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.
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 actually 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 looked pretty disproportionate. (In) other cases you (have) people putting their hands on their hearts and saying, we got no bonus this year, we're going to get no bonus next year. It's a watching brief, I guess.
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 value's increasing, businesses are doing well.
So I think the key question is: is executive compensation linked to the right things? And does it deliver the right behaviours? Linking incentive compensation to medium and longer-term shareholder return is a good thing. That means 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's going down.
And what's the balance between base compensation and at-risk compensation? That varies from industry to industry. You need to make sure that the incentives for senior executives are aligned to the business objectives of the company - (also) that the relative salary packages of the 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 broadly is sort of in the middle. MM: 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 very 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.
MM:Well, should shareholders get the power to determine 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.
One of the points is the gap between what people see as reasonable and unreasonable. We've done a longitudinal study looking at the movements in CEO payments. From '01 to '07, the CPI's 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.
The other thing that everybody notices is that our market has been driven during the boom period principally - not solely - by resource companies. That created the high tide that lifted all the boats. Now that the tide's gone out and a lot of boats are left quite a long way from the water, people are in some cases going for short 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?
MM: Is there a drift towards short-term incentives?
JOHN 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 $1 million. Short term incentives 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 is true that 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.
As we go forward, we're seeing a lot of the incentive payments starting to drop off. So some people are out of the money already.
And ironically, you probably should be paying more money because they're actually working harder, (now) that the numbers are going the wrong way. And when everyone's rising with the tide, you probably shouldn't be paying as much.
MM: 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? There's a very famous director around who says ''executive remuneration's worth about two or three per cent of the company's assets and value, and I spend 90 per cent of the time justifying that and forgetting about the other 97 per cent''.
It is such an emotive issue. Also, I think it is used as a grab bag for voting dissatisfaction against lots of other things. If you listen to some of the debates on the floor, 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: That might be a retail shareholder's view. Institutions don't vote against remuneration proposals unless we've analysed them and are dissatisfied. We thought that the best thing was to engage with the company about the things that we thought were bad about their remuneration policy, or anything else for that matter . Our beneficiaries depend substantially, in their retirement, on the success of these companies. So we don't want to be bagging them in the public. It's a much better thing to approach them privately and 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.
MM: But then when it doesn't happen?
O'SULLIVAN: That's the reason why there is the beginning of voting against particular directors. There are other kinds of company 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.
MM: Do remuneration committees work? When the report comes up for a board vote, would there be directors thinking ''I can just tick this - the work's been done''.
EDDINGTON: On good boards, when the chairman of a particular subcommittee reports (they) know what to bring to the table. It's not uncommon for a non-exec director who's not on the remuneration committee to ask for some 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 decide you want every member of the board to be involved in the minutiae of compensation or remuneration, or the risk and governance, then directors will need to meet once a week and they'll need to be full-time.
COLVIN: Most boards don't necessarily appoint a CEO more than once, or possibly twice. Some don't do it at all, because they become a board member when it's been done previously. So, it is often then delegated to the people, hopefully, who have the most experience. 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: I do think the critical time is the appointment of the CEO. And the damage is frequently done with the originating contract and can't be undone. And that's what gave 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 and what were 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''. You always face the problem of falling in love too quickly.
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.
Any board that's not asleep at the wheel ain't going to walk down that road again. But look at (US insurer American International Group) and their bonus payments. Not all boards are smart.
MM: Are the remuneration and search consultants part of the answer or part of the problem?
O'SULLIVAN: A bit of both. With great respect to the legal profession, you can always get an opinion that suits the purpose.
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 the remuneration levels. A lawyer will be asked: is this permissible under law. And 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? The consultant will either say yes or no, and usually be required to write to the board to say that they've reviewed this.
Remuneration consultants are good up to a point, and then it's got to come back to commonsense.
LAWRENCE: And unfortunately we see, too many times, boards hiding behind their advice. Quite often 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 peer group from an independent remuneration consultant''. We say ''Well, would you show me the peer group? No?''.
One that really stuck in my memory (was the) recent departure of a long-standing, very successful CEO . The company now is facing a choice between merger or death. The board decided to pay him $9.1 million plus entitlements. And when asked ''Did you think this was a good idea?'' They said ''Well, we had legal advice that we could pay him $22m''. But that's not the question that was being asked. And it's very, very hard, to get comfortable when you keep getting answers like that.
One of the reasons why I think remuneration is perhaps disproportionately focussed on is that it's 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. It's not a perfect one, but it's one of the few ones you've actually got.
O'SULLIVAN: Well-hired CEOs don't need exit payments at all. And that particular one was so egregious that the shareholders rebelled. And pretty flagrantly they just said, well, the shareholders can jump in the lake, we're going to give him the maximum we can under the law... and without having to go to the shareholders, because we want him to hang around and be a consulting voice.
He's gone. There was no transparency...
MM: There was a sense of loyalty though.
O'SULLIVAN: It was a failure, a real failure. We had another one where one of the issues in a merger was the options that people had. They got a remuneration company to reconstruct what would have happened at a certain, assumed share price. Because (of that) they took a very large amount of money out to pay people for foregone options packages that would actually have been underwater by 10,000 fathoms if they'd been allowed to run.
And the principal executive in the company, voted his own holding and turned the issue - which is another conflict we were not too thrilled with.
When we confronted the chairman of the company about (the options), 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.
COLVIN: This gets back to where you can structure the contracts carefully, beforehand. One of the ways is to have a fixed term - which is now called a maximum term contract as it also allows for termination during the term (e.g. 3- 5 years). It's then honourable for the CEO and the board to leave at the end of the maximum term. It expires and there are no termination payments, other than statutory entitlements, accrued benefits to the date of termination, and everybody moves on. Alternatively, you can renegotiate another maximum term.
MM: What's 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. We're happy to push them out as far as you can possibly get them.
Short-term incentives are frequently based not only on financial but non-financial considerations which (companies say) are sometimes difficult to disclose - but we're very sceptical about the non-disclosure.
LAWRENCE: The Corporations Act does not distinguish in what you're required to disclose to shareholders between short and long term. It doesn't actually acknowledge their existence.
It just says any remuneration that is tied to a performance condition, you must disclose a detailed summary of the performance condition. In the 2008 year, in the top 100 company, 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 of their target bonus.
MM: It does seem that it's base pay in drag.
COLVIN: Why not go back to where you get a base pay, and you get a discretionary bonus.
Many commentators say we're not going to have any part of a discretionary bonus - 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 etc.
A couple of years ago, this (old fashioned) approach would have been regarded as not disclosing enough elements of the discretion. However, given the current economic circumstances (which nobody foresaw), it might be a good time to have a rethink about some of these structural elements and possibilities (e.g CEO contracts).
O'SULLIVAN: You used the word trust. You have to earn trust. Very largely, the behaviour over the last 10 years or so, 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. You have to tell people something about why you're doing it or not doing it. At the moment, the markets will say ''we want to know - why did you raise it by 97 per cent? What have they done that's so much better?''.
COLVIN: But if you had the discretionary bonus, for example, and at the end of it the chairman got up and said ''look, I have awarded a percentage, 50 per cent, because we have been on the edge of going out (of business)'', the difficulty then is, are you giving really confidential information to your competitors? And are you spooking the market by being really honest?
Those are critical issues to chairmen. It's very difficult to talk to some retail shareholders about something as sensitive as that.
O'SULLIVAN: I'm told again and again by chairmen and directors ''but we do always exercise our discretion against executives''. But it doesn't happen very often.
LAWRENCE: I wouldn't hide the light under a bushel. 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.
LAWRENCE: The 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. And that should be between the chairman and the chief executive.
O'SULLIVAN: Yes. But those criteria should be disclosed.
MM: Do we have agreement that simplification of remuneration policies is desirable?
EDDINGTON: I think that's right. 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, ensuring that it's incentivising the right things.
If you need a PhD in mathematics to work it out, self-evidently it's wrong. And where things are complicated - people don't trust what they don't understand.
MM: 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.
And the next thing, I think, is a simplification of remuneration generally, and I hope that you won't see anybody else running executive remuneration in the top companies other than the board. You won't have executives involved in that process until it is appropriate.
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, not the things that don't.
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. And they should take back control of the situation if they need to in their company. If the same people repeat the same errors, then the ultimate recourse is to say to these people if you're going to do this again and again and again, we really need to get somebody else in there.
LAWRENCE: I think, what will happen is that boards and executive teams, are going to be a lot more careful about risk and how it relates to pay. What I hope will happen is that boards think about what their stance on executive pay says about their position with their shareholders and with the community.
Trust is a precious commodity. It's hard to get, very easy to lose.