Good governance

Boards of ASX 200 companies have collectively strived to improve the alignment of pay and performance, and respond to intense market pressure on executive rewards. But is more needed to help restore community trust in big business?

As the Financial Services Royal Commission exposes a litany of bad behaviour, and as regulators question bank remuneration structures, the public could ask whether board efforts on executive pay are nearly enough or if new thinking is required.

Regulators believe more work on pay is warranted. Australian Prudential Regulation Authority (APRA) Chairman Wayne Byres in September 2018 said remuneration policies across large APRA-regulated entities met minimum requirements but were “some way off best practice”.

APRA’s review identified three problems with pay. One, employees at lower levels of organisations received downward adjustments to pay that were not always matched by corresponding adjustments at an executive level to recognise line accountability.

Two, performance measures for pay incentives are too focused on shareholder metrics such as Total Shareholder Return (TSR) – and that excessive weightings of such metrics can drive behaviour that does not support long-term organisation success and sustainability.

“The current structure of long-term incentives in Australia is particularly problematic in this regard, and is out of step with how best practices in remuneration are evolving internationally… This will also have to change,” said Byres in a speech, “Helping Regain theTrust”.

The third problem is shortcomings in oversight by board remuneration committees in some APRA-regulated entities. Stronger governance of executive pay is needed, argues APRA.

The Australian Securities & Investments Commission is also focusing more on pay. It signalled in September 2018 that it will investigate executive-remuneration practices.

“Remuneration is a clear driver of conduct,” said ASIC Commissioner John Price in a speech on improving conduct and restoring trust. “We will be looking at whether executive-remuneration structures, grants and vesting of variable remuneration are driving the right behaviour and accountability of executives in Australia’s listed companies. An initial issue we will be considering is focusing on the decisions by the board remuneration committee to award and grant variable remuneration.”

Taken together, it seems that regulators believe there is too much weighting on financial metrics in performance assessment for pay incentives (hard targets) and not enough weighting on broader non-financial measures that also drive company performance and sustainability, such as organisational culture and customer satisfaction (soft targets).

Investors still favour TSR

Boards of ASX 200 companies might be exasperated by the thought of introducing or increasing a weighting on soft targets for pay to improve corporate behaviour and help regain public trust. Some boards have tried to include soft targets for pay, but institutional investors have objected.

Others, such as National Australia Bank, have recently overhauled their remuneration structures to make them more customer and shareholder focussed.

Global proxy firm ISS Governance, in its April 2018 updated pay-for-performance methodology, “Evaluating Pay for Performance”, said the one common measure for investors in the context of long-term pay-for-performance evaluations was TSR.

ISS added: “This does not imply that ISS advocates for companies to use TSR as the single metric underlying their incentive programs; many companies and shareholders may prefer that incentive awards be tied to the company's business goals more broadly than TSR.

“…in one corner are regulators that want greater use of soft targets in reward performance incentives to help improve corporate behaviour and rebuild trust; in the other corner are institutional investors and their advisers that want the performance focus to remain on TSR.”

“However, if a company’s business strategy is sound and well executed, the expectation is that it will create value for share owners over time, and this will generally be reflected in long-term total shareholder returns. TSR is therefore the primary measure used in ISS's quantitative pay-for-performance alignment models.”

Some institutional investors privately argue that TSR or Return on Equity (ROE) is the most reliable measure of executive performance. Soft targets, such as organisation-culture outcomes, can be hard to measure, and management can “game” net promoter scores and other metrics to achieve rewards.

Thus, in one corner are regulators that want greater use of soft targets in reward performance incentives to help improve corporate behaviour and rebuild trust; in the other corner are institutional investors and their advisers that want the performance focus to remain on TSR.

Boards are caught in the middle. An upside from the Financial Services Royal Commission might be a renewed push from the governance community on executive-pay innovation. TSR-based frameworks, at least for APRA-regulated entities, may not be incentivising the kinds of behaviour that organisations, investors and the community expect.

TSR, of course, is a crucial performance metric, but on its own is a poor distinguisher of “good” or “bad” revenue. An executive team might boost revenue by exploiting customers, reach profit targets, boost the share price and TSR, and achieve performance incentives.

An over-reliance on relative TSR is equally problematic. Shareholders wonder why the CEO earned large rewards when the organisation’s TSR was poor, although relatively better than peers, and the share price fell. A misalignment between CEO and shareholder rewards is an ongoing issue in the pay debate.

Moreover, current disclosure and reporting practices arguably do not sufficiently inform the market about reward punishments for bad behaviour at lower rungs in organisations.

The Governance Leadership Centre asked leading remuneration experts for innovations on executive pay. The ideas below are conceptual and may receive push-back from executive teams, proxy advisers and institutional investors.

What is clear is that a new debate on pay-for-performance is needed that better aligns executive reward structures with community expectations and trust.

Here are three ideas:

1. Group-wide soft targets based on outcomes

John Egan of Egan Associates says there is merit in introducing soft non-financial target performance metrics for groups and individuals in corporates. For example, a large telecommunications company might include a target for its top 100 executives and managers based on customer complaints to the Telecommunications Industry Ombudsman. If, say, more than 20,000 complaints are received in the financial year, the bonus of the top 100 managers is affected.

The same concept could apply to financial services, utilities or other large organisations that are scrutinised by independent parties. Egan accepts the idea would be complex to implement: choosing the right metrics, ensuring data is reliable and selling the idea to management and the market would be difficult. But the idea of group-wide soft targets deserves debate.

“The benefit is that performance is based on an independent third-party such as an industry ombudsman, rather than internally-generated data by management,” says Egan. “Also, the data is based on measurable outcomes and observable behaviours, not information around culture that is harder to measure and therefore can be gamed by management.”

Another benefit, says Egan, is that the targets would better match community expectations. “The public wants to know that a telco’s top staff are not earning their reward if the organisation is torturing people with bad service and excessively cutting costs. Or that leaders in a bank are not getting their reward if the Australian Financial Complaints Authority is being bombarded with complaints about people being sold the wrong product or treated unfairly by banks.”

Extending measurable soft targets to more managers sends a powerful message, says Egan. “Boards are saying to the top people, ‘if the organisation gets more complaints than is deemed acceptable, everybody suffers with their bonus’. All the leaders are affected, not just that seven or eight in the executive team who may or may not have soft targets in their incentives.”

He says modifiers could be used with group-wide soft targets. “For example, the group might lose 20 per cent of their bonus in a year if the complaints target is not met. In the following year, if complaints are sharply lower and it is clear the firm’s leaders have done a good job to fix the problem, they could achieve 120 per cent of the bonus if they meet all targets.”

Egan adds: “Management and their staff are paid a competitive salary to act honourably in their dealings with all stakeholders , to uphold their employers Code of Conduct while seeking to be recognised financially for excelling at their job playing by the rules.”

2. Disclosure of bad behaviour

Mechanisms for listed companies to disclose bad behaviour, actions taken and bonus penalties, has had little consideration during the Financial Services Royal Commission. All too often, bad behaviour is first disclosed when a whistle-blower alerts a newspaper.

It is hard for the public to assess how large organisations respond to lower-level bad behaviours or how it affects pay. Companies are usually on the back foot when misconduct is revealed publicly, or they only disclose inappropriate behaviour by executives.

“Disclosure of identified bad behaviour in corporates, generally, is poor,” says Michael Robinson, a director of Guerdon Associates. “We need a grown-up conversation about this: in every large company in every country, someone, somewhere will be doing the wrong thing. That’s inevitable. Organisations must assume that this behaviour will eventually become public and that they need to be more transparent about it.”

Robinson says there is scope for better self-reporting of bad behaviours. For example, the executive remuneration report in the annual report could include a section that outlines identified instances of bad behaviour, actions taken and how this affected pay rewards.

“I’m not proposing that organisations name names for lower-level bad behaviour or get into specifics,” says Robinson. “But they could in tabular form highlight the problem identified, report in broad terms on actions taken, and how it affected the incentive of the manager responsible and those he or she reports to.”

For example, a bank might disclose that an internal audit of its call-centre identified that a small group of telemarketers breached organisation policy and sold products inappropriately. The bank would disclose in the annual report that it is aware of the problem, has counselled and retrained affected staff, reviewed its systems, and reduced the incentive for managers of the call-centre by a quarter, as well as the executive responsible for customer service.

“By self-reporting, corporates would be much more upfront about bad behaviour and able to show the market and public that those responsible have had pay reduced,” says Robinson. “They would demonstrate that they are proactively addressing the behaviour.”

Robinson likens self-reporting of bad behaviour to Occupational Health and Safety (OHS) reporting. “Listed companies are typically very upfront about how they report OHS data and that disclosure has led to meaningful improvements in safety. There should be the same type of self-reporting with identified bad behaviours and outcomes.”

3. Extending accountability for bad behaviour

Robinson agrees with APRA’s view that organisations need remuneration structures that penalise executives when bad behaviour occurs on their watch, even when they are not directly responsible. “Companies have been quick to dock the employee responsible for the behaviour, but often there is no penalty for people higher up in the organisation who manage them.”

Malus and clawback provisions are key mechanisms for corporates to reduce pay for behaviours that cause reputational damage. Malus is where a short- or long-term incentive that has not vested is cancelled. Clawback provisions - the recovery of remuneration that has already vested – require executives to pay back remuneration if problems are later identified, under certain conditions.

Malus is typically applied at lower rather than executive levels in organisations and its application is too discretionary, says Robinson. Overseas research indicates that it is more effective, according to Robinson, for reward structures to have a default position where the executive is automatically docked part of their incentive if bad behaviour occurs in their area of responsibility. The company retains discretion to undock the penalty.

“Almost no Australian company currently has this approach,” says Robinson. “Introducing a default position where the executive is penalised if one of their reports, or someone further down the chain, behaves poorly, creates a stronger incentive to stamp out bad behaviour throughout the organisation. The onus is on the executive or manager to show why their bonus penalty should be undocked and the company has discretion to do so, if warranted.”