A Review of Proxy Advisors and Institutional Investor Guidelines on Executive Remuneration

When it comes to executive remuneration there are multiple stakeholder commentators including government institutions such as ASIC and APRA, universities and think-tanks, remuneration consultants, proxy advisors, retail and institutional investors to name a few.

With the heat of the ongoing AGM season as well as the continuing impact of the Hayne Royal Commission, tension is building up not just for Boards and company executives, but for other stakeholders such as remuneration consultants, proxy advisors and large institutional shareholders.

At this stage, executive remuneration in Australia cannot be regarded as ‘heavily regulated’ despite the impact of the Corporations Act, ASX Corporate Governance Principles and the recent restrictions imposed by BEAR upon financial services. In addition to these rules, guidelines published by proxy advisors and large institutional shareholders are closely followed by Boards and shareholders of many “large cap” companies.

Proxy advisors’ views on executive remuneration have gained more significance over time in line with the increase in company ownership institutional investors both globally and in Australia.

“Between 1950 and 2000, institutional ownership of total U.S. equity outstanding increased from approximately 6% to approximately 50% where it has since remained”.

According to a research paper written by Susan Black and Joshua Kirkwood published in RBA’s Bulletin in September 2010, “prior to the financial crisis, institutional investors were the largest single class of investor, owning almost half of listed Australian equities”. Although this has changed in favour of foreign investors and retail investors following the financial crisis, institutional investors made up approximately 40% of the total Australian equity outstanding in 2010.

Traditionally, institutional investors relied heavily on advice from proxy advisors as they did not have the resources to thoroughly consider the thousands of resolutions that required their vote. However, over the years institutional investors have increased their direct involvement in the area of executive pay. Some of the largest institutional investors also have their internal corporate governance teams tasked with making voting decisions and ensuring consistent voting across investment vehicles. In this regard, BlackRock, Vanguard and State Street, the three largest global asset managers, provide their own guidelines in relation to ‘preferred’ executive remuneration practices.

This article aims to provide a review of proxy advisors’ and large institutional shareholders’ published views on executive remuneration.  A review of the Australian (and New Zealand where combined) remuneration report guidelines of the Australian Shareholders Association (ASA), Ownership Matters, ISS, CGI Glass Lewis, State Street, BlackRock and Vanguard have indicated that, in essence, there are more areas where they concur than those where they diverge.

Essentially, each of these organisations emphasises the importance of establishing a clear link between variable pay and company performance as reflected in returns to shareholders. Other areas of consensus include avoiding re-testing of LTI hurdles, minimum shareholding requirements for CEOs and executives, avoidance of cliff vesting and the requirement for cogent explanation in those cases where Boards make decisions and use their discretion for all remuneration related outcomes including LTIs and STIs. Use of claw back and malus clauses are also regarded as good market practice.

Whilst non-financial KPIs are not preferred LTI hurdles, ASA indicate that they should be limited to a small portion of the LTI award. They are better suited for STIs and should be measurable.

Other executive pay design criteria which are treated unfavourably by the majority of proxy advisors and large institutional shareholders include the use of face value rather than fair value. ISS guidelines indicate that disclosure of incentives should include the potential value of awards to individual scheme participants on full vesting, expressed by reference to the face value of shares and expressed as a multiple of base salary. However, BlackRock support the use of fair value as per their 2015 voting guidelines.

Which LTI Hurdle?

Absolute share price hurdles are generally not supported as share price could be more influenced by market forces than the contribution of the executives as well as the potential disconnect between company performance and share price increase. Use of multiple LTI hurdles is usually regarded as good practice.  Whilst EPS, TSR (absolute or relative) and return hurdles constitute the most commonly used LTI hurdles by ASX listed companies, proxy advisors and institutional shareholders appear to have different views in relation to their relevance and impact on company outperformance.

Commonly cited shortcomings in relation to a relative TSR measure include difficulty in selection of a robust peer group and insufficient relationship between relative TSR and company outperformance. ASA guidelines emphasise the importance of setting an appropriate sliding scale according to which an LTI award starts to vest above the median of a peer group and 100% vests if the company performs above 85th percentile. CGI Glass Lewis state that the use of a relative TSR measure neither drives outperformance nor incentivises behaviour based on their previous research.

The potential disconnect between growth in EPS and the share price increase and the use of underlying or normalised profit instead of statutory profit when calculating EPS are cited as the potential shortcomings of an EPS measure by proxy advisors. Also noted is that the LTI security (option, right or share) is a crucial factor when selecting the right LTI hurdle as are industry and company specific factors. Analyst forecasts are also considered crucial when setting threshold, target and maximum performance levels for LTI hurdles.

Dilution Limits

Dilutionary impact of equity plans are another area of scrutiny by proxy advisors and institutional investors. BlackRock and CGI Glass Lewis support a 5% annual cap on ordinary issued capital for newly issued shares and options under all employee and executive incentive schemes whereas this cap could be stretched to 10% for developing companies. ISS guidelines indicate an overall cap of 10%.

Combined plans

According to their March 2018 Guidelines for ASX200 companies, ASA does not regard combined plans as “true LTIs” if the number of shares or performance rights are determined by the company’s performance over a one‐year period with no further performance hurdles to be met until vesting.

CGI Glass Lewis indicate that while they assess all combined plans on a case-by-case basis, their expectations from those plans include a minimum vesting and post vesting period of five years.

Whether you’re a private entity or a Government department, Egan Associates can help you ensure your incentive structures are comprehensive and resilient.  Call Zoe Lockyer now on (02) 9225 3225 for a confidential discussion or email zlockyer@eganrem.com.