Difficulties of rewarding bosses for achieving soft targets

Culture is not something boards can easily define, measure or pay executives for.

Calls for stronger alignment between executive pay and organisation culture after the Australian Prudential Regulation Authority’s (APRA) review of the Commonwealth Bank sidestep a critical question: what is culture?

For all the debate about organisation culture, the concept remains ambiguous. The lack of a consensus definition makes culture hard to define, measure and reward. Fund managers have criticised boards for using “soft targets”, such as culture, in setting executive pay.

“Nobody has adequately defined culture,” says Michael Robinson, director of remuneration and board consultant, Guerdon Associates. “Before boards start paying for improvements in organisation culture, they need to be very clear on what it is they are rewarding.”

Robinson defines culture as a set of normative behaviours. Rather than rely on more esoteric concepts, such as values and assumptions, organisations should measure the range and frequency of observed behaviours and decide which will be tolerated.

He likens these behaviours to a bell curve. “Big problems, such as employee fraud, usually occur at the ends of the curve. But boards often rely on tools on organisation culture that focus on averages when all the damage is done in the ‘outliers’.”

Robinson gives the example of an employee engagement survey. “Directors might look at data on how the average employee feels about reporting bad behaviour in the organisation. But there’s not enough focus on a few employees who are reluctant to report wrongdoing.”

Net promoter scores, a management tool used to measure customer loyalty, are another example, says Robinson. “A board looks at the average score of whether customers will promote the company to others but doesn’t looking at the minority who are criticising the organisation.”

Robinson says too many service providers have rebadged employee or customer tools as indicators of organisation culture. “Some of these tools are useful, but in general they encourage boards to spend too much time on averages and not enough on outliers. Management who have their pay riding on this are happy to present average scores to the boards. They get their bonus based on average score for a measure of culture when there are problems at the extremes.”

Measurement is one of several challenges in linking culture with executive pay. Organisation culture is often portrayed as a human-resources issue: for example, the shared assumptions, values and beliefs that govern employee behaviour. But culture is multi-dimensional.

Culture duration is another issue. Gains or losses in organisation culture can take years to play out. The banking sector has had numerous initiatives this decade to improve organisation culture, but the Financial Services Royal Commission has uncovered many shortcomings.

Market wary of soft targets in REM

Gaining market acceptance for “soft targets” in remuneration, such as organisation culture, is problematic. Commonwealth Bank shareholders in 2016 delivered a “first strike” on its remuneration report, amid investor scepticism over the use of “soft targets” to set bonuses.

CBA was criticised for a lack of clear metrics and targets in its REM report that year. The bank originally wanted to introduce a new "people and community" measure to determine 25 per cent of then CEO Ian Narev's long-term incentive, with another 25 per cent relating to customer satisfaction and 50 per cent based on total shareholder return.

The bank reverted to a scheme that used 75 per cent total shareholder return and 25 per cent customer satisfaction.

Fund managers and investor groups, such as the Australian Shareholders’ Association, complained at the time about the growing use of soft targets in pay by CBA and other companies. Criticisms revolved around difficulties in quantifying soft targets and whether executives should be paid extra for not damaging organisation culture.

One chairman, on the condition of anonymity, told the Governance Leadership Centre that many institutional investors are strongly against using soft targets in executive pay. He said: “A clear, recurring message I receive from investor meetings is that institutions want pay set against total shareholder return and other hard targets. They don’t trust soft targets such as culture.”

Investors have good reason to be wary. APRA noted “significant weaknesses in the implementation and broader oversight of the remuneration process in CBA” in its Prudential Inquiry into the Commonwealth Bank of Australia (CBA) Final Report, released in May.

APRA devoted an entire chapter of the report to CBA’s remuneration processes and said on page 71: “At the highest level, the CBA Board has not until recently held the CEO and Group Executives to account by exercising its discretion to materially reduce remuneration outcomes in response to adverse risk management, compliance and customer outcomes.”

APRA said it was “extremely rare”, prior to 2016/17, for the CBA CEO and group executives to have pay reduced on risk grounds or after reputational damage. It observed a lack of guidance from the bank’s Board Remuneration Committee on how managers should exercise their discretion when reducing remuneration for poor risk outcomes.

CBA was an early adopter of incorporating soft targets around people and customer satification into executive pay incentives. Clearly, linking pay to soft targets has not had the desired effect on improving bank culture, based on APRA’s findings.

Malus and clawbacks

Robinson expects “malus” provisions – the forfeiture of unvested remuneration – to be applied more widely within organisations following APRA’s reports and revelations from the Financial Services Royal Commission.

Several companies in the latest profit-reporting season disclosed provisions to forfeit unvested executive rewards in the event of financial misstatement, malfeasance or fraud. The banks, for example, have applied malus provisions on managers who have engaged in corporate wrongdoing.

“Typically, malus has been applied at lower levels in organisations,” says Robinson. “We haven’t seen malus widely applied to executive levels. I suspect more companies will start saying to executives, ‘Even though you didn’t commit the fraud, it happened on your watch through a lower-level employee, and you have to take some responsibility for the problem’.”

Robinson adds: “I think we’ll see APRA-regulated entities and increasingly ASIC-regulated ones deducting pay from executives when their staff are found to engage in misbehaviour. That will send a strong message to executives and the community at large that executives are ultimately accountable for staff actions.”

Clawbacks – the recovery of remuneration that has already vested– could feature. Some large Australian companies have clawback provisions that require executives to pay back remuneration if problems are later identified. APRA-regulated entities do not have clawback policies, which can be complex to implement.

International trends point to greater use of clawbacks. The Sarbanes Oxley Act in the US requires companies to clawback remuneration in defined circumstances, such as financial-account misstatement or fraud. For example, an executive who inflated earnings in a division to achieve bonus targets would have to pay that vested remuneration back to the company.

The United Kingdom in 2015 introduced clawbacks in its banking sector. The regulation requires banks to apply malus, and recover incentives paid via clawback, for seven years from the date of the award, with an extension to 10 years in certain circumstances.

“The use of clawback provisions in Australia and overseas will slowly grow, but remain fairly limited,” says Robinson. “It can be hard to enforce that executives pay back rewards when it does not relate to a clearcut issue of malfeasance or fraud, which may have court backing. How do you apply clawback to recover pay on issues that revolve around executive incompetence?”