Influencing Culture Through Remuneration

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With regulators threatening to more closely scrutinise corporate culture, Directors will be looking to exercise all of the levers in their control to influence its development, including remuneration.

Background – why corporate culture is 2016’s hot topic

In the wake of revelations of financial planning misconduct at the Commonwealth Bank and NAB in 2014, the financial regulator ASIC (Australian Securities and Investments Commission) proposed an extension of current legislation in mid 2015 that would enable stricter policing of corporate culture.

Boards can use remuneration to influence culture

At the time, AICD (Australian Institute of Company Directors) chief executive John Brogden said that “ongoing education for Directors and executives, for example, is likely to be a far more effective tool than the introduction of reactive regulation that attempts to produce a pro-forma version of good corporate culture”.

Unfortunately, further allegations of misconduct emerged and ASIC maintained its pressure on organisation culture. Since May 2015, it has made no less than six speeches on the topic, with the latest being on the 5th April. Two days later, the AICD published a press release inviting ASIC, APRA (Australian Prudential Regulation Authority) and the Treasury to meet with company Directors to “seek common ground” on Boards and corporate culture.

“Directors know that they are responsible for culture first and last. Boards must be at the forefront of the culture of their organisation,” Brogden stated. “We fully recognise that there are examples of egregious and unacceptable behaviour in some organisations.”

More recently he noted that “Financial incentives have to reward good culture as well as good performance. It’s clear that in some instances that is ignored.”

Yet it appears the AICD is concerned about the direction in which ASIC’s culture agenda is heading.

“Current debate isn’t constructive and the best way to progress is for stakeholders to sit down and discuss the issues. Our sole objective should be to ensure that Australia’s corporate culture is the best in the world and works to the benefit of the community-at-large,” the press release stated.

Former AICD chief John Colvin has also expressed his concerns about ASIC’s direction in a recent article1 in the Company and Securities Law Journal, noting that culture should not be regulated because it is an ambiguous concept that “cannot be defined and measured in an objective sense”. Even if it could be regulated, he continued, its regulation would only add to the regulatory burden on organisations and Directors and could lead to abuse of power by ASIC. The article (which contains a thorough summary and analysis of the situation) is available from Thomson Reuters here.

Colvin concludes with a comment from the former Chief Justice of the High Court, Murray Gleeson, during his time as Chief Justice of the Supreme Court of NSW:

“What exactly does it mean to say that there is an attitude existing within a body corporate? … Legislation which creates criminal offences should be reasonably clear in its application. And what happens if there exists within a body corporate both an attitude and the opposite of the same attitude? … I have enormous difficulties about attaching criminal sanctions to attitudes, and I am bound to say that I do not think that expressions like ‘corporate culture’ have a place in the criminal law.”

It is uncertain as yet how this will end, however, it is clear that whether new regulation is introduced or not, Boards will need to be more aware of their companies’ culture.

Using incentives to direct culture – are rewards or penalties more effective?

“Staff use facts and perceptions about remuneration and incentives to discover what your firm truly values … And values help determine behaviour. If the staff handbook says one thing, while the bonus pool says another, your staff will tend to believe the bonus pool,” according to Deloitte.

Remuneration can be one of the Board’s most powerful influences on company culture.

Currently there is little focus on culture in remuneration reports – often organisations will reflect on creating a performance driven or customer centric culture, but no specifics on how the current remuneration framework fosters a specific culture imperative that is codified in publicly available documentation.

In a survey of 2015 remuneration reports, Egan Associates noted that the concept was most likely to be introduced as a small component of the short term incentive, that is, the organisations have attempted to focus executive attention on culture by making part of executive reward contingent specifically on it.

Is this the most effective driver of culture?

The level of reward that will be available under such incentive schemes for awards to executives who achieve cultural performance conditions is limited.

Culture is a non-financial incentive. Non-financial incentives generally do not encompass more than 50% of short term incentive awards as institutional investors and proxy advisors prefer a financial focus and believe that non-financial factors, being more difficult to measure, can provide the Board with too much discretion to make unwarranted awards.

Culture is also generally not the only non-financial incentive considered in an incentive plan. Other examples include implementation of strategy; business process improvement; business development; efficiency improvement; information technology improvement; innovation; leadership and skills development; M&A integration; client and stakeholder relationships; and quality.

Culture itself also has a broad focus with a number of elements that could be considered, such as the avoidance of bullying, fraud, risk and discrimination and encouragement of inclusion, innovation, communication, collaboration and proactive monitoring and escalation of potential risks to brand and product, which may include safety and the environment.

Therefore unless the Board temporarily increases the proportion of the incentive in the short term to address a problematic culture, the amount that is available to the Board to use to specifically reward elements of culture is generally very small in relation to the balance of the executive package.

Such a small payment may not be enough to encourage executives to focus their attention on culture.

Let us consider the flip side. Can we use penalties to encourage the development of an appropriate culture?

There are three methods organisations can use to do this:

  1. Making all payments under incentives subject to Board discretion, with Boards able to cancel payments to executives unless they have acted in compliance with the company’s culture including their code of ethics and potentially management style, which would need to be clearly defined and documented.
  2. Having a formal gateway built into incentive plans that requires the same conditions, or focuses on a particular aspect of culture which the organisation is currently trying to improve. Unless the condition is met, no incentive is paid.
  3. Using malus or clawback to take back incentives that have already vested to executives when behaviour contrary to the company’s culture comes to light.

These methods have the potential to be a more effective driver of culture because they reinforce that executives must operate within the company’s cultural guidelines at all times, with adherence potentially affecting their entire variable reward.

However, they have the disadvantage that the Board may find it difficult to assess whether employees have been acting within the desired cultural guidelines. Assessments may become a foregone conclusion, always finding that employees have behaved satisfactorily.

To avoid this, a process would have to be developed under which the question of cultural adherence is considered. For legal and transparency reasons it may be best that organisations also have their expectations in terms of corporate culture documented in more detail and communicated to all employees.

Designing the remuneration framework to support culture

While having specific measures (or penalties) in incentives may help Boards direct culture, the design of the overall remuneration framework must also be considered in the context of the effect it will have on employees’ individual and collective mindsets and how this aligns to the organisations’ desired culture and strategy.

Remuneration decisions that will have an influence on culture include:

  • The amount of fixed versus variable remuneration (Risk profile)
  • Whether remuneration is paid in cash or equity (Collaboration and ownership)
  • How long employees must wait until they receive the benefit of earned remuneration (Long versus short term focus)
  • What conditions employees must meet in order to achieve their full remuneration opportunity (Balance of financial and non financial factors including environment, safety, social and governance factors.)
  • The choice of vesting schedule for incentives (Cliff vesting, sliding scale)
  • Whether or not to use gateways to emphasise important behaviours
  • Under what conditions the Board will use discretion
  • Whether the Board broadens the use of malus or clawback from responding to a financial misstatement to include culturally undesired events or outcomes

Questions remuneration committees may ask when creating a remuneration framework include:

  • What does “culture” mean to the remuneration committee? What is the organisation’s current culture? What is understood as exemplary? What is not? Will this culture foster delivery of the company’s current strategy?
  • Does the remuneration mix create the correct risk profile for the organisation?
  • Does the nature of reward inherently encourage risk taking? (Eg options versus rights or cash.) Is this desired?
  • Do incentives and performance conditions encourage employees to focus on individual or collaborative goals? Innovate or consolidate? Be flexible or follow processes? What is desired?
  • How do incentives affect treatment of customers and colleagues? Does the incentive create conflicts of interest? Does the remuneration framework discourage the escalation of potential issues?
  • Are there incentives that contradict each other? (For example, financial versus ESG incentives.) If so, how is the executive expected to act based on the remuneration framework? Do adjustments need to be made?

Documenting culture

Few organisations define in their remuneration report what the company understands under the term “culture”, leaving it open to interpretation for investors and executives.

Egan Associates has collected some information from expert sources on what culture encompasses to inform Boards undergoing this journey.

The Australian Criminal Code

Corporate culture means an attitude, policy, rule, course of conduct or practice existing within the body corporate generally or in the part of the body corporate in which the relevant activities takes place.

AICD

The culture of an organisation could be thought of as its “personality”. It is represented by shared values, norms, practices and core beliefs that shape behaviour. Organisational culture is sometimes described as “how we do things around here”.

The culture of an organisation therefore influences what it does, its relationships with stakeholders and its reputation. It can also be an important determinant of whether the organisation is able to achieve its strategic objectives and deliver on its purpose.

Source: Good Governance Principles and Guidance for Not-for-Profit Organisations, 2013

The Association of Chartered and Certified Accountants

[Culture] serves to provide a common sense of identity and engagement with a bigger picture while building stability and guiding the behaviour of the organisation’s members.

It is more complex than a monolithic culture as it recognises that any workplace potentially has many overlapping ideo-cultures, some of which have evolved from a common ancestor but with others probably emerging locally. Such cultures may be partly based on observable characteristics, but they can also be formed through people’s perceptions and any assessment of culture needs to accommodate both these objective and subjective aspects.

[Culture influences behaviours] in a number of quite specific ways: by influencing performance and reward, giving direction, determining priorities, reinforcing a sense of common identity, protecting common values, determining how emotions will find expression, promoting (or preventing) ambiguity and fragmentation, reinforcing taboos, precluding (or encouraging) critical examination, and encouraging (or discouraging) relationships across social boundaries.

Source: Culture and channelling corporate behaviour, 2014

Bain and Company

Culture is the glue that holds a complex organisation together. It inspires loyalty in employees and makes them want to be a part of a team. It motivates people to do the right thing, not just the easy thing. At companies with winning cultures, people not only know what they should do, they know why they should do it.

Building a winning culture, 2006

BCG

An organisation’s values and characteristic set of behaviours, which collectively define how things get done in support of the organisation’s purpose and strategy. Culture is what people say and do around others—and, tellingly, what they say and do when no one else is around.

BCG notes that determining a culture requires translating strategy into a set of specific capabilities and behaviours to realise it on seven dimensions:

  • Structured Versus Flexible:How specifically are processes and acceptable behaviours defined? How closely are they followed in practice?
  • Controlling Versus Delegating:To what extent is power and decision making concentrated at the top or diffused throughout the organisation?
  • Cautious Versus Risk Permitting:How much does the organisation support risk taking?
  • Thinking Versus Doing:To what degree do people spend time developing ideas versus actually executing them?
  • Diplomatic Versus Direct:How transparent are interactions and communications between coworkers and managers?
  • Individualistic Versus Collaborative:To what extent are employees concerned with their own individual performance versus shared goals?
  • Internal Versus External:To what extent are processes and behaviours oriented toward the outside world versus the internal environment?

Source: High Performance Culture: Keeping it, Getting it, 2013

Deloitte

[Culture is] information about how to behave when adapting to particular environments. This information is rich and varied, and we pick it up both consciously and unconsciously. It covers all the vital bases that are common to any company:

  • How we challenge one another and escalate potential issues;
  • What happens when mistakes are made;
  • What is prioritised in trade-off decisions;
  • When it is appropriate to deviate from established norms;
  • The way things are done round here;
  • How we treat customers and colleagues;
  • What’s allowed and not allowed;
  • What’s expected of me: timing, frequency, intensity and standards of excellence;
  • What behaviours are valued;
  • Who to please and how to please them; and
  • Where to strike trade-offs when values, goals or priorities come into conflict.

At its simplest, a company’s culture answers two very basic questions faced by each of its employees. What must I do to get ahead in this place? How do I need to behave even when no one else is watching?

Source: Culture for Sceptics, The Catalyst for Strategy and Transformation, 2014

Johnson’s Cultural Web

This model characterises a company’s culture using six elements (summarised by Egan Associates):

  • Control Systems – What is monitored, how is it monitored and how closely?
  • Organisational Structures – What do reporting lines and hierarchies look like on paper and in reality?
  • Power Structures – How is power distributed in the organisation? Who makes the decisions?
  • Symbols – What language and objects represent the organisation and employee groups within it? What status symbols exist in the organisation?
  • Rituals and Routines – What activities are central to the organisation?
  • Stories and Myths – What stories are told by employees of the organisation? Who are the heroes of those stories and what beliefs do they reflect?

Source: The Cultural Web, 2016

Spencer Stuart

Culture is the culmination of the shared values, beliefs, and assumptions that shape the behaviour of the organisation—the “unwritten rules” that guide the thousands of decisions employees make throughout the company every day.

A framework for assessing organisational culture is rooted in the insight that a surprisingly limited set of rules can result in highly complex and diverse behavioural patterns.

Every organisation and every executive must address the inherent tension between two critical dimensions of organisational dynamics:

  • Attitude toward change.

Organisations open to change are flexible, innovative, and inquisitive versus those that prefer to manage change, which are stable, have proven processes, and like control.

  • Attitude about people.

An organisation may value independent individuals—those with initiative who are also self-empowered, or it may value interdependent people—those who are collaborative and thrive on group engagement and interactivity.

A company’s culture is defined by where an organisation falls on these two dimensions, and this reflects how thousands of employees make individual decisions to manage the costs and benefits associated with those tensions over time. Individuals come “pre-wired” for how they deal with other people and with change (e.g., “approach or avoid,” “fight or flight”).

Source: Defining Corporate Culture, 2015

The Hofstede Centre

Organisational Culture is defined as the way in which members of an organisation relate to each other, their work and the outside world in comparison to other organisations.

The Center promotes a model to help pinpoint an organisation’s culture, with the central elements (summarised by Egan Associates) below:

  • Means oriented vs Goal oriented – Do employees identify with the “how” or the “what”?
  • Internally driven vs Externally driven – Does the company know what’s good for the customer and the world or does the customer know best, even if the ethics are questionable?
  • Easy going work discipline vs strict work discipline – Is the organisational structure loose and unpredictable or strict and defined?
  • Local vs Professional – Do employees identify themselves with their business unit or their job family?
  • Open System vs Closed system – Are newcomers made welcome or not?
  • Employee Oriented vs Work Oriented – Do employees matter most or the task?
  • Degree of acceptance of leadership style – Does the leadership style of management match subordinates’ preferences or not?
  • Degree of identification with the organisation – Do employees identify with the organisation in its entirety or particular aspects/teams of the group or none at all?

Source: The Hofstede Centre

1Colvin,  JHC and  Argent, J, ‘Corporate and Personal Liability for “Culture” in Corporations?’, Company and Securities Law Journal, volume 34, pp. 30-47

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