Five years after the introduction of the two strikes rule, it’s a good time to reflect on the legislation’s effectiveness in ensuring reasonable executive remuneration.
This is especially the case given the apparent heightened focus this year on remuneration report votes.
What works, and what doesn’t? Our thoughts below are inspired by an interview with the Financial Times, which sought our views this month on the operation of the rule and the issues which may be relevant if the UK were to adopt a similar rule.
- Appears to affect executive reward
Preliminary results from research conducted by Professor David L. Yermack from the NYU Stern School of Business and Professor Ray da Silva Rosa from the University of Western Australia found that for companies receiving a strike between 2011 and 2013 total CEO Pay fell in the year afterwards by an average of 20% while for a second strike it fell in the following year by approximately 32%. We will follow up on this research after the full results have been released.
ACSI research into CEO pay has drawn attention to a reduction in CEO fixed pay following the introduction of the two strikes rule. Its latest report into CEO pay noted that median ASX 100 fixed pay declined 3.1% year on year in 2015, continuing a trend that has seen fixed pay decline almost 12% from the 2012-2013 financial year. We wrote on this report in our September Agenda.
- Increases shareholder engagement
The rule has reminded Boards that they are not an island unto themselves, but are there to represent the interest of shareholders.
Where there has been a strike, and even before a strike occurs, the rule has mobilised Boards to engage with their shareholders and ask which aspects of the remuneration strategy shareholders are unhappy with. This opens a dialogue that will hopefully lead to an improvement.
- Improves transparency and quality of disclosure
Sometimes adverse votes are due to influencers and shareholders forming a view based on a lack of information, drawing attention to inadequate disclosure. This focus has led to more information being disclosed on the mechanics of pay strategy.
The two strikes rule also requires companies to respond to remuneration concerns considered at the AGM in their annual report. This has led to more complete descriptions of any changes to the design of the remuneration structure and the reasons for implementing such changes in the remuneration report in the year following a strike. There is still scope for improvement however. Boards that decide their remuneration strategy is appropriate should defend it rather than purely publish two paragraphs which state the Board believes it is right.
- Encourages major shareholders to consider the wishes of all shareholders
In a small number of companies major shareholders sit on the Board and these Directors may hold the view that they can ignore other shareholders and manage remuneration as they would in a private company. The two strikes rule enables minority shareholders to express their opinions on remuneration.
- Increases focus on whether pay is reasonable
The two strikes rule has provided a platform for shareholder groups such as the Australian Shareholder Association to express a view about the appropriateness of pay. This cannot be described as a left-wing reaction: there are conservative forces that harbour concerns on whether the level of executive reward is reasonable.
Proxy advisors, journalists and others who are continuously involved in reviewing remuneration matters also often highlight weaknesses in disclosure or the way executive pay is set that Boards have overlooked and should be concerned about.
In the earlier stages of the rule’s application the focus was more on the “how” of executive pay (for example whether using metrics such as underlying profit are appropriate to determine performance pay) rather than “how much”. Increasingly, however, there has been a focus on the quantum of fixed remuneration (being base salary, superannuation and benefits). This is partly due to the environment of low wage increases, where a pay raise of 10% for a CEO is considered inappropriate.
- Strikes may not reflect the views of the majority of shareholders
There are two issues that may come into play.
- If a large proportion of shareholders do not vote on the remuneration report resolution, the effect of those that do is increased. Two examples of where this may skew votes include where management have a large shareholding and are not entitled to vote on the remuneration report, or where there is a large proportion of retail investors who are less likely to vote on AGM resolutions.
- If there a small number of shareholders with a significant shareholding, because the vote is based on the percent of shares held rather than the number of shareholders, a strike may be recorded based on the opposition of a small proportion of shareholders. This is of particular concern where those shareholders have a particular agenda that may not be in the best interests of other shareholders.
- Proxy advisors have significant influence
Proxy advisors will make their voting recommendations based on whether they believe a company’s remuneration structure is reflective of best practice – their focus will vary from year to year.
This year there seems to be a heightened focus on annual incentive payments — the criteria that lead to an incentive payment and the pay for performance alignment in terms of actual levels of profit improvement, dividend yield, and share price improvement.
However, there are some critics of proxy advisors who accuse them of making decisions on remuneration structure without spending any time to understand the company’s motivations when making remuneration review decisions.
Such proxy advisors can use part time or outsourced analysts who may be based overseas and do not always get in touch with the organisation in order to understand its practices, instead making judgements based on a global template.
Notwithstanding these observations, proxy advisor analysis will often flag shortcomings in pay strategy and disclosure which should be addressed by the Board.
- Shareholders may not have considered the factors that led to decisions on executive pay
There was a recent vote against the Remuneration Report sponsored largely by one of the proxy advisers, where the primary observation was that the recently appointed Chief Executive was paid a lot of money compared to what they believed he would have been paid in his previous job, and paid more than his predecessor. This did not acknowledge that the predecessor was employed by private equity and was paid predominantly through shares and cash incentives.
Occasionally there will be an observation that an executive has made too much money without acknowledging that shareholders have made a significant profit as well.
There have also been situations where fixed remuneration levels have been questioned using market capitalisation benchmarking. While market capitalisation is an important indicator for benchmarking, there are many other factors that need to be considered, including:
- the assets managed, the diversity of those assets,
- the jurisdictions in which those assets operate,
- the jurisdictions in which business is conducted and the impost of variable regulations,
- the number of employees,
- annual revenues, and
- annual profits.
These considerations are also important.
- Strikes may have nothing to do with the size or structure of reward
Because of the 25% threshold, it is easier for significant shareholders to express displeasure via a vote against a remuneration report rather than by voting against a Director’s election (where over 50% adverse votes are required to stop a Director being elected).
There are any number of concerns that activist shareholders may be expressing with the remuneration report vote. Examples include displeasure regarding:
- The performance of a Director or the Chief Executive
- An ESG (environment, social and governance) initiative being taken by the company
- Poor or unexpected financial results or errors in judgement
- Tenure of the Chairman or Directors
- Board composition (The mix of skills within the Board)
The remuneration report vote may even represent a platform for shareholders targeting a takeover.
As yet there is little research on the effect of strikes on Directors’ career prospects. However, if a company receives a strike against their remuneration report for reasons other than remuneration and their careers are affected, it hardly seems just.
No system is ever perfect. There are certainly aspects of the two strikes rule that could be improved. How to restrict the use of votes against the remuneration report to voters with legitimate remuneration concerns is uncertain.
A potential improvement in another area may be that the credentials of the staff completing the research for proxy advisors be disclosed as well as the methodology they use to reach their conclusions and prepare their recommendations.
For balance, there may need to be more detail on remuneration consultants’ credentials, recommendations and reasoning in the remuneration report.
It would also be helpful for there to be understanding from shareholders that remuneration is a complex area that is constantly changing based on market dynamics and where “best practice” can vary having regard to industry, operating locations, financial scale and talent attraction and retention challenges.
In executive remuneration, attention to detail is key, yet it is important to see the big picture. Boards don’t always get it right, consultants don’t always get it right, proxy advisers don’t always get it right.