(article by Greg Brogan)

 

When the Productivity Commission issued its 400 page Draft Report on Executive Remuneration last month, the acceptance of its findings by almost all commentators bordered on the nauseating. John Drurie of The Australian was one of the very few who correctly identified the paper as the “whitewash” it clearly was. So, why the general acquiescence and applause?

 

The Productivity Commission’s conclusions could be paraphrased as “everything’s pretty much OK and we just want to suggest a few changes at the edges”. This was great news for the vested interests in the business community and for the Federal Government - who hope they won’t have to deal with this issue again any time soon. Tragically, they will. The encouragement inherent in the report will ensure that the Boards of under-performing companies can continue to use ‘the market’ as an excuse to overpay under-achieving executives. Basically, these types of companies, of which there are many, have been given a ticket to jump on the gravy train and ride it at their leisure.

 

Although Executive Pay Systems does not agree with the overall findings of the Draft Report nor the paraphrased conclusion, the purpose of this paper is to bring to your attention one specific example of how and why the report will be ineffectual in dealing with the problem. Before commenting on the specific problem, I should point out that it is our view that the recommendations suggested in the Draft Report are sound in and of themselves and should be supported. They should, however, be supplemented by some additional recommendations concerning the subject matter outlined below.

 

 

One major problem with the Draft Report

 

The Productivity Commission has mentioned the issue of the correlation between Executive Pay and company performance in section 3.5 (pp 65 – 71). This is one of the weaker parts of a particularly weak paper and happens to dismiss THE most important question in the Executive pay debate. The line of argument presented seeks to permit the Productivity Commission to avoid the question altogether. The result is that not a single recommendation deals with the issue of company performance /executive pay correlation.

 

The Commission has argued that it is not possible to assess a numerical relationship between performance and remuneration and draw any useful conclusions:

 

“Statistical analysis that attempts to identify a numerical relationship between remuneration and ….performance could lead to incorrect conclusions” (p66) and, again “The implication is that statistical analysis could lead to spurious conclusions” (p67)

 

This comment has been made in the context of the general population of companies and it must be assumed that, by ‘conclusions’ they mean conclusions about the relationship generally as opposed to conclusions about the relationship in any particular company.

Assuming the observation is correct (which is not conceded), it does not follow that an individual company cannot identify such a relationship. Indeed many chapters of the report are devoted to explaining that executive pay has risen precisely because companies have adopted performance based incentives determined, presumably, by establishing a relationship between performance and executive pay. Under these circumstances it seems immaterial that a general statistical correlation does or does not support spurious conclusions.

 

It is true that the overall increases in executive pay are roughly correlated to the movement in various ASX indices when the data for all companies in a sample is analysed over lengthy periods. This fact, however, does not erase the need to address those companies whose pay practices are clearly negatively correlated – companies who reward executives where the shareholders are clearly disadvantaged. This is like saying we don’t need a law against stealing because the data shows that 99% of people don’t steal things.

 

The problem with this line of thinking is that it has been used by the Productivity Commission to entirely avoid the most critical issue in this whole debate – the lack of correlation between company performance and executive pay in many large companies. Basically , they’ve looked at the data – most of which has been provided by the global remuneration consulting firms - and said “this is too hard”, a result those very same vested interests would have been delighted to have read when the report was issued.

 

Basically, on this most important question at least, the Productivity Commission has been snowed. The reader is invited to have a look at the references throughout the report and the list of organisations invited to contribute to public hearings and the like. It is a Who’s Who of local and global Remuneration advisers. Their primary objective is to ensure the maintenance of the status quo and the Productivity Commission has delivered precisely the result they wanted.

 

It must be concluded that the Productivity Commission is simply not equipped with the depth of commercial experience to deal with global vested interests who have spent the past 20 years creating the very system which the Productivity Commission was asked to examine. They’ve asked the hackers to help them design a better internet and the hackers have said “no, this one’s fine”. The Productivity Commission responds “Ok then, let’s leave it as it is shall we”. Kevin has sent a boy on a man’s errand.

 

Possible Remedy for the Final Report

 

The most important change that the Productivity Commission could recommend relates to the Disclosure of more information explaining the decision making around long and short term incentives.

 

1.       Pre and Post Disclosure

 

Shareholders would be better able to decide how to cast their remuneration approval votes if companies disclosed the basis upon which next year’s remuneration decisions would be made. The Board could explain the performance measures, the targets, the calculations and the manner in which they intend to exercise their judgment. Shareholders could be asked to approve the methodology beforehand. In this way shareholders would effectively be bound by their decision (last year) to approve the method and would be able to decide (next year) whether the method they approved has been applied in accordance with their wishes. In effect, they couldn’t argue with an outcome which arose from a method they agreed to the year before. Many companies would object to this level of disclosure on the basis that they would be disclosing commercially sensitive information. This is a ruse. They already have to disclose these details elsewhere.

 

2.       Total non-fixed pay for the company

 

The Productivity Commission should consider recommending that a company’s total spend on incentives be disclosed. This would allow shareholders to assess whether the spend is acceptable as a proportion of profit (or whatever measure is important to them). It would also allow shareholders to determine the proportion of the total spend that has been paid to executives and whether they agree that this is an appropriate proportion (relative to the non-executive workforce).

 

3.       Proportion of Profit

 

The Productivity Commission should consider recommending that companies disclose how much of the profit they intend to spend (next year) and have spent (this year) on incentives. In the event that the proportion seems too large, the Board then has the opportunity of disclosing the reasons why it considers such a high proportion to be prudent.

 

4.       Justification for the payments

 

The Productivity Commission should consider recommending the disclosure of the Boards justification for the spend and for the spend as a proportion of profit, both for the company as a whole and for the executive group in particular. The payments would need to be justified in absolute terms and also relative to the stated remuneration policy which was presumably approved by shareholders in prior years.

 

5.       Magnitude of change from the previous year

 

The Productivity Commission should consider recommending the disclosure of the magnitude of the change in executive remuneration (since last year or over a period of time). This would enable shareholders to decide whether remuneration increases are acceptable compared to improvements (or degradation) in performance over the same period.

 

Proactive Disclosure

 

Companies wishing to ensure shareholder acceptance of their Remuneration Report should consider the above suggestions. Where the shareholders have approved the method of determination of non-fixed executive pay they will feel that they have been involved in the determination process and the likelihood of a subsequent negative vote will diminish markedly. Similarly, where shareholders are aware of the total remuneration spend and the proportion that it bears to the disclosed profit and the amount and the proportion are demonstrably acceptable, the chances of a near 100% acceptance will be greatly multiplied.

 

Executive Pay Systems assistance

 

We, at Executive Pay Systems, have developed methodologies over many years which allow companies to measure performance and to link remuneration outcomes to those measures in advance. We would be happy to assist with the development of methodologies, policies, procedures and apparatus which will ensure that only the very best Executives are attracted to your company, that the remuneration programs contribute to improved company performance and that the shareholders consistently accept the Remuneration Report when the time comes.