Monday, January 04, 2010

Productivity Commission releases weak report on runaway executive pay rises

The Australian Government today released the Productivity Commission's final report on Executive Remuneration in Australia. The final report follows the Commission's discussion draft in late September. The inquiry's chairman, Gary Banks, said the changes from the September version are mostly “fine-tuning” though some have been significant. “This includes our proposed 'two strikes' rule, requiring boards to submit for re-election where shareholders repeatedly vote against their remuneration decisions,” he said. “We consider that we now have a formulation that will encourage behavioural change in those boards where that is needed, without posing significant downside risks for public companies generally.” The Government will respond to the recommendations later in the new year.

The full report is available in PDF format at the Productivity Commission’s website however the overview section gives a good synopsis of the report’s key points. It begins with the need for the report by saying that massive executive salaries in the two decades leading up to the GFC often despite poor company performance “have fuelled community concerns that executive remuneration is out of control.” The report also noted that executive pay escaped the GFC unscathed. This is most notable in top 100 companies while the top 20 CEOs earned an average $7.2m a year in 2008-9, about 110 times the average Australian wage.

Liberalisation of the economy, global competition, increased company sizes and incentives were all cited as causes for the large salaries. The problem is that incentive payments have been introduced without appropriate hurdles and golden handshakes have been excessive and indicate compliant boards. These have lead to issues with investor confidence and the trust of the wider community.

The commission says the solution to these problems does not mean by-passing company boards, capping pay or introducing binding shareholder votes. Instead it recommends two actions. Firstly companies should remove conflicts of interest through independent remuneration committees and the use of remuneration consultants. Secondly, companies should promote board accountability and shareholder engagement through pay disclosure and “strengthen the consequences” for boards who are unresponsive to shareholder demands on pay.

Problems with disclosure mean there is no long-term data for executive pay. But what data is available suggests CEO pay grew between 13 and 16 percent a year between 1995 and 2000 going down to 6 percent a year between 2000 and 2007. The report says company size accounts for up to half these pay rises and large companies do need internationally experienced and highly capable CEOs. But there has also been a flow-on from excessive pay rises in the US to Australia particularly in the importing of high-profile (and highly paid) CEOs.

The commission sits on the fence as to whether compulsory disclosure of executive earnings at listed companies (introduced in 1998) has accelerated remuneration. But it is less ambiguous about incentivised payments which can be rorted by compliant boards or camouflaged pay arrangements that make the ‘at risk’ components a virtual certainty to achieve. The outcome is that many CEOs have been rewarded for failure or dumb good luck.

Nonetheless the commission warned against prescriptive methods such as pay caps which would have practical problems due to market variations and cause disadvantage to Australian companies competing against similar overseas firms. It also says a shareholder binding vote would be “unworkable” due to the complexity of the report and would compromise the board’s ability to negotiate with executives. The board remains a crucial element, they say, in ensuring a company has a remuneration strategy that promotes its long-term interests.

To that effect, the Commission recommend improvements to corporate governance, the credibility of boards and making boards more accountable in relation to pay setting. It endorsed the ASX Corporate Governance Council proposal for companies to report publicly on progress in achieving their own declared targets. It also encouraged greater transparency around selection of board candidates regardless of gender. Shareholders should also have a say on proposals by boards to limit board vacancies.

It also proposes strengthening requirements for the establishment of remuneration committees. It says their membership should be independent of company executives, particularly for the top 300 companies who require remuneration consultants to report directly to the board. And their remuneration reports should disclose the use of remuneration consultants.

One of the key new recommendations is the weakened “two-strikes rule” of shareholder voting against remuneration reports. This means that in year 1 if more than 25 percent of shareholders vote against the report, companies will be obliged to explain their actions in the report. Then in year 2, if the no vote is still over 25 percent, there would be a separate re-election resolution. If this resolution passes, the company must call an extraordinary general meeting within 90 days to re-elect directors. In the September proposal, there would have been an automatic spill after two protest votes.

The commission says that while a high vote against remuneration doesn’t necessarily translate into a vote against directors, the mechanism “would still hold to account those boards considered deficient in relation to executive pay practices.” This aspect remains to be seen and in truth, it is questionable at this distance whether the watered-down approach of the Commission will have any effect on runaway executive salaries. Ultimately it should come down to consumer power, and more responsible and knowledgeable buying decisions to ensure that companies are punished for rewarding greedy executives.

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