As the global financial crisis continues to affect the corporate sector with depressed share prices and rising unemployment, there is greater and greater scrutiny of executive remuneration taking place. In particular, media criticism of termination payments to executives has resulted in a plethora of reform proposals from stakeholders designed to curb executive salaries and termination payments.
Last Wednesday 18 March 2009, the Treasurer, Wayne Swan, and the Minister for Superannuation and Corporate Law, Senator Nick Sherry, made a joint announcement proposing reform of the Corporations Act 2001 (Cth) (Corporations Act) in respect of termination payments. The reform proposal includes:
- amending the Corporations Act to cap termination payments at one year’s average base pay unless shareholder approval is obtained
- extending the Corporations Act shareholder approval requirements to cover termination payments made to any ‘key management personnel’, and
- expanding the definition of ‘termination benefit’ under the Corporations Act to catch all types of payments, benefits and rewards given on termination (other than statutory superannuation).
The Rudd Government has also referred the broader issue of executive remuneration to the Productivity Commission, which is expected to report by the end of 2009.
In this article we discuss:
- the detail of the reform proposals and what they may mean for business
- the scope of the Productivity Commission referral, and
- some of the other reforms and reviews currently underway in Australia and overseas which have the potential to affect remuneration practices for business.
Reform proposals
Reducing the cap on termination payments
Summary of proposed change
Generally, the Corporations Act 2001 (Cth) (Corporations Act) prohibits the payment of a benefit in connection with a person’s retirement from a board or managerial office unless the company gets shareholder approval or a specific statutory exception applies.
The exceptions to the need for shareholder approval apply in respect of payments made in consideration for the agreement to take office, damages payments for breach of contract and payments for past services rendered, and are subject to a formulaic cap under the Corporations Act.
The upper limit on payments which can be made under the exceptions to the shareholder approval requirement are for executives with:
- three years’ service or more, the person’s average annual remuneration over the past three years multiplied by the number of years’ service (capped at seven years), and
- with less than three years’ service, the total remuneration paid to the person during the period of service.
Treasurer Swan and Senator Sherry have proposed reducing this ‘cap’ to a maximum of one year’s annual base pay. Any payment in excess of one year’s average annual base pay will require shareholder approval under the reform.
This proposal broadly conforms with the recommendations of stakeholders such as the Australian Council of Superannuation Investors. However, the Australian Institute of Company Directors and other stakeholders have flagged that ultimately the issue should remain one for company boards and that further legislation in the area could be counter-productive.
Implications, complications and outstanding issues
Reducing the current statutory cap under the Corporations Act will likely result in companies being required to seek shareholder approval of termination payments more frequently. While this may be difficult to achieve in some circumstances, a well-designed communications strategy can often facilitate this process. Also, if approval is sought on or soon after appointment, rather than on termination, it may be more likely obtained.
However, a major source of difficulty in respect of the proposed reform is the low threshold of one year’s average base pay, beyond which termination payments will require approval. This is compounded by the fact that termination payments are often misunderstood by members of the public. In particular, media reports tend to focus on the headline figure, rather than the entitlements which underpin it. Such payments commonly comprise a large number of components such as accrued annual leave, long service leave, superannuation, outstanding bonus and long term incentive and other ordinary contractual entitlements. Stronger emphasis on how the termination payment is calculated may serve to assuage some shareholder concerns, particularly amongst institutional shareholders, but it will be significantly more onerous to pay termination benefits.
Companies will also need to review their executive contracts if the reform proposal is implemented. Often a clause is included in executive contracts which automatically adjusts downward any entitlement to a termination payment which would otherwise be in breach of the Corporations Act. If the Corporations Act limits are not detailed in the contract, then companies may need to seek the consent of executives to vary these limits downwards to reflect the new statutory caps, or otherwise face claims by executives for their lost entitlements. The issue will also require consideration in the context of new and renegotiated executive employment contracts where there may be conflict between the inclusion of a clause allowing the company to reduce any termination payments if they would require shareholder approval and an executive’s desire to have some level of commitment from the company that it would seek shareholder approval if required.
Extension of termination payment approval requirements to key management personnel
Summary of proposed change
The Rudd Government is also proposing the extension of the termination payment shareholder approval requirements to include senior executives and persons of influence within a company.
Currently, section 200B of the Corporations Act only imposes the shareholder approval requirement on payments made in relation to a person’s retirement from the position of director of the company or director of its related bodies corporate (eg, directors of its subsidiaries).
Treasurer Swan and Senator Sherry are proposing that the requirement for shareholder approval under section 200B be extended to include the same class of people whose remuneration is disclosed in the annual Remuneration Report.
Currently, section 300A of the Corporations Act requires that the Remuneration Report discloses remuneration details for the following individuals:
- if the company is part of a consolidated group, each member of the group’s key management personnel, its five most highly remunerated company executives and its five most highly remunerated group executives, and
- if the company is not part of a consolidated group, each member of its key management personnel, and its five most highly remunerated company executives.
The term ‘company executive’ refers to the secretary or people who make decisions which affect the whole or a substantial part of the company’s business or have the capacity to affect the company’s financial standing.
‘Key management personnel’ is defined in AASB 124 as persons having authority and responsibility for planning, directing and controlling the activities of the entity, directly or indirectly, including any director (whether executive or otherwise) of that entity.
Implications, complications and outstanding issues
The identification and determination of who are key management personnel is already a source of some difficulty for companies because the definition is challenging to apply in practice. In particular, identifying key management personnel may be made difficult in the context of executives changing roles or leaving or commencing employment part way through the year and because categorisation will depend on actual responsibilities and influence rather than role descriptions and reporting lines.
If the scope of section 200B is expanded to include all people who would fall within the definition of ‘key management personnel’, companies will be required to consider as a matter of course whether departing employees fall within section 200B. It is therefore likely that regulation of this reform will involve additional costs to business as companies more frequently need to consider who their key management personnel are, and in many cases, to engage external advisers for guidance where uncertainty arises.
The reform proposal is also problematic in that not all employees will be known to satisfy the definition of key management personnel at the time their contracts of employment are negotiated and signed. This may create significant uncertainty about what can be included in the contract in terms of termination benefits. Companies seeking to avoid the requirement for shareholder approval may include the provision discussed above to limit termination payments to an amount not requiring approval in all executive employment contracts.
Expanding the definition of ‘termination benefit’
Summary of proposed change
Currently, ‘termination benefits’ are broadly defined under the Corporations Act. They include any payment or property given:
- by way of compensation for a person’s loss of office
- in connection with a person’s loss of office, or
- in connection with a person's retirement from office.
Importantly, a business will be giving a ‘termination benefit’ where it falls within one of these three limbs even if the business is obliged to give the benefit under a contract. Pensions or lump sums paid or payable in connection with the person's retirement from an office, such as defined benefit superannuation payments, are also caught by the current definition.
Treasurer Swan and Senator Sherry have flagged the Government’s intention to further broaden the definition of ‘termination benefit’ to catch all types of payment made at termination.
Implications, complications and outstanding issues
There is a real risk that the expansion of the definition of ‘termination benefit’ will serve to capture a payment in lieu of notice as a ‘termination benefit’.
Following Justice Einstein’s decision in Randall v Aristocrat Leisure1 payments in lieu of notice are not ‘termination benefits’ under the Corporations Act but, rather, payments required to bring about the effective termination of the employment relationship.
Contractual notice periods for very senior executive roles are often substantial lengths of time in order to allow businesses adequate opportunity to undertake succession planning and perform recruitment searches with due diligence. Expanding the definition of ‘termination benefits’ to capture payments in lieu of notice will mean that businesses are more frequently over the statutory cap where the executive is paid in lieu of some or all of the notice period. Accordingly, such an amendment would mean that businesses will more frequently potentially require shareholder approval. Another potential outcome of such a change may be a trend to lengthier notice periods during which executives remain employed (although they may not work during this period).
Other unanswered questions
The proposed reforms raise a number of other issues which will hopefully be addressed once the exposure draft of the proposed legislation is released. These include the following:
When do the laws kick in?
The press release announcement by Treasurer Swan and Senator Sherry states that the Rudd Government recognises that they cannot legislate retrospectively in this area. However, the laws could be drafted to apply from the date of the release (18 March 2009). This means that companies should ensure this issue is considered for all executive contracts entered into from 18 March 2009.
Further, at this stage it is not entirely clear whether the government intends to apply the proposed new laws to termination entitlements under contracts entered into after a certain date or to the actual termination payments made after a certain date. If the government seeks to apply the laws retrospectively to termination payments, businesses paying termination benefits in the interim would be exposed to the risk of litigation from executives whose entitlements are prevented by the legislation.
In any event, companies will need to be alive to the reform proposal because the market will likely have an expectation that they ‘early-adopt’ the reform. Therefore companies should ensure that any contracts entered into with executives from today allow the company to comply with its obligations as they might stand in the future.
What happens where STIs/LTIs vest on an executive’s departure?
Given that the government has indicated that ’termination benefits’ will be defined broadly under the Corporations Act, it is likely that any bonus or short-term incentives (STI) or long-term incentives (LTI) which vest or are paid upon termination will be caught by the termination benefits cap.
This will require that any vesting or payment of LTIs or STIs which would increase a termination payment to more than 12 months’ average base salary will have to be approved by shareholders.
This could provide an impetus for companies to implement vesting periods for equity instruments granted to ‘good leaver’ executives that continue notwithstanding termination. This should not only avoid such instruments being captured as termination benefits, but will also be in line with the current views of some stakeholders that LTIs should continue to be performance tested after an executive’s departure.
Will payments to facilitate an executive’s departure be caught?
By lowering the threshold for shareholder approval, it will become more time-consuming and difficult to effect ‘ex gratia’ payments to departing executives. Therefore, the proposed reforms will likely diminish companies’ ability to use additional payments upon termination as leverage to negotiate a ’smooth’ exit with an executive who is not performing to expectations.
What happens with defined superannuation benefits?
The government has not specified how the new cap would apply to superannuation payments under defined benefits plans. Typically, payments on termination under a defined benefit superannuation plan have been classed as restricted termination benefits.
Unless superannuation payments are excluded from the new cap, companies will need to start making ongoing contributions to accumulation funds rather than offering executives defined benefits plan entitlements.
Productivity Commission examination of executive remuneration
As announced by Treasurer Swan and Senator Sherry, the Rudd Government has asked the Productivity Commission, to be led by Professor Alan Fels, to examine Australia’s framework in relation to the remuneration of directors and executives.
The Productivity Commission has been asked to make recommendations on how the existing framework governing remuneration practices in Australia could be improved. This is intended to be a broad-ranging examination that will consider the existing regulatory arrangements that apply to director and executive remuneration for companies that are disclosing entities under the Corporations Act, including shareholder voting, disclosure and reporting practices.
Specifically, the commission is requested to consider:
- trends in director and executive remuneration in Australia and internationally
- the effectiveness of the existing framework for the oversight, accountability and transparency of director and executive remuneration practices
- the role of institutional and retail shareholders in the development, setting, reporting and consideration of remuneration practices
- any mechanisms that would better align the interests of boards and executives with those of shareholders and the wider community, and
- the effectiveness of the international responses to remuneration issues arising from the global financial crisis.
In undertaking the inquiry, the commission will also liaise with the Australia's Future Tax System Review and the Australian Prudential Regulatory Authority (APRA). The APRA review is discussed in more detail below.
The Productivity Commission is aiming to release its executive remuneration issues paper by early April 2009. The final report will then be submitted to the government by 18 December 2009. Dates for receipt of public submissions, draft report publication and public hearings on the draft report will be advised shortly.
As part of the review process, the Productivity Commission will provide an opportunity for public participation. Freehills is able to assist you in drafting submissions to the inquiry.
Other developments
In Australia
There are also several other governmental and regulatory inquiries and reviews on foot which may impact on how companies remunerate executives.
APRA review of remuneration structures in banks
In our February issue of the Employee Relations Review, we discussed the current review of executive remuneration2 being conducted by APRA. That review aims to ensure executive remuneration in APRA-regulated financial institutions is structured to promote long-term sustainability and avoid perverse incentives.
APRA is expected to release the recommendations arising from its review along with a principles-based approach to structuring executive remuneration prior to the G20 summit in London on 2 April 2009. However, APRA Chairman John Laker, in his address to the Australian British Chamber of Commerce in Sydney on 26 February 2009, outlined that the proposed framework would most likely reflect the following two principles:
- Boards are responsible for remuneration arrangements: the board need not understand or approve the remuneration arrangements for every employee, but it should understand and approve the overall remuneration structure. The board will typically apply this principle through a board remuneration committee of independent directors, but the entire board remains responsible, and
- Boards should extend their stewardship of remuneration matters to all groups of personnel whose performance and activities can materially affect the institution’s overall performance: generally, the relevant groups would include the senior executives of the institution, risk management staff, commissioned sales employees and agents, and traders and other operators where incentive remuneration can be material. The larger and more complex the institution, the more the board will need to consider remuneration arrangements beyond the senior executive group.
APRA board member John Trowbridge, who is directly responsible for developing the guidelines, also suggested to a Senate estimates committee on 25 February 2009 that APRA wouldn’t be prescribing the quantum of remuneration, but could use its powers to require banks and insurers to set aside more capital if APRA thought they did not have appropriate remuneration policies.
Inquiry into corporate collapses
On 25 February 2009 the Parliamentary Joint Committee on Corporations and Financial Services resolved to inquire into, and report on by 23 November 2009, the issues associated with recent financial product and services provider collapses, such as Storm Financial, Opes Prime and other similar collapses.
This inquiry will include a specific mandate to examine the role remuneration structures in the financial services sector have played in such collapses.
ASIC greater powers to require disclosure of performance hurdles
On 26 February 2009, the AFR reported that ASIC was reviewing whether it should have greater powers to require companies to disclose performance hurdles for executive remuneration where companies have not disclosed hurdles on the basis that they are commercial in confidence.
RiskMetrics has also been critical of companies with opaque performance hurdles for short term incentive schemes, particularly where companies have increased the proportion of short term incentives relative to long term incentives. RiskMetrics has advocated the retrospective disclosure of performance hurdles to allow companies to be judged on their past record and give shareholders more confidence in companies’ board processes.
Overseas rescue packages
The global financial crisis has led to many companies throughout the world receiving urgent injections of government funds to starve off possible bankruptcy. Overseas governments have wasted no time, constructing and implementing immediate rescue packages, to ‘bail out’ these struggling institutions. However, the payments have not come without consideration for the bargain in the form of strict limits on executive remuneration.
The United States
President Obama made headlines around the world, with the announcement of strict new regulations on executive compensation for financial services firms and companies set to receive part of the US government’s $700 billion financial rescue plan, the Total Asset Relief Program (TARP).
Companies have received government assistance either through generally available programs, such as the government’s capital-injection effort, or through specifically designed rescue packages tailored to their business needs. Companies in the later category receiving ‘exceptional assistance’, such as Bank of America Corp. and Citigroup Inc., have been subject to more onerous conditions in respect of executive remuneration.
Since the announcement by President Obama, the conditions imposed on companies receiving tax-payer funded assistance, have varied slightly. There have been three standards or guidelines restricting executive compensation applicable to financial instituations receiving assistance under the TARP program. Most recently, the American Recovery and Investment Tax Act of 2009 was signed into law on 17 February 2009, revising restrictions on executive remuneration. These revised restrictions for companies receiving assistance include:
- prohibition on certain bonus, retention and incentive compensation for senior executive officers (SEOs) and up to 20 other employees
- prohibition on ‘golden parachute’ payments to SEOs and the five most highly compensated employees
- requirement to produce a company-wide policy on excessive or luxury expenitures
- compensation plans must be submitted to a shareholder vote
- prohibition on incentives that involve ‘unnecessary and excessive risks’
- required ‘clawback’ provisions of any bonus, retention award or incentive compensation paid to SEOs and the next 20 most highly-compensated employees, if they are found to be based on materiallly inaccurate information
- prohibition on any compensation plan that would encourage maniuplation of earnings to enhance compensation
- limitation on the tax deductibility of annual compensation of SEOs to $500,000
- requirement of annual certification by the CEO and CFO of the company’s compliance with the restrictions, and
- requirement that the company establish a compensation committee consisting solely of independent directors to review employee compensation plans.
The costs for companies complying with these regulations may be far greater than they first appear. Regulation of executive remuneration could have the effect of reducing a company’s talent pool as senior executives seek employment opportunities with companies offering greater financial rewards, free from the limitations imposed on regulated companies. Costs may also increase as companies are forced to seek the resources of external consultants, to ensure that they are meeting the stringent criteria.
Whether these conditions result in any industry reforms remain to be seen. Companies receiving funds under the TARP program may repay these funds at any time and in doing so will release themselves from the compensation restrictions. Therefore, the restrictive conditions may operate as an incentive for repayment in order to avoid restrictive conditions, rather than acting as an impetus for change within the financial industry.
Europe
European companies wishing to receive government financial support have also been subject to conditions relating to executive compensation.
In Switzerland, UBS AG—the only Swiss bank to receive a government bailout so far—has announced that senior executives would not be receiving bonuses for 2008 and any compensation arrangements are to be subject to government oversight.
In Norway, the senior executives in the banking sector are taking action ahead of any government-imposed cap, promising to voluntarily freeze their salaries.
President Sarkozy in France has placed restrictions on golden parachutes for executives of companys benefiting from state handouts and has established an oversight committee to oversee executive compensation. Similar measurs are also being taken in Ireland and Germany.
UK regulation
The UK Financial Services Authority (FSA) has been the first regulator to publish an industry wide comprehensive code of practice on remuneration.
On 26 February 2009, the UK’s financial regulator, the FSA published its code of practice on executive remuneration. The code follows a letter which the FSA sent out to all bank and building society Chief Executive Officers in October 2008. This letter set out a number of guiding principles for financial institutions to adhere to when determining executive remuneration structures. The code is largely consistent with these principles, although there is some slight variation.
At this stage, the code remains in draft form and it is intended to apply to all FSA regulated firms. The code was released in conjunction with the UK Government’s announcement about its Asset Protection Scheme. The code is intended to form part of the eligibility criteria for firms participating in the Scheme. For banks and other UK incorporated financial institutions not participating in the Scheme, the code will become effective following a formal consultation process. However, the impact of the FSA’s guidance is not likely to be confined to financial institutions. Already UK companies are reviewing their practices against the code’s criteria.
The code is primarily concerned with managing risk. This is reflected in the following general principle, which forms the basis of the code: ‘Firms must ensure that their remuneration policies are consistent with effective risk management.’
Supporting the general principle, are specific principles which are grouped under in the following headings:
- governance
- measure of performance for the calculation of bonuses
- measure of performance for long-term incentive plans, and
- composition of remuneration.
The emphasis on governance is a striking feature of the code. The code expands the responsibility of remuneration committees throughout the business. The may be requested by the FSA to prepare an annual statement on its remuneration policies and following this the FSA may seek a meeting with the Chair of the Remuneration Committee to discuss this annual statement. The statement is to include an assessment on the impact of remuneration policies on the business.
In assessing the calculation of bonuses, the code requires businesses to review their calculation of bonus pools to include an adjustment for current and future risk. Non-performance based criteria including adherence to effective risk management and compliance with regulations, should form a significant part of the performance assessment process and performance should not solely be based on the results of the current financial year.
The code identifies common long-term incentive measures, such as earnings per share and total shareholder return, as inappropriate because they are not adjusted for longer term risk factors. A shift away from these common performance measures will involve a shift in mindset for companies and investors alike, as they have long been seen as the most reliable, albeit not perfect, measures of long term performance.
The FSA has clearly stated that the code is not concerned with setting levels of remuneration. Determining quantum is to remain a matter for boards and shareholders. The code does however, set out a number of principles concerning the composition of remuneration. These relate to the deferral of bonuses, the assessment of performance, and the fixed component of remuneration.
Executive remuneration – where to from here?
Company directors are already under legal obligations to act in the best interests of the company they serve and these duties extend to remuneration practices. For this purpose, the Australian Institute of Company Directors issued the ‘Executive Remuneration Guidelines for Listed Company Boards’ in February 2009 which are designed to assist large publicly-listed companies negotiate and set executive remuneration. The guidelines reflect the AICD’s view that executive remuneration should remain a matter for boards, and that further regulation in this area is unnecessary and may be counterproductive to the desired outcomes sought.
Treasurer Swan and Senator Sherry’s recent proposals for reform of termination payments to executives seek to increase shareholder participation in the way companies’ remunerate their executives. This signals a move away from the current corporate law which reflects that remuneration is a matter for company boards.
In the context of an international market for executive services, structuring executive remuneration involves a delicate balancing of:
- attracting appropriately qualified and experienced executives
- retaining executives, and
- providing incentives that motivate and challenge executives to perform at their peak for the benefit of the business.
Introducing added shareholder approval requirements for termination payments to executives, not in the context of a US government style industry ‘bail out’, has the potential to be unnecessarily and inappropriately restrictive and reduce flexibility for businesses in the international market for talent. In the most severe circumstances, it could limit companies’ ability to be competitive in attracting and retaining executives in Australia.
Where entitlements in relation to termination are provided in executive contracts, companies will need to carefully review whether the entitlements are expressed to be subject to the appropriate shareholder approvals which might apply. This will also apply in respect of employees who are not executives, but who may be candidates for promotion within the company in the future.
Failure to express termination entitlements within the executive contract having regard to the reform proposals may result in companies being subject to contractual duties which they cannot discharge from a regulatory standpoint without shareholder approval, which, potentially, could lead to litigation by executives and further specific criticism from stakeholders where the company does not want to go to shareholders.
Finally, the Productivity Commission review will be an opportunity for business and others to make submissions regarding the issue of executive remuneration more generally in order that any further legislation in the area considers appropriately and addresses adequately the interests of all stakeholders. The recently introduced UK Code of Practice may be instructive for those interested or involved in the PC review.
This article was written by Justine Turnbull, Partner, Sydney, John Cooper, Partner, Timothy Stutt, Articled Clerk and Georgia Rutecki, Solicitor, Melbourne.
Endnotes
1. Randall v Aristocrat Leisure Limited [2004] NSWSC 411
2. Executive remuneration in Australia: Some current issues from Employee Relations Review February 2009
More information
For information regarding possible implcations for your business, contact a member of the Employee Relations team.