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Staying ahead of the wave: will the recommendations from the Royal Commission cause a tsunami of changes for executive remuneration?

Tucked neatly in the Royal Commission report, starting on page 347, is a little section that focuses on Executive Remuneration. This section has received little media attention; however the recommendations could instigate significant changes that are likely to flow to all Australian companies.

This article highlights the key issues for Boards, particularly Remuneration Committees, and provides some commentary on how these recommendations might change the executive remuneration landscape.

Design Issues

Two comments caught my eye in this section.

…financial metrics must not determine remuneration. Risk of all kinds, including reputation risk, compliance risk and conduct risk, must be taken into account in both designing and implementing the remuneration system.” P350

…focusing only, or largely, on a measure of total shareholder return when deciding whether long-term variable remuneration should be paid does not allow consideration of all relevant aspects of the executive’s performance. In particular, I would add, it does not allow consideration of how the executive has managed risk.” P356

Most Long-Term-Incentives (LTI) in Australia are designed to vest on the employee meeting two conditions. Firstly, a service condition – the executive must still be working for the company at the end of the performance period – and secondly a performance condition. In most cases, the performance condition is the achievement of a financial metric over the performance period. This metric is typically Total Shareholder Return (TSR) relative to a defined peer group, or an absolute hurdle. How the company achieves the financial outcome isn’t directly taken into account.

Commissioner Hayne is critical of the heavy emphasis on financial metrics as the primary measure to determine LTI bonuses. So, should companies replace the TSR metric as a vesting condition in the LTI design?

Under current accounting standards removing a market based financial metric such as TSR will have significant implications for the accounting cost of the bonus, as non-financial vesting conditions may not be taken into account in the valuation. Furthermore, as noted in the report, shareholders may resist changes to LTI design which mean incentives are not directly linked with shareholder returns.

Rather than replacing the TSR metric an alternative could be to introduce a risk management element as an additional vesting criterion. This would make payment of the LTI bonuses subject to three conditions: service, financial performance AND risk management performance.

As with most changes, there are pros and cons with each option and companies need to fully understand the practical consequences of any changes before proposing them to shareholders.

Implementation Issues

A large part of this section of the Royal Commission report is dedicated to analysing the failings of CBA’s remuneration arrangements – specifically, it’s near full payment of Short-Term Incentives in 2016 despite major breaches by its life insurance business as well as scandals relating to money laundering etc. The report highlights the importance of remuneration committees of Boards having the necessary information systems to make informed and timely decisions. Two comments are noteworthy:

Although good design of remuneration arrangements is critical to reducing the risk of misconduct, the issues demonstrated by the evidence before the Commission were often issues of implementation rather than design.” P359

As recently as April 2018, APRA observed in its information paper on remuneration practices at large financial institutions that its review ‘noted instances of poor quality, incomplete or inadequate documentation’ about risk management performance being provided to board committees.” P361

This section also discusses the issue of transparency and whether companies need to disclose details when bonuses are reduced (referred to as “risk related adjustments”). On this issue, the APRA representative made the point that requiring companies to make public disclosures of risk related adjustments could deter companies from reducing bonuses. This response highlights one of the key problems with using subjective non-financial hurdles; that is ultimately, these vesting decisions are made by individuals (or Boards) with personal relationships with the recipient, who are potentially conflicted.

Regulatory Compliance and Oversight

The prudential standards and regulatory oversight also came under heavy criticism from Commissioner Hayne.

…the prudential standards should expressly require APRA regulated institutions to design their remuneration systems to encourage sound management of non-financial risks, and to reduce the risk of misconduct.” P351

…the prudential standards should expressly require the board of a financial institution (whether through its remuneration committee or otherwise) to make regular assessments of the effectiveness of the remuneration system in encouraging sound management of nonfinancial risks and reducing the risk of misconduct.” P352

APRA (and, where appropriate, ASIC) should do more to gather information about the way that remuneration systems are being applied in practice, and about whether those systems are actually encouraging sound management of non-financial risks and reducing the risk of misconduct.” P352

APRA should set limits on the use of financial metrics in connection with long-term variable remuneration.” P365

It is clear from these comments and recommendations that the Commissioner believes there needs to be more restrictions around remuneration structures and greater oversight from APRA. The report also suggests that regulators need to collect more data on executive remuneration arrangements and outcomes.

Banks and other deposit taking institutions already have some constraints on remuneration design through the need to comply with BEAR. It is inevitable that these restrictions will increase (APRA is currently undertaking a review). Any changes that apply to APRA regulated entities are likely to be looked at carefully by ASIC and potentially extended to cover companies in other industries.

We will continue to monitor developments in this regard, in particular the outcomes of the APRA review later this year which will provide a good indication of changes to come.