Many pundits believe the two strikes rule on executive pay has been ill-conceived and will result in a host of unintended consequences. As the dust settles on last year’s AGM season, Tony Featherstone sifts the facts from the fiction and investigates what boards can expect this year on this issue.
As business theatre goes, the "two strikes" rule potentially makes for gripping drama. If one believes the hype, the new rule will force a showdown in 2012 between shareholders and dozens of listed companies that have had a protest vote of 25 per cent or more against their remuneration reports. A second strike could lead to ugly board spills, as shareholders take revenge on directors for excessive executive pay.
The mere threat of a spill could supposedly damage share prices, as investors dump stocks in companies that are likely to receive two strikes at successive annual general meetings (AGMs). JP Morgan research found companies with a hypothetical strike between 2008 and 2010 underperformed the S&P/ASX 200 index a month after their first strike. Those with two or three strikes performed even worse. An actual board spill would surely do even more share price damage.
Other speculated fallouts from the two strike rule include: strained relations between boards and executives on pay; a move away from non-financial performance targets for long-term incentives that are more likely to attract a first strike; less scope for companies that have underpaid their executives relative to their peers to make big pay adjustments; and board composition issues as directors retire before their companies get a second strike, and as directors refuse to join boards with a second strike and a potential board spill hovering over them.
There have even been reports that dozens of ASX-listed companies in the top 500 by market capitalisation could face a board spill in the two main AGM seasons this year. At its extreme, this suggests dozens of directors could lose their jobs in 2012, causing chaos among Australian boards and further pressuring the main share market indices.
But as always, the facts are far less interesting than the fiction.
"It’s too early to say whether the two strikes rule has had a positive or negative effect on the alignment of executive pay and performance because it’s only in its first year," says Australian Council of Super Investors (ACSI) CEO Ann Byrne. "However, I do think there has been an over-reaction to the two strikes rule."
Only 15 of 176 companies in the ASX 200 (some had not held their AGMs when the research was completed) registered a vote of more than 25 per cent against their remuneration reports, Australian Institute of Company Directors analysis shows. Only a handful of ASX 100 by market capitalisation received a first strike. The median protest vote was 33 per cent.
Company Directors’ research shows the hypothetical percentage of ASX 200 companies that failed to meet the 25 per cent threshold fell from an annual average of 14.5 per cent between 2008 and 2010 (had the two strikes rule been in place then) to nine per cent in 2011. Put another way, the vast majority of Australia’s ASX 200 listed companies had their remuneration reports approved by the vast majority of their shareholders.
Also lost in some commentary about the two strikes rule is the process itself. If 25 per cent or more votes are cast against adopting the remuneration report at two successive AGMs, a spill meeting must be held within 90 days, at which an ordinary resolution must then be put to re-elect directors in office at the second AGM.
This means boards can work – and have been, judging by results from the latest AGM season – to reduce the risk of a second consecutive strike by revisiting remuneration arrangements and through better communications with investors on executive pay issues.
It seems unlikely that many ASX 200 companies that receive two consecutive strikes, especially those with dominant shareholders, would receive 50 per cent of eligible votes cast to spill the board. Key management personnel cannot vote on adopting the remuneration report, but in an ordinary resolution every shareholder has the right to vote. This makes the 50 per cent requirement to spill the board a big hurdle, and only two companies (Pacific Brands and Crown) of the 15 that received a first strike in the latest AGM season had a protest vote of more than 50 per cent against their remuneration reports.
"Proactive companies will not wait until their second AGM if they have had a first strike," says Jon Finlay, a Deloitte partner and head of its board remuneration adviser services. "They are getting in early by organising investor briefings, gauging shareholder feedback on remuneration matters and explaining what they are doing to ensure investors accept how they are using performance-based pay to drive company performance."
Finlay adds: "Even if an ASX 200 company does get a second strike, it is unlikely that many spill resolutions would pass, given 50 per cent of the vote is required and all shareholders can vote on the resolution. It is unlikely that shareholders or directors would risk damaging the company and its share price through a board spill, except in those situations where very strong action is required against a company’s executive pay practices. I doubt we will see many, if any, board spills among ASX 200 companies in 2012."
Not surprisingly, much of the media focus has been on "outlier" companies that received a big protest vote. Less considered was the work of many boards that achieved higher shareholder approval for their company’s remuneration reports.
Transurban Group, Challenger, PaperlinX, Billabong International and Boart Longyear saw the vote against their remuneration reports fall under the 25 per cent threshold, some well below. Transurban, for example, went from 52 per cent of proxy votes against its remuneration report in 2010, to about nine per cent in 2011, which suggests its board did a good job changing the company’s executive pay approach and explaining the revised approach to its key investors.
A leading remuneration adviser, John Egan, of Egan Associates, says many boards deserve credit for improving the vote on their remuneration report. "A number of boards have approached this challenge in a proactive manner," he observes. "They have gone to shareholders and their representatives before the AGM to explain the company’s circumstance and its plans, and to more appropriately accommodate conflicts that are perceived between shareholder expectations and executive reward."
Egan says examples of "well-managed, open communication" on executive pay include the work of Transurban chairman Lindsay Maxsted; QR National chairman John Prescott, whose company missed its 2011 financial year forecast because of the Queensland floods and cyclones; and OneSteel chairman Peter Smedley, who worked closely with the company’s major shareholders to explain its pay approach, resulting in a more favourable vote on its remuneration report despite significant challenges in the global steel industry and the rejection of rival BlueScope Steel’s remuneration report (38.8 per cent of shareholders voted against it).
The experience of these and other companies show how strong board engagement with shareholders can improve the understanding of a company’s pay practices and reduce the risk of a first or second strike.
Byrne says ACSI, which represents funds that collectively have more than $300 billion in assets under management, had many more visits from companies last year explaining their positions on executive pay. "Boards were certainly more proactive on executive pay, although some still decided to contact us after they had sent out their meeting papers. ACSI does not only want to talk to companies about executive pay; there are other more important issues for investors."
Byrne says there are still recurring problems that companies need to address before their next AGM. Too many still do not disclose performance hurdles for long-term incentives, the quantum of pay in some small and medium-size listed companies is excessive and a proper audit system for share voting, long overdue, is another issue ACSI will push for in 2012.
Another overstated risk is directors retiring from companies that have a first strike, to preserve their reputation or because they do not want the angst of a possible board spill. Robert Webster, senior client partner and head of global board services at Korn Ferry International, has seen no evidence of directors thinking about leaving the board of a company that has a first strike.
"Maybe at the margin, a director who is thinking about retiring anyway might choose to go early," he says. "I have always found the best directors are there in good and bad times. I don’t know of directors who are easily frightened by things such as the two strikes rule or likely to make rash decisions because of it."
Egon Zehnder International partner Chris Thomas says the two strikes rule has not reduced the attractiveness of directorships of ASX 200 companies. "The Centro judgment has had a far bigger effect than the two strikes legislation in making directors think twice about joining a board," he says. "I see the voting on remuneration reports as more of an irritant than a major factor that turns people off joining boards of companies that have had a strike or boards generally."
The analysis of remuneration report voting from the latest AGM season and expert comments suggest boards have mostly done a good job with this clumsy two strikes rule. But it is dangerous to form a view only on published voting statistics, because they do not reveal how much work boards have put into this issue, whether the two strikes rule was necessary and other unintended consequences.
Prominent board figures, such as Stockland chairman Graham Bradley AC FAICD and QBE Insurance Group chairman Belinda Hutchinson AM FAICD, criticised the two strikes rules late in 2011. Others, such as Cabcharge Australia executive chairman Reg Kermode, attacked it. The obvious problem is the 25 per cent voting threshold is far too low and gives minority interests too much scope for mischief.
Engineering group UGL is a case in point, says Egan. "A board such as UGL, which had noted shareholders’ concerns and adjusted its CEO’s pay in the 2010 financial year and had outperformed its traditional comparator peers, received a negative vote of 30 per cent, driven by less than 12 per cent of shareholders because of the spread of its share register. This means more than 85 per cent of shareholders were not opposing the UGL remuneration report."
Egan says the two strike threshold should be higher. "The two strikes rule is, and has been, inappropriate in its structure, although the intent behind it may well have some validity. If a two strikes arrangement is to be retained, then like in all democratic processes, a minimum of, say, 40 per cent of all shareholders, in our view, should endorse a negative vote before the board is forced to declare all board positions vacant."
Egan adds: "While this is less than a majority, we find in many democracies that governments receiving less than 50 per cent of the vote are given the opportunity to govern, but rarely does a government hold less than 15 per cent of the vote, which in reality is the outcome of the Government’s legislation on the two strikes rule."
Deloitte’s Finlay says the two strikes rule is especially problematic for dual-listed companies, such as BHP Billiton, Brambles and Rio Tinto.
"The rule only applies to Australian boards, so what happens if investors in London, for example, are happier with the performance of a dual-listed company than Australian investors, due to market or currency issues?
"You could have a situation where there is potential for a spill of the Australian directors, even though investors in the London-listed entity believe the board has done a good job on setting executive pay."
Finlay says the two strikes rule has added to board workloads. "Our work with boards shows the overall workload for directors has increased substantially," he says.
"Obviously the Centro judgment has put more pressure on boards, and audit and remuneration committees are meeting more often. Also, the intense focus on executive pay and the two strikes rule has put more pressure on remuneration committees and added to their workloads.
"When you look at voting results from the AGM season, and the very low number of top 100 companies that received a first strike, you wonder if the two strikes rule was necessary or if its benefits outweigh the negatives."
According to Finlay, another unintended consequence is boards taking a more conservative approach with performance hurdles for the vesting of long-term equity incentives.
He says: "The two strikes rule could force boards to think twice about basing performance-based pay on non-financial metrics, such as customer satisfaction or achieving restructuring or milestone targets, as was the case with Bluescope Steel. Boards might think that basing performance-based pay on non-financial metrics increases the risk of a first or second strike, and move away from this practice, which would be a shame."
Finlay says the two strikes rule is adjusting how remuneration committees and CEOs work together to manage pay for other senior executives.
"In years past, CEOs often had much more say in setting pay for their direct reports," he says.
"Increasing regulation is requiring boards to quite rightly take much greater interest in the quantum and structure of pay for the company’s top executives.
"I see the two strikes rule requiring patience on both sides to ensure senior executive remuneration continues to effectively drive company performance for investors."
Perhaps the best that can be said about the two strikes rule is that it has led to more communication between boards and key shareholders on executive pay.
It has also led to a more proactive approach by boards to explain how executive pay aligns with a company’s strategy and rewards philosophy and to clearer remuneration reports in annual reports, which is sadly lacking for too many companies.
But everything has a cost. Do shareholders want boards spending excessive amounts of time and cost on executive pay matters, at the expense of corporate strategy or other key board functions that arguably create more value? Was the two strikes rule needed in the first place, given the low number of first strikes in a bear market that, in theory, should inflame shareholder angst against executive pay, given falling share prices and dividends? What would the protest vote be like in a bull market?
Arguably the loudest message from the AGM season is that two strikes fallout so far has been a bigger issue for the media than for investors. And that populist policy is a poor substitute for well-considered, thoughtful consultation on key legislation that affects boards and ultimately investors.
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