On 20 December 2010, the Parliamentary Secretary to the Treasurer released an Exposure Draft Bill dealing primarily with remuneration, along with a discussion paper on a proposal to clawback remuneration that has been based on flawed financial statements.
This represents the Government's response to the Productivity Commission report released in January 2010.
The measures in the Exposure Draft Bill are far reaching and - it has to be said - largely ill-considered; the Discussion Paper possibly more so. They suggest that the Government's proposed approach is to use corporate governance rules to implement social policy objectives, rather than improve corporate governance or corporate performance.
The measures are as follows:
This proposal will require a motion to be put to an AGM where there has been a 25% or more negative vote at that AGM and the immediately preceding one - i.e. two successive 25% or more negative votes.
Companies with one "strike" at an AGM will need to include the spill motion in their next AGM notice, so that if there is a 25% or more negative vote at that meeting the spill motion can be voted on at that meeting. This seems unwarranted - and should be amended to only require that the possibility of a motion is flagged in the explanatory materials for the next AGM so shareholders are aware of what is at stake if there is a second 25% or more negative vote.
If the "spill" motion is passed, a further shareholders' meeting will need to be held within 90 days, at which all board positions will be declared vacant (except a managing director) and directors' appointments will be voted on.
It seems somewhat over-reaching that a full board spill should be triggered where there may be a very strong majority support for the remuneration report, but for some reason falling below 75% of the votes actually cast, perhaps because of shareholder inertia or indifference. And it should be kept in mind that shareholder turnout is typically significantly less than 100%, so a 25% negative vote would usually represent much less than 25% of all the votes that could have been cast.
During the 2010 AGM season, for example, of the 11 companies within the ASX 100 with a 25% negative vote on the remuneration report, the shareholder turnout ranged from 40% to 70%.1
It might be different if the remuneration report were actually voted down at two successive AGMs, but even then the measure seems to assume that remuneration is the most important thing boards deal with. It would be absurd to see a well performing company being forced into a board spill over remuneration reporting, although a poor showing on a remuneration report vote is usually a sign of shareholders who are unhappy for other reasons and wish to "send a message". The absurdity is underlined by the fact that under the current law 5% of the shareholders by votes or 100 shareholders by number can requisition a meeting to spill the board at any time.
One could suggest that there would be more relevant triggers for a board spill than remuneration reports, say two successive years of losses, or two years of negative shareholder returns. However, to suggest such triggers should be enough to show that such measures would be deleterious, and an unnecessary intrusion into the operation of companies. But a remuneration reporting approval trigger is even less sensible than one based on losses or negative returns.
Somewhat amusingly the draft legislation provides that all directors (except a managing director) cease to hold office at the start of the spill meeting. This means the company will have no non-executive directors for the duration of the spill meeting, and the managing director may need to chair a meeting that may well have been triggered by displeasure about the managing director's own remuneration. And what happens if the meeting is adjourned before it is completed?
It is tempting to ask whether remuneration reporting - or remuneration generally - is so broken that it needs quite this much fixing.
This measure is something that sounds alright if you say it quickly, but the devil is in the detail. In addition to new disclosures concerning the use of remuneration consultants, remuneration consultants will need to be engaged by and report to non-executive directors.
The draft legislation goes so far as to prescribe who can execute a contract with a remuneration consultant, being the most prescriptive measure in the Corporations Act in this regard. Nowhere else in corporate life does Parliament prescribe who can execute a document, not even in the related party transaction provisions.
It will be a contravention of the Act for a remuneration consultant to give advice concerning Key Management Personnel (KMP) to anyone other than a nonexecutive director (unless the entire board are executive directors). This is impractical and misses the point that management is supposed to formulate remuneration policies and strategies for approval by the remuneration committee and the board. Whether the remuneration committee or the board needs independent advice is a matter for them to determine in accordance with their duties. To mandate "structural" independence in this way is goes beyond a number of the requirements for auditors, where the need for independence is unquestioned.
The required disclosure is extensive including which directors executed the contract, to whom the advice was given, a summary of the nature of the advice and the principles on which it was prepared and consideration for the advice.
This places remuneration advice disclosure at a level above disclosures concerning other advisers. One could suggest that arrangements concerning investment banking advice (and fees) could be far more material from a financial point of view than remuneration advice.
KMP will be prohibited from voting on remuneration report resolutions, except in relation to directed proxies from people who are not KMP or "closely related parties" of KMP.
Given the non-binding nature of the remuneration resolution (but recognising the extreme consequences that may flow from a 25% negative vote) it is significant that KMP should be disenfranchised from exercising what are, in effect, property rights. Why should KMP be singled out to be disenfranchised? Why not directors? Why not all the employees who are affected by the remuneration policies in the report being voted on?
Moreover, the prohibition could mean that the 25% negative vote could be triggered at much less than 25% of total shares on issue if KMP hold a significant number of shares - as is the case with companies where a founder CEO holds a large stake.
KMP will be prohibited from hedging remuneration that is at risk (i.e. subject to a performance condition). The rationale is that de-linking remuneration from company performance is "inconsistent with a key principle underlying Australia's remuneration framework that remuneration should be linked to performance" although the materials do not specify where that principle is articulated.
This measure will overturn the long held convention that a board determines its own size. While the effect of a board decision about the size of the board (a "board limit") can have the effect of meaning there are no "vacancies" on the board, modern governance theory does not support large boards. Moreover, the ASX Corporate Governance Principles and Recommendations seem to assume that the board or nomination committee are better placed than shareholders to determine board composition and review board performance.
The measure will require a vote at every AGM to maintain a particular board limit.
Unusually, voting on a poll on such a vote will need to be recorded and kept for 7 years. This will be the only kind of vote under the Corporations Act with an explicit requirement for votes to be recorded and kept. One could ask why this one type of vote should be singled out, but the answer may be that this will presage other similar requirements.
Proxyholders will be obliged to exercise directed votes. This obligation currently applies only to a chair of a meeting. This will mean that a directed proxy will lose the residual discretion to choose not to vote. One wonders how big a problem this has been - there seems to be little evidence on the point.
Thankfully, one of the proposed measures is a positive reform for companies. KMP reporting (and the consequences for termination payments etc) will be reduced to KMP on a consolidated basis (or KMP for the company if there are no consolidated accounts). Currently, the five highest paid employees of the company and within the group must also be reported on.
Submissions on the Exposure Draft Bill are due by 20 January 2011. Johnson Winter & Slattery is making a submission on the Exposure Draft Bill. Please contact us if you have any comments you would like included in our submission.
The essence of this proposal is that remuneration should be clawed back if it was determined on the basis of flawed financial statements, i.e. financial statements subject to a material misstatement.
While it is true that executives may have an incentive to falsify financial statements to gain rewards based on financial performance, there is little evidence that this has been a significant problem in Australia, compared to some overseas jurisdictions. That said, it is difficult to argue with the principle, although it may work unfairly in relation to executives who might be required disgorge benefits but who were entirely innocent in relation to the flawed financial statement.
Regardless of the underlying merit of the proposal, the Discussion Paper appears to proceed on the basis of a number of flawed premises.
In paragraph 2.2, for example, it states that shareholders can only recover overpaid remuneration amounts by commencing legal proceedings. Shareholders cannot recover such amounts at all - if anything it is a matter for the company - and shareholders could only take statutory derivative action on behalf of the company. The error is repeated in paragraph 2.9.
In paragraph 3.47 there is a reference to re-issue of financial statements and the Auditing Standard on subsequent events ASA 560, along with a suggestion that accounts would need to be revised for events occurring after the date of the accounts. This is incorrect. Paragraph 22 of ASA 560 says this:
"When, after the financial report has been issued, the auditor becomes aware of a fact which existed at the date of the auditor's report and which, if known at that date, may have caused the auditor to modify the auditor's report, the auditor shall consider whether the financial report needs revision, shall discuss the matter with management and those charged with governance, and shall take the action appropriate in the circumstances." (our emphasis)
That is, financial statements would not be "reissued", at least as far as ASA 560 is concerned, in relation to facts occurring after the date the financial statements are signed.
Somewhat surprisingly, the Discussion Paper contains a proposal to actually penalise executives - rather than require repayment of "excess" bonuses - by requiring repayment of remuneration on the basis of a multiple of the percentage of the error in the financial statement. A 10% error in the financial statements might lead to a 100% loss of relevant remuneration. Any measure that goes further than repayment of the excess compared to what would have been awarded had the accounts been correct would be punitive, unwarranted and poor policy.
Further, there is a recognition of the difficulties in determining causation in relation to share-based payments where there has been a misstatement. So the Discussion Paper floats three potentially punitive possibilities - ignore the share price and use another indicator, clawback profits from sale of shares awarded "during the period of the material misstatement" (whatever that means) or "freeze share options" that were awarded "during the period of the material misstatement".
The limitations of the analysis in the Discussion Paper are highlighted by paragraph 3.56. It discusses the possibility that there might be a material misstatement in financial statements that did not affect remuneration outcomes, but seems to assume that amounts would be clawed back in such an event, in the absence of an express exception. To propose clawback where there has been no effect on remuneration would be misguided as well as punitive.
We await with interest the submissions on the Discussion Paper, which are due by 31 March 2011 and hope the Government reconsiders this proposal. We expect to make a submission.
1 JWS surveyed the voting trends on remuneration reports of the ASX 100 companies during the 2010 AGM season. We will be publishing the survey results separately.
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