March 21, 2009
The Government is moving to rein in what an angry public see as excessive executive payouts. Here, four key players debate the issues, and look for answers, with BusinessDay’s MALCOLM MAIDEN.
MALCOLM MAIDEN The question that people outside the business world are asking is – in this environment, is executive remuneration too high?
MARTIN LAWRENCE There are certain cases where pay is just too high.
CEO pay – Sir Rod Eddington
Sir Rod Eddington, Chairman JP Morgan Australia and NZ and a director of News Corp and Rio Tinto explains what boards must do to regain community confidence.
We don’t see it happen very often in Australia. There was a case with Adelaide Bank two years ago where the termination payout to their managing director was so large that they had to issue a profit warning. Everyone, I think, would quite happily say that that is too high.
The better question is: is executive pay linked to performance? Is it actually a fair reward for what’s been achieved?
We’re finding that out right now because we’re starting to see the first disclosures made after things have really started to turn down.
In some cases it’s looked pretty disproportionate.
SIR ROD EDDINGTON Historically, it’s a debate you only have when markets are turning down. It’s not usually a big issue when markets are ramping up, shareholder values increasing, businesses are doing well.
The key question is: is executive compensation linked to the right things? And does it deliver the right behaviours? Linking compensation to medium and longer-term shareholder return is a good thing. You get some strange outcomes – because there’s a lead and a lag effect, you’ll perhaps have rather bigger incentive payments at a time when the market is going down.
You need to make sure that the incentives for senior executives are aligned to the objectives of the company – that the relative salary packages of senior people in a company are appropriate.
In Japan, senior executives get a much smaller premium over the packages of what I would call front-line staff. In America, that difference is substantial. Australia is sort of in the middle.
MAIDEN Are the Government’s moves to cap golden handshakes, and inquire into executive remuneration, the right ones?
JOHN COLVIN With the benefit of hindsight, it would seem there have been mistakes made by some companies. But we believe that education is better than legislation in fixing whatever problems exist. On the termination payments changes – we’re disappointed that legislative action is being taken without prior consultation and ahead of the expected Government discussion paper.
LAWRENCE The changes will allow shareholders to protect the company against huge payments to departing executives and should help boards in their bargaining with executives. If boards respond by simply increasing salaries – again – it will be clear whose interests they are protecting.
MICHAEL O’SULLIVAN The inquiry’s timetable will mean that the Government will not be taking any further steps to intervene in the remuneration issue for at least 12 months.
MAIDEN Well, should shareholders get the power to determine executive pay packages?
O’SULLIVAN I think it’s a foolish proposition to ask shareholders to make detailed judgements when they don’t have – they simply can never have – the information. You need the degree of disclosure you would have in a takeover situation, where you’re in a locked room, in order to make those kind of judgements in any sensible way.
We think that the Opposition policy of a compulsory shareholder vote is foolish. We do think that shareholders should vote on issues of shares, including shares bought on-market for executives. But other than that, we don’t want a compulsory vote.
We’ve done a longitudinal study looking at the movements in chief executive officer payments. From ’01 to ’07, the consumer price index has increased by 17.7 per cent; average weekly earnings have done quite well, 32 per cent; but CEO fixed remuneration – not bonuses, not rights issues, not options – 97 per cent.
It just seems to me that what used to be the work value of any job hasn’t increased in that kind of proportion.
Now that the tide’s gone out and a lot of “boats” are left a long way from the water, people are in some cases going for short-term cash bonuses (that are) not in any way transparent – described to us privately as “if we don’t retain this fellow, he’ll walk”. We really don’t think that is credible: where’s he going to walk to?
COLVIN In the US, in ’84, Congress brought in a law saying that you can’t get a tax deduction for more than three times pay for a termination payment. Everybody (then) rose to that level because that was a norm which the Government had set, as opposed to leaving people to say “well, is that right?”.
I think it was Bill Clinton who brought in a law, in ’93, that said you can’t have a tax deduction for anything more than $1million. Short and long-term incentives just shot off.
So you’ve got regulation distorting the market, making it much worse. We have some of those distortions in Australia. Squeeze the balloon at one end and it goes somewhere else.
O’SULLIVAN It’s hard to say that those regulations caused the egregious behaviour.
COLVIN It doesn’t drive it, but it does distort it. Boards must take control of executive remuneration, particularly the CEO’s. You’ve got to get that absolutely spot on.
Ironically, you probably should be paying more money because they’re actually working harder (now) that the numbers are going the wrong way. When everyone’s rising with the tide, you probably shouldn’t be paying as much.
MAIDEN When remuneration reports are rejected, the same shareholders at the same meeting overwhelmingly support the re-election of the directors who presented the report – seems illogical, doesn’t it?
COLVIN Does it? It is such an emotive issue. I think it is used as a grab bag for voting dissatisfaction against lots of other things. There’s often other angst about the share price: “This is my retirement saving, I’m angry … I’m not quite sure how to deal with it, but I’ll vote against the remuneration report.”
O’SULLIVAN: Institutions don’t vote against remuneration proposals unless we’ve analysed them and are dissatisfied. The best thing is to engage with the company about the bad things in their remuneration policy, or anything else. Our beneficiaries depend substantially, in their retirement, on the success of these companies. We don’t want to be bagging them in the public. It’s much better to approach them privately, see if we can persuade them to adopt a better course, or at least satisfy us that the course that they’ve taken is actually correct.
MAIDEN And when that doesn’t happen?
O’SULLIVAN That’s why there is the beginning of voting against particular directors. There are failures for which I think you can legitimately say that independent directors didn’t play the role that we would have expected of unconflicted representatives.
MAIDEN Do remuneration committees work? When the board votes on those reports, would there be directors thinking: “I can just tick this – the work’s been done?”
EDDINGTON It’s not uncommon for a non-executive director who’s not on the remuneration committee to ask for clarification because they know it’s going to be very much in the public domain, as it should be, and they’re going to have to defend it collectively.
If you want every member of the board involved in the minutiae of compensation or remuneration, or the risk and governance, directors will need to meet once a week and they’ll need to be full-time.
COLVIN Most boards don’t appoint a CEO more than once. Some don’t do it at all, because they become a board member when it’s been done previously. If the board’s doing it correctly, they will also have the remuneration consultants, the lawyers, the governance people, reporting directly to the subcommittee first, and then secondly to the whole board.
O’SULLIVAN The damage is frequently done with the original contract, and can’t be undone. That’s what gives rise to golden parachutes and all these kinds of “welcome-aboard” payments.
LAWRENCE Part of the problem is that when a board is recruiting a new CEO, it’s like drawing up a pre-nup agreement when you’re trying to convince somebody to marry you.
And we’ve seen it go wrong spectacularly fast.
COLVIN When I was drafting them, the best boards started the contract well in advance of looking for anybody. They had a big discussion about how far they’d go, the hot spots. The board was basically ready to say: “Whoever’s doing the negotiation … has authority to those levels. Come back and chat to us if we get him.”
EDDINGTON I didn’t get a golden goodbye. I would never have accepted one. I wouldn’t expect it to be in the contract. And my view is it’s nonsense, really. You don’t need to put it in there. Good chief executives will front up as long as you offer them a good competitive salary. They don’t want payment for failure either.
But look at (US insurer American International Group) and their bonus payments. Not all boards are smart.
MAIDEN Are the remuneration and search consultants part of the answer or part of the problem?
O’SULLIVAN A bit of both.
COLVIN The lawyers, if they’re doing their job well, will set out the contract and the structure. They won’t advise – because they’re not qualified – on remuneration levels. A lawyer will be asked: is this permissible under law. Their job is to say it is or it isn’t.
Then the next question of the remuneration consultant is: is this fair and reasonable? Yes or no? Remuneration consultants are good up to a point, and then it’s got to come back to commonsense.
LAWRENCE: Unfortunately we see, too many times, boards hiding behind their advice. We’ll say, “Why did you decide to pay your CEO an amount which, if I compare him to the obvious peers, his base for turning up is much higher?” And they say, “Oh, we got an appropriate peergroup from an independent consultant.”
Remuneration is one of the very few insights you get into the relationship between the executives and the board. An executive team that is able to get the remuneration outcomes it wants most of the time is also more likely to be able to come to a board with a merger proposal that perhaps shouldn’t have been done, and get it through. It’s an insight for how that relationship works.
O’SULLIVAN One of the issues in a merger was options that people had. They got a remuneration company to reconstruct what would have happened at an assumed share price.
They paid people for forgone options packages that would have been underwater by 10,000 fathoms if they’d been allowed to run.
When we confronted the chairman, he was sort of laughing with us, saying, “Well, I don’t blame you for not being able to understand it; I could never understand it either.”
That’s just not an independent chairman’s role – to give something a tick when he plainly had no idea how it was calculated.
MAIDEN What is the difference between short and long-term incentives?
O’SULLIVAN One is to encourage making decisions that pay off in the long term. And we’ve always said we don’t mind if people don’t get the rewards for that after they’ve left the company.
Short-term incentives are frequently based not only on financial, but non-financial considerations which (companies say) are sometimes difficult to disclose – but we are very sceptical about the non-disclosure.
LAWRENCE The Corporations Act doesn’t actually acknowledge short and long-term incentives’ existence. It just says any remuneration that is tied to a performance condition, you must disclose a detailed summary of the condition. In 2008, in the top 100 companies, 94 per cent of CEOs got more than 50 per cent of their target bonus, and 45 per cent got more than 100 per cent.
MAIDEN It does seem that it’s base pay in drag.
COLVIN Why not go back to where you get a base pay and a discretionary bonus? Many commentators say we’re not going to have any part of a (system) which allows the board to use their discretion – but that’s probably a trust issue.
Let’s say a chairman went to the shareholders and said: “We’re going to have a base pay. Then the CEO can have a bonus at the discretion of the board up to a set amount.” The chairman may say, “I’m going to do that because I don’t know yet whether the CEO’s going to work out. I also don’t know whether we need to pay a little bit more to keep somebody around in really tough times, or really good times.”
However, this will give the board the flexibility to adjust up and down to meet the existing circumstances without relying on any complicated formulas.
O’SULLIVAN Very largely, the behaviour over the last 10 years has caused a loss of trust. I think you can never have a situation where you don’t disclose the basis for your discretionary judgement.
COLVIN But if the chairman got up and said, “Look, I have awarded 50per cent, because we have been on the edge of going out (of business)”, are you giving really confidential information to your competitors?
Are you spooking the market by being really honest?
LAWRENCE Just say that the board exercises discretion this year to reduce these payments.
EDDINGTON Boards will never do that, nor should they. If a chairman’s going to have a performance discussion with the chief executive he doesn’t want to read about it in the annual report – or the newspapers the next day.
LAWRENCEThe problem is we do (read) about the non-performance payments.
EDDINGTON You don’t read about the conversation where the chairman says to the chief executive, “I think you’ve earned 70 per cent of your bonus this year.”
That’s the sort of conversation a good chairman has with his chief executive, although clearly the size of the bonus should be in the public domain.
MAIDEN Do we have agreement that simplification of remuneration policies is desirable?
EDDINGTON Simple has always got to be better. If you’ve got a formula everyone can understand quite quickly – staff and shareholders – then you’re probably in the right place.
If you need a PhD in mathematics to work it out, self-evidently it’s wrong. People don’t trust what they don’t understand.
MAIDEN Finally, what do you think is going to be the biggest change to remuneration policy that comes out of this?
COLVIN I think one will be something which we haven’t got on to: a focus on what does remuneration do in terms of the culture of the organisation, not only in terms of who we are and what we do, but the ethics and the whole structure that goes behind that.
EDDINGTON I hope that all this focus on remuneration which we’re seeing now will result in clear and hopefully simpler compensation packages for executives that are tied to the things that matter in the business.
O’SULLIVAN What ought to happen is that boards should understand that in relation to some of these bad remuneration policies, responsibility is with them.
If the same people repeat the same errors, then the ultimate recourse is to say to these people, “We really need to get somebody else in there.”
LAWRENCE What I hope will happen is that boards think about whattheir stance on executive pay says about their position with theirshareholders and with the community.
Trust is a precious commodity. It’s hard to get, very easy to lose.
SIR ROD EDDINGTON Chairman-designate of ANZ Bank. He is also a director of News Corporation and Rio Tinto and a former chief executive of British Airways. Chairs Prime Minister Kevin Rudd’s Business Advisory Council.
MICHAEL O’SULLIVAN President of the Australian Council of Superannuation Investors, which advises super funds on corporate governance and other investment risks. Deputy chairman of CARE Super.
MARTIN LAWRENCE Co-head of Asia-Pacific governance research for RiskMetrics, responsible for Australia and NZ proxy research. Former manager corporate governance at BT Financial Group’s Governance Advisory Service.
JOHN COLVIN Chief executive of the Australian Institute of Company Directors. A lawyer by training, he was formerly a partner at legal firm Freehills, specialising in employment law and corporate governance, advising companies on executive appointments.