Discretion Guidelines for Remuneration Committees

What is Board Discretion?

A remuneration framework generally comprises a series of policies and rules that govern how, when and how much remuneration will be paid to employees.

The Board might choose to exercise its discretion and make promises or payments under the remuneration framework which diverge from their outlined rules, for example in a situation where an employee is considered a special case or where unintended consequences arise that impact on the implementation of the company’s policies or rules.

Why discretion has a bad reputation

There are three main reasons why Boards have become reluctant to exercise discretion.

• Transparency

Discretion has historically been a black box, where Boards would take decisions without publicly explaining their rationale. This absence of information has led to concerns on the part of shareholders and investors that Boards were not exercising discretion using rigorous processes or in the best interests of the shareholder.

• Bias

There is a view among shareholders and institutional investors that discretion is mainly exercised to increase executive pay rather than reduce it. The perception that Boards and executives are part of one elite club which engages in mutual back scratching has not improved their view, although some high-profile examples of downwards discretion, for example BHP and Origin Energy, have revealed that Directors consider potential reward outcomes following careful review of the company’s relative performance.

• Proxy advisor views

The use of upwards discretion is a red flag that will attract scrutiny from proxy advisors and institutional investors. If they decide the discretion was not in the interest of shareholders, they may decide to vote against the remuneration report. As noted in our summary of proxy advisor views from August 2016, discretionary adjustments to performance conditions, start dates or the exercise price of options after grant will be heavily scrutinised, as well the backdating of awards. Changes are generally not well received if they are perceived to be compensating executives for a lack of prior vesting due to poor company performance or providing value to employees with no equivalent value realised for shareholders. There is generally support for Board decisions where adjustments are made due to serious concerns about executive retention or significant company transformation, if disclosure is adequate.

Why Egan Associates believes discretion may be back in fashion

With the introduction of clawback, malus and conduct gateways that may lead to non-payment of an earned incentive, discretion has never been more important.
Egan Associates is increasingly being approached by Boards who are contemplating the exercise of discretion to address the effect of unforeseen challenges on remuneration or ensure the attraction and retention of key staff. In some cases, Boards are concerned with what they see as large windfall payouts or curtailed benefits to executives as the result of sudden share price fluctuations for reasons beyond the executives’ control. Egan Associates has guided these companies in finding an acceptable solution.

This trend echoes recent commentary on the difficulty of motivating executives using formulaic incentives and pushback from Directors against adverse remuneration report votes. Directors are frustrated that their knowledge of their business is not being respected by those advocating a strike. The Directors’ view is that they understand the business much better than any external party could, and are therefore best placed to decide what remuneration strategies should be adopted and how much executives deserve for the performance they have delivered.

Egan Associates would agree that in most cases, Boards are best placed to make decisions about executive remuneration, including any necessary divergence from defined policies and plan rules.

Indeed, although proxy advisors have punished the use of discretion they believe inappropriate in the past, this does not mean they frown on the use of discretion in general.

CGI Glass Lewis acknowledges that “there may be circumstances where threshold performance measures have not been achieved due to unforeseen circumstances and the board in such cases may wish to use its discretion to reward an executive”.

The important thing is to explain why discretion has been used. Blackrock notes in its voting guidelines “In such circumstances, the remuneration report should provide a cogent explanation for any awards where, prima facie, performance has not been achieved.”

If Boards follow (and disclose) a standard process for exercising discretion, there is also likely to be better acceptance that decisions made have been taken with due diligence.

A matter of trust

A working group of high profile directors and executives convened by the Investment Association in the UK to discuss problems with executive pay noted in 2016 that:

The current system of remuneration has evolved reactively as a small number of companies have gone against best practice and compromised shareholder trust.

New investor policies and guidelines have been introduced to prevent the poor practice reoccurring. Naturally, investors are keen to prevent instances of inappropriate pay or payment for failure. Companies, though, can often view this caution as an inflexible stance.

In order for flexibility to be introduced in the system, trust needs to be regained where it has been lost so that investors will feel comfortable supporting companies who choose a different approach.

In the same way that introducing an unconventional remuneration structure requires trust, exercising discretion requires trust that Directors’ decisions, while not following a formula, will be made in the best interests of shareholders.

The Working Group stated:

Investors need to be able to see that there is a track record of responsible use of discretion in order to approve upward discretion. By clearly justifying all remuneration committee decisions and specifically the application of discretion, remuneration committees can improve their credibility with investors. Additionally, if a company has applied negative discretion in situations where external circumstances have improved the executives position outside of their control (for example where there have been favourable impacts on earnings from a strengthening exchange rate), investors are more likely to be comfortable in supporting upward discretion if adverse circumstances negatively affect the executive (e.g. earnings being impacted by a weakening of exchange rates). The Working Group believes that by being clear and transparent about the committee’s decision making on discretion, companies will be able to build up trust with their investors and stakeholders.

Guidelines for Discretion

Discretion is defined by the Oxford Dictionary as “the freedom to act and think as one wishes, usually within legal limits”.

The last three words are important. In 2015, the Federal Court ruled on a case where an employee who had been made redundant from Westpac claimed that he was owed a bonus for his last year of service. According to the employment contract:

The eligibility to be considered for and the payment of any variable reward or incentive payment is at the absolute discretion of Westpac.

The employee had received bonus payments for 2009 and 2010, but not for 2011 when he was made redundant. The redundancy had stemmed from a restructure and a new manager, who downgraded the employee’s performance ratings.

Westpac claimed the employee was not entitled to receive a bonus because he was not employed on the date it was to be paid, and even if he were, his new performance grading would restrict him from receiving one.

The court found that while there was a general clause excluding the application of a list of company policies from forming part of the employment contract, a more specific clause regarding redundancies stated that his entitlements would be determined in accordance with applicable policies. Therefore, the employee was eligible for a bonus.

It then found that the employee’s manager had acted without a rational basis, had relied on impermissible matters such as performance outside the performance period and failed to follow Westpac’s incentive processes. The employee was awarded a bonus equivalent to that received in prior years.

Law firms have outlined lessons from the case, including:

• Companies must understand the entitlement to and calculation of bonuses, including having an understanding of contractual entitlements and relevant policies.
• The decision to pay a bonus or not is not a completely free one. Any decision on payment must be made on a reasonable basis and must not include “procedurally unfair, capricious, or arbitrary” exercise of discretion.
• Companies should maintain evidence of decision-making procedures followed to determine the bonus payment or non-payment and ensure there is a sound business case to support awarding or not awarding a discretionary bonus.
• Where companies wish to withhold bonuses due to financial constraints or for employee misconduct, they should include this in contracts/policies.
• Companies should also have clear communications ready to address queries from employees.

The Western Australian Ombudsman noted in its guidelines for exercise of discretion in administrative decision making (2009) that:

“It is not sufficient to exercise discretion and approve an application simply because it seems the right thing to do. When exercising discretion, decision-makers need to act reasonably and impartially. They must not handle matters in which they have an actual or reasonably perceived conflict of interest … Some of the general principles relevant to the exercise of discretion are:

• Acting in good faith and for a proper purpose;
• Complying with legislative procedures;
• Considering only relevant considerations and ignoring irrelevant ones;
• Acting reasonably and on reasonable grounds;
• Making decisions based on supporting evidence;
• Giving adequate weight to a matter of great importance but not giving excessive weight to a matter of no great importance;
• Giving proper consideration to the merits of the case;
• Providing the person affected by the decision with procedural fairness; and
• Exercising the discretion independently and not under the dictation of a third person or body. “

Given the legal case above, it is interesting that Westpac sets out the criteria it considers when exercising discretion on executive remuneration in its annual report. These include:

• Matters not known or not relevant at the beginning of the financial year, which are relevant to the under- or over-performance of the CEO and Group Executives during the financial year;
• The degree of stretch implicit in the scoreboard measures and targets themselves and the context in which the targets were set;
• Whether the operating environment during the financial year has been materially better or worse than forecast;
• Comparison with the performance of the Group’s principal competitors;
• Any relevant positive or negative risk management or reputational issue that impacts the Group;
• The quality of the financial result as shown by its composition and consistency;
• Whether there have been major positive or negative aspects regarding the quality of leadership and/or behaviours consistent with our values; and
• Any other relevant under- or over-performance or other matter not captured.

Examples from 2016

The following table contains some of the companies that exercised discretion in 2016. Upwards and downwards discretion is represented, with most companies that have exercised upwards discretion avoiding a remuneration report strike.

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