On CEO Pay
Egan Associates has provided remuneration and governance advice to many of Australia and New Zealand’s largest companies over a number of years. This article reflects on how advice being sought today is offered in a very complex environment, under the watchful eye of regulators, shareholders, companies and CEOs alike.
In this interview, John shares how he and the team at Egan Associates provide advice on CEO reward in this ever changing, contemporary and competitive setting.
The Problems We Deal With
Q : Is your advice essentially the same to all clients? If not, what are the circumstances which lead you as a consultant to providing different kinds of advice to a client?
John Egan : Our advice in relation to CEO reward is always customised. While we base our advice on data, and in fact invest heavily in the collection of very specific market data, the art of our consulting is to understand the relevance of data for each client. We listen to the Board and their expectations of the CEO and the challenges which they have identified for the period immediately ahead. This may incorporate:
▪ formulating a reward strategy for a long serving and highly effective CEO in a highly competitive setting;
▪ developing a strategy for significant annual increments in a CEO’s reward following an internal appointment to the position at a significant discount to the predecessor CEO;
▪ the foreshadowed retirement of the CEO and the securing of internal candidates while they consider talent external to the company as a potential successor;
▪ managing the challenge of securing a new CEO after the current CEO has been terminated;
▪ preparing for the appointment of a divisional executive to the role of a CEO of a listed entity after a demerger;
▪ assisting a private equity organisation in identifying appropriate reward for a CEO in preparation for an IPO or a trade sale;
▪ addressing the challenge of retaining internal candidates in preparation for the planned retirement of a CEO while concurrently considering the cost of securing talent external to the company as a potential successor.
Each circumstance dictates a different strategy for determining the right level of CEO pay. It is not only when a CEO changes that pay levels are reviewed. We have also in the past two years been involved in assisting Boards in addressing the renegotiation of termination arrangements in compliance with the recent legislation and endeavouring to address the loss of benefit in those circumstances over a period of time, while still retaining alignment of the CEO’s reward with the company’s performance. In essence there are generally no two CEO reviews which we undertake which are the same. The circumstances at the time of review can be different in relation to the individual executive or the company, the company’s prospects, its immediate past performance or other challenges which arise from time to time which are unique to the relationship between the CEO and the Board and the company’s challenges.
Q : Have you been called upon to advise on CEO pay in circumstances where a company’s scale has been dramatically increased as a result of “acquisitive initiatives” or reduced as a result of divestment or the impact of the global financial crisis? How do you address these challenges? What are the key sensitivities?
John Egan : Circumstances of dramatic change in scale can arise from loss of significant contracts, the splitting of a listed company into more than one listed entity or the divestment of a significant business in a trade sale. If the CEO of the business remains, as opposed to retires, in such an event there is normally an accommodation in respect of his or her fixed remuneration, and the total reward opportunity may be modified to reflect the change. This might occur over a two to three year period and will clearly be reflected if there is a change of CEO, with the incoming CEO being rewarded in accordance with the downscaled operation. On the other hand, where there is a dramatic increase in the scale of an organisation as a result of an “acquisitive initiative” the recognition of this significant up scaling would also normally take place over more than one year as the acquisition is integrated into the host company and performance in accordance with the business case leading to the acquisition has been realised. A doubling of an organisation’s size, which can result from one or more acquisitions over a limited period of time, does not lead to a doubling of a CEO’s reward. Boards are sensitive in these circumstances to performance and shareholder expectations, particularly where new capital has been raised from shareholders as opposed to debt.
Q : In advising on CEO pay, when you are called upon to provide advice on their level of annual incentive, does that include whether it is paid in cash or equity, and paid annually or partly deferred?
John Egan : Providing advice in relation to annual cash received and deferral of reward, either aligned to a retention issue, sustainability of performance or longer time lines than annual, is always a key element in tailoring advice in relation to a CEO’s reward.
Q : You provide advice on long term share based incentives. Is this advice separate from a broader set of incentive plans which might be adopted by the company for their leadership team?
John Egan : In almost every review we undertake for a CEO, except in circumstances of private companies, not-for-profit organisations or organisations without a long term incentive plan, we comment on either existing benefits under a long term incentive plan where there are a number of years of service and performance required for benefits to be realised or comment on the competitiveness of the existing arrangements. We are often called upon to advise on the renewal of long term incentive programs at the level of CEO where securities under prevailing plans are anticipated to vest in the coming twelve to eighteen months. Our advice is normally aligned to the structure of incentive plans which apply more broadly to the leadership team of the company, excepting in circumstances where long established plans no longer represent an appropriate or relevant design in the current broad commercial setting being addressed by the company or its medium term prospects.
This might involve preparing recommendations on using a different form of equity instrument, for example adopting share rights in lieu of the long established option plan, modifying the performance hurdles, introducing additional performance hurdles and ensuring that they are anchored in a manner which is relevant to the company while broadly mindful of the views of investors. In this context we will often prepare briefs for the Chairman of the Remuneration Committee to meet with major shareholders, including proxy advisers.
The above processes may appear exhausting but with increased scrutiny and legislated obligations on Boards, particularly members of the Remuneration Committee and its chair, this work needs to be thorough, comprehensive and the advice tendered thoughtful though customised to our clients’ needs.
Q : Is length of service or past performance a relevant consideration from a consultant’s perspective or is this an issue on which the Board exercise their judgement?
John Egan : While we are often called upon to provide advice at the level of CEO, including a specific recommendation, we would flag with the Board that their judgement should be overlaid by other considerations which would include the CEO’s period of service and effectiveness, the criticality of retaining the CEO in the period ahead or other factors which would have an impact on future tenure or future performance.
Q : What is an example of a particularly difficult client request?
John Egan : There are probably two types of requests which we would find challenging. One is where a client seeks our support of a decision which has already been made and where we may be asked to retrofit a payment or offer of a payment or benefit to a CEO. Another arises when we are asked to comment on advice prepared by others where our knowledge and opinion would not be supportive of either the evidence or the recommendation submitted to our client. Where the challenge is substantiating evidence, and we are not in a position to validate it, we would advise the Board accordingly.
Where a Board faces an unusual set of circumstances and/or commercial imperatives and bring us into their confidence, we are often able to assist, and occasionally find ourselves engaged in direct negotiation with the CEO resulting in a variation to the offer of payment or benefit, as well as to the timing of the payment.
Types of Reports We Prepare
Q : Do you provide your clients with a brief report with a simple recommendation or do you also supply information on your data sources and the reason behind your recommendation?
John Egan : No one report is the same, and we take into account the needs of the organisation as we determine the appropriate data source to use as the basis of our advice, providing a range of data suited to their circumstance. For example, for a listed company client, we are likely to provide information on other companies with comparable annual revenues, total and net assets, operating profit and market capitalisation. We are particularly mindful where a number of sources of information may have been provided that no one element produces bias in relation to a recommendation. We may also undertake an analysis which excludes certain industry sectors such as the resources sector or the financial services sector where not relevant to our client’s profile. Equally, we may focus on a particular group of companies, whether they be in fast moving consumer businesses, the energy sector or other industrials with comparable and relevant financial attributes. We would then provide a statistical summary of data so that the Board can consider more than one form of comparator information in its deliberations. While our reports are concise, they need to be sufficiently comprehensive so as to provide useful information for a Board.
Q : Do you undertake specific research when a request for advice on a CEO’s reward is sought?
John Egan : The answer to that is yes and no. Over more than the past twenty years we have maintained data from published information and our own research and client resources on the remuneration of CEOs, CFOs and the CEO’s direct reports and selected others on more than 400 companies. Occasionally our client enquiries will require us to extend our research to international comparators or a more detailed examination of practices among identified competitors or like companies. We would see this as a normal part of our advice and increasingly so given the sensitivities around the consultant’s independence from management in preparing such advice. It is critical from the Board’s perspective that the research has been thorough and that in their consideration of the issues they have adequate and reliable resources on which to base their collective judgement.
Relations with Executives and Advisers
Q : Is it usual to be asked to talk to the Chief Executive Officer explaining your advice where it might be contrary to his or her expectation?
John Egan : I frequently talk to CEOs in relation to either decisions which a Board has made without advice or where we have tendered advice which is different from the expectations of the CEO. If it is a recently appointed CEO arising from an internal promotion there will often be disappointment if they replace a long serving CEO who has been well rewarded reflecting that long service and stewardship. In many cases long serving CEOs have taken an organisation from a modest scale to a far more significant business in terms of profitability, market capitalisation, revenue and geographic footprint and been rewarded accordingly. From the Board’s perspective, an internally appointed incoming CEO may take a period of two or more years to gain the Board’s confidence and matching the prior CEO’s reward. They would address this challenge progressively and I would often be asked to set out the Board’s strategy and competitive positioning, while at the same time reflecting upon the gap that exists between the incoming CEO’s prior remuneration arrangements and those which he or she has been offered to lead the company. A lot of ego is involved in these negotiations and because of the open publication of remuneration information at that level in the marketplace it does not take a long period of time before a CEO forms a view as to his or her ranking among comparator companies and/or CEOs.
Q : Are you required from time to time to work with other advisers or liaise with other advisers in the preparation of advice to Boards?
John Egan : Our work is regularly undertaken in parallel with advice being received from others. Typically in the case of a new appointment, our advice would be presented in collaboration with one of the leading executive search firms. If it is associated with a revision of equity based incentive plans, the company will often be seeking advice from their audit firm and their legal advisers. In this context our work is normally associated with developing a competitive strategy and performance hurdles, as distinct from technical, tax or legal sign-off provided by others. We believe that increasingly the work of a remuneration adviser will be collaborating with others, particularly legal advisers.
Relationship with the Board
Q : How does Egan Associates go about preparing advice for a Chairman on the CEO’s pay?
John Egan : Initially we would seek insights into the nature of the role and whether the advice is being sought to retain a CEO, as part of an annual review process or to secure a new CEO. We would also have regard to the nature of the challenges at the time the advice was being sought, – the industry sector in which the business predominantly operates, whether it is principally a domestic business or one which straddles a number of continents and/or sectors, either from a supply orientation or a manufacturing, sales and distribution perspective. We would give some consideration to the likely provenance of the CEO and seek information in relation to any particular challenges on the horizon which the Board may seek to address.
Q : Do you provide a framework which guides the Board on remuneration decision making?
John Egan : In our discussions with the Board Remuneration Committee or the full Board, we always indicate to them the factors which should influence their decision in relation to a CEO’s reward, whether it be their fixed remuneration, their incentive opportunity and the performance criteria relevant in the circumstances of the business at the time, or their equity participation in a long term incentive, including relevant time lines and vesting considerations. Much of this discussion will often centre around performance hurdles and managing unexpected circumstance.
Q : How do you address the challenge, should it arise, where the Board’s Remuneration Report provides a clear statement of its competitive positioning and policy when your research reveals that its practices are at variance with that shareholder communication?
John Egan : This issue is reasonably straightforward and, as referred to above, we are careful in preparing our advice that the Board’s foreshadowed remuneration practice when implemented is consistent with their stated policy set out in their Remuneration Report for shareholders’ review and consideration prior to their non-binding though highly influential vote on the report. Where their intent is to implement reward strategies which are not consistent with long stated remuneration policy we highlight this and would recommend that either the policy statement be amended, the decision be modified or a shareholder communication is prepared. These disconnects can occur for a number of reasons, including renewal of the leadership team, significant growth in the company, recency of appointment of the leadership team or long and highly effective service of the leadership team. It is often sufficient for a Board to be able to explain these changes to shareholders.
Q : Has the work of the Productivity Commission and the Treasury and the legislation emerging from it led to a change in the nature of advice or the structure of CEO reward?
John Egan : The work of the Productivity Commission represented the most significant review on executive remuneration and thinking since the introduction of fringe benefits tax and remuneration disclosure in the 80s. It has had an impact in that legislation has been presented to the Federal Parliament dealing with a number of its recommendations and its findings have had a direct impact on practice and/or sponsored other enquiries. At this stage the journey of responding to the Productivity Commission, in our judgement, is only commencing among the majority of Boards in the ASX 300. We are still awaiting the Government’s response to the Corporations and Markets Advisory Committee’s report addressing the simplification of communication around executive remuneration and the legislative architecture to facilitate this outcome. (See the associated Article 4 in this newsletter.)
The Productivity Commission also sponsored the somewhat controversial two strikes legislation whereby 25% of voting shareholders not supporting a Remuneration Report will after two such votes lead to a spill of the Board. At the time of the Productivity Commission enquiry there were also legislative changes introduced in relation to the maximum payments on termination of executives, including CEOs. The second finding of the Productivity Commission which will need to be responded to, in our judgement, is yet to be thoroughly addressed. This finding relates to the disclosure of remuneration policy and will present its own challenges to the ASX top 300 as they adapt to it.
Q : Has a copy of your advice ever been requested by a major shareholder or regulator? What is the typical nature of a regulator’s enquiry?
John Egan : Egan Associates have occasionally spoken to a client’s major shareholders regarding senior executive reward strategy and certainly prepared briefing papers for discussions with proxy advisers and major shareholders, particularly at a time of change or in response to a prior negative vote on the Remuneration Report.
Regulators have also occasionally sought an explanation or copy of advice from the Board of a client following their own investigation and/or in response to shareholder questioning at an AGM. Enquiries are generally limited to a single payment and/or occasionally related party payments, which is generally beyond our remit as remuneration consultants. Their enquiries of our clients are often as straightforward as “Did you take advice on the matter?” and “Can we have a copy of that advice?” We anticipate that these enquiries will continue. Our expectation is that where a consultant’s advice is soundly based on market evidence and referenced to wide experience the Board would have met their obligation to shareholders and the law. It is our belief that a key challenge which may face a remuneration consultant and ultimately its client is where a consultant has provided advice with incomplete information being provided by the client company on the circumstances it faced at the time the advice was proffered.
Current Business Influences
Q : Has your work in advising Boards on CEO pay become more difficult since the global financial crisis?
John Egan : There were two key challenges which boards faced. One was a decline in value of listed companies on the market and in many instances a decline in profitability. Lower annual bonus payments and a lack of vesting of a significant number of long term equity based incentive plans combined to reduce the overall value of remuneration packages for many of these retiring CEOs. This led in part to the retirement of a number of CEOs on lower than anticipated fixed pay and, in the 2009 financial year, a significant decline in the value of incentives received by incumbent CEOs. The second challenge encountered was the increasing sensitivity by Boards to high levels of fixed pay and continuation of bonuses which flowed through to “Mahogany Row‟ in the previous five years. When it came to replacing their CEOs, a number of high profile companies did so on lower levels of fixed remuneration and with incentive plans that had a strong focus on returning the company to pre GFC levels of profitability and market value. In many instances, these levels were not achieved by mid 2011 and so pay has continued to be impacted.