be used to reward an executive
2.  to encourage executives to ensure future superior performance - based on  growth in earnings per share, return on funds employed or another verifiable measure the board considers best reflects long-term progress across the cycle

• Short term incentives are questionable as incentives for CEOs unless they are entirely consistent with long term company strategic objectives and transparently measurable

o   and as for everything concerning executive remuneration, they must be disclosed to shareholders, if necessary for commercial reasons, retrospectively

• Boards must not permit executives to enter into arrangements (such as hedging) that reduce the risk elements essential to effective incentive schemes

o   Either there is risk or there is not - no risk, no incentive

• Termination payments to failed executives that are above statutory entitlements or that include additional amounts in lieu of notice are unacceptable to retail shareholders

o   Boards need to get departure conditions in employment contracts right from the start and shareholders must be told what they are upfront

• Golden parachutes are totally unacceptable to shareholders

o   no matter what they are called - likewise, other lump sum payments additional to the agreed annual remuneration package, for example, executive retention payments, and compensation for "benefits foregone at previous employers"

• The final plank on which ASA's policy places a considerable degree of reliance to bring it home to boards that their owners want to be listened to carefully and with genuine respect is that their positions too would be on the line if shareholders feel they are being ignored

o   Where independent shareholders have given a significant, for example 20%, negative vote against a remuneration report and the board concerned has failed to take appropriate corrective action, the ASA intends to vote undirected proxies against any of the directors up for re-election at the next AGM of that company.

This last point has been further strengthened by the PC with its so-called' two strikes' recommendation.  A recommendation termed ‘radical'; opposed as ‘crazy'.  It is neither.

The proposal merely adds a facilitative feature to the existing position.  Although ASA would sound a note of warning here - and it has been acknowledged by the Productivity Commission - as with all regulatory proposals, it is vital to look for potential unintended consequences. There may be undesirable implications arising from the proposal that require covering off.

But in terms of some of the criticisms, what seems to have been glossed over is the fact that minorities cannot remove either an entire board or even one director. Only majorities of shareholders can do this. So to suggest or imply that a minority - even a large 25% minority - can remove a board is incorrect.  What the PC has proposed is to remove the requirement for shareholders to go through a regulated (249N/ 249P) process to get an opportunity of demonstrating whether a board has lost the confidence of the majority of their shareholders over a critically important issue - how they pay their top managers, and themselves. And they'll need to have lost such confidence over at least a two year period.

To underline the fact that the concept is neither new nor radical, only last week, shareholders in a listed company banded together to replace an entire board of a listed company because they had lost confidence that the board was acting in the long term interests of its owners (Van Eyck Three Pillars).  The majority vote to replace the board, in this case, was around 60% - 65%.

This was a very rare occurrence of shareholder activism taken to its ultimate by shareholders. Its very rarity indicates the conservative use of existing powers. There is no reason to suppose that shareholders would be anything other than very careful and conservative in exercising these types of powers that they already hold.

There is a degree of fit between what the ASA set out as its vision for aligning the interests of top executives with those of their shareholders, and the directions taken in the Productivity Commission's draft report. The Commission's focus on incentive structures and the links between performance and pay that companies and stakeholders like the ASA so much want to see established effectively, is gratifying.

However, its treatment remains deficient.

We couldn't agree more with the PC's conclusion on remuneration principles (p 297) that "well-designed pay structures facilitate alignment of interests, whereas poorly designed schemes can deliver the opposite."

The draft report says (p 70) "the relationship between performance and remuneration was found not to be statistically significant ... The exception was a positive relationship between net profit growth and the value of total remuneration".  And it goes on to say "....the nature of the disclosed remuneration data means that it is not well suited to investigating relationships between remuneration and corporate performance. Better data could yield different results."

We agree. There is a need to see more on how boards can effectively employ performance measures in practice. ASA was hoping this inquiry would undertake research further into this area to shed more quantitative light on the factors within the control of CEOs and MDs that actually impact on long term outcomes for companies.

Shareholders don't want to see performance hurdles used to influence executive behaviour when these hurdles have little or nothing to do with the long term outcome for their companies. Or worse, actually work against those desired outcomes.  The help boards need can come from a body like this inquiry, and in the months remaining till its completion, the ASA would like to see the groundwork laid for ongoing public funded research to enable better and more effective measures to be developed.

We need boards and shareholders to understand better what measures can be used to link incentives to company performance.