The Importance of Discretion

It is unusual in current times to observe short or long term incentives where the award is determined solely at the discretion of the Board. However, discretion has far from lost its place in incentive payments and policy.
Board discretion

Formulaic incentives will never be able to provide the right remuneration result in every situation, leading to occasions where the incentive does not reflect true performance. It is at this point that discretion steps in, where the Board can adjust outcomes up or down.

Although discretion has not been well received in some settings where stakeholders considered payment adjustments to be underserved, proxy advisors generally approve a reasoned use of discretion as long as the explanation is disclosed.

Examples of situations where companies have used discretion include:

  • To respond to company performance and industry conditions

MMA is a marine services company with a customer base of oil and gas companies. The commodities downturn resulted in difficult conditions for the company, where utilisation of its fleet dropped.

Given the “overall performance of the company and current market conditions”, the Board exercised its discretion not to pay the KMP any STI for 2015 and suspend STI for 2016 unless conditions improved. It also decided to defer the vesting of the 2012 LTI for another year contingent on service.

Seven Group also suffered from the commodity market downturn, with impairments leading to a substantial loss for the 2015 annual year. Although partial STI would have paid out under the plan as executives had met some performance conditions, the Board considered any vesting to be inappropriate.

“Under the design of the STI plan, performance against goals other than the corporate NPAT goal could trigger a partial award. However for FY15, while KMPs substantially achieved other goals, in light of the overall financial performance of the Group, the Board considered that the provision of STI payments to executives would not have been appropriate. As such the Board applied its discretion to determine that no awards be made under the FY15 STI plan. This exercise of downward discretion reflects the Board’s commitment to maintaining the link between executive remuneration and Group performance.”

  • To align outcomes with shareholder value creation

In 2013, BHP’s Board exercised its discretion to reduce the vesting of 2008 LTI awards by 35% for all participants even though performance against the relative TSR condition would have led to 100% vesting of the awards. The Board stated that it considered a range of factors when making this decision, including that although BHP had performed well against comparator companies, the downward trend of mining shares meant that there had been a negative total shareholder return in absolute terms.

  • To respond to shareholder feedback

Kathmandu encountered shareholder concerns following the release of the 2015 Notice of AGM. The issue was the degree of difficulty of the CEO’s disclosed LTI EPS performance hurdle. Given poor performance in the 2015 financial year, any EPS improvement would be off a low base, making the hurdle too easy in the eyes of a key stakeholder. The Board responded with a promise to exercise discretion to make the performance hurdle more difficult. When pushed for more details, the Board then provided a new vesting schedule.

  • To reflect milestone achievements or challenges

Rio Tinto adjusted its 2013 STI award downwards by between 10% and 40% to reflect cost overruns in a project to modernise an aluminium smelter.  Due to these overruns and other factors, the assets were impaired by around $700 million.

In 2014, Wesfarmers used its discretion to increase the STI of the Finance Director to the maximum possible payment due to his work on the sale of its insurance business.

  • To reward executives for good performance despite hurdles not being met

Seven West Media operates an STI bonus pool which only accrues funds if EBIT targets are met. In 2015, the group’s Television, Newspapers and Magazines business met their EBIT budget but the overall result was pulled down by unbudgeted digital investments including Presto – outside the budgets of all the executives other than the MD.

Overall, the target was narrowly missed by 1.4%. The company noted that it was “the best recorded result against budget for the group in over four years”.  The Board decided to use its discretion to award a reduced STI reward pool, representing 20% of target level. The MD and CEO elected not to be considered for an STI award.

“While the Group’s FY15 financial results and remuneration outcomes reflect the challenging operating environment, they should be held in context of the hard work and dedication of our people and their continued commitment to strengthening the cost base and competitive position of the Group over the long term and to the benefit of Seven West Media shareholders.”

A similar situation occurred in 2011 to Pacific Brands. The Board decided to award STI payments despite an EBITA gateway not being met. The decision was made because the shortfall was modest and due to external factors, such as Kmart’s decision to stop stocking Pacific Brands products and increased cotton prices. Stakeholders did not approve of the Board’s decision and the company received a strike on its remuneration report.

  • To counteract market volatility

In the wake of the Samarco disaster, BHP shares dropped significantly. The CEO was due to receive a grant of rights at that lower price, which would have resulted in more rights being granted than was originally intended. The Board exercised its discretion to vary its methodology for the allocations and use a higher price to determine the number of instruments to grant.

  • To reflect conditions outside the KMP’s control

Due to the impact of the Queensland floods in 2011, the Reject Shop decided to vest 50% of performance rights granted between 2008 and 2010 despite the original EPS hurdles not being met. Voting indicated that some shareholders did not approve of this decision.

  • To reward a good leaver

Telstra’s long term CEO David Thodey retired in the 2015 year. He joined Telstra in 2001 and was promoted to the top job in 2009.

The Board used its discretion to allow Mr Thodey to keep a proportion of the rights granted to him in the 2015 year, as well as all the rights granted to him in the 2012, 2013 and 2014 years. These remain on foot and continue to be subject to the original performance conditions. Unless Board discretion was exercised, the rights would have lapsed at the time of his retirement.

  • To retain executives

Vocation had a challenging period post listing, with the loss of key government subsidies following a review of the organisation’s practices and subsequent commentary. Reputation damage hit revenues, leading to a loss that had been unexpected at the time of publishing its prospectus. Its operations were subject to further audits and the company faced class actions.

STI payments were made on a discretionary basis during this time. Turnover at the executive level was high and the sale of certain businesses within the organisation was considered important. An STI payment was made to a business group head as a retention incentive to facilitate the sale of one business, after which she departed the organisation.

  • To reward an executive for extreme performance

Crown has a discretionary STI payment for its CEO Rowen Craigie though the maximum incentive should the company perform well above budget expectations is modest by market standards.

There are many other situations under which discretion may be exercised including:

  • Early vesting of LTI plans in the case of a takeover
  • Alteration of long term incentive plan hurdles or timelines to facilitate a remuneration framework change
  • Cancellation of awards or exercise of malus given a major reputational issue or financial misstatement
  • Reduction or cancellation of incentive payments to take a stance on work fatalities or major environmental incidents
  • Adjustment for unexpected events
  • Payment of awards in shares given cashflow issues, or cash given dilution concerns

Getting it right

Although the application of reasonable discretion is acceptable, even desired, Boards do need to make sure they go about it the right way.  It’s particularly important that the Board’s use of discretion is enabled by policy and contractual documentation.

Following a recent court case where Westpac was found to have breached its policies when it made a decision not to award a discretionary bonus, Herbert Smith Freehills provided companies with a few pointers. It recommends organisations:

  • correctly apply criteria for determining employee eligibility for any bonus;
  • comply with any procedural requirements relating to the bonus contained in the employment contract or under an applicable policy referred to in the employment contract;
  • maintain evidence of decision-making procedures followed to determine the bonus payment or non-payment;
  • ensure there is a sound business case to support [awarding or] not awarding a discretionary bonus; and
  • have clear communications ready to address queries from employees, as this is often an issue of significant importance (particularly where employment is also being terminated).
  • exercise caution when referencing policies in their employment contracts in relation to the payment of bonuses (or otherwise), given the risk that such policies may be found to have been incorporated into the contract.

Another law firm SWAAB notes that:

The Courts want us to understand that – the decision to pay a bonus or not is not a completely free one.

Even where payments are stated to be at the employer’s sole discretion, any decision on payment must be made on a reasonable basis.

If you are paying bonuses according to performance, it is worthwhile ensuring that the assessment of performance be carried out reasonably and in line with company policies.

If you want the freedom to withhold bonuses due to financial constraints or employee misconduct, the law requires that you include such requirement in your contracts / policies.

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