‘Rem’— the annual process listed companies undertake to set executive remuneration is contentious and vexed. That’s according to the directors of Australia’s top 200 listed companies.
‘Rem’ is the term commonly used by ASX200 directors when describing the executive remuneration setting process, which includes the internal discussions with executives, engagement with external remuneration consultants, meetings with shareholders and proxy advisers, and the actual vote on executive remuneration at the AGM.
I recently conducted an extensive study to understand how ASX200 directors focus their time in their practice of governance under ASX Corporate Governance Council’s Corporate Governance Principles and Recommendations (Principles and Recommendations). In what is an Australian first, 41 current ASX200 directors (holding a combined 70 ASX200 board roles) participated in qualitative, open-ended interviews. The study found that when reflecting on their practice of governance, ASX200 directors primarily focus on ‘rem’, relationships and risk (the 3 Rs).
The ‘rem’ focus emerged during the analysis of Principle 8 (Remunerate fairly and responsibly) in the Principles and Recommendations, focusing on the tensions surrounding the process of setting executive remuneration. It illustrates a significant tension around current practices that have emerged following a period of scrutiny and legislative change. Following the Productivity Commission inquiry into executive remuneration, the Corporations Amendment (Improving Accountability on Director and Executive Remuneration) Act 2011 introduced the two-strikes and re-election process in relation to the non-binding shareholder vote on remuneration in 2011.
Increase in the power of stakeholders
The board’s role in managing rem involves balancing the interests of shareholders with executive employees. As one director noted: ‘It’s the most emotive part of any organisation … externally it’s the thing that most people are interested in’ (Interviewee). Since the introduction of the two-strikes rule and with increased external pressures, directors have experienced, and become increasingly concerned about, the significantly altered power structures in the rem process in relation to obtaining stakeholder support and approval.
The role of remuneration consultants has risen dramatically in recent years, with directors and boards using them to provide external validation of their remuneration structures. This is seen as an effective mitigant to the risk of getting a strike; however, many directors were of the view that boards have become beholden to their advice, as one director described ‘boards have become hostage to rem consultants’ (Interviewee).
One director was very critical of the role they played in the rem process: ‘They now do statistical sampling … the system defeats them, and they agree with me’ (Interviewee). Here, they were outlining that boards require external validation in the form of benchmarking to industry medians in order to support their rem proposals when taking them to proxy advisers and the shareholders at the AGM. The complexity of the remuneration report was also of great concern to directors. As one director noted: ‘I can’t understand rem reports, I don’t understand what they are earning, I don’t understand the genuine risks they take, the motivations’ (Interviewee).
The power of proxy advisers has also risen dramatically in recent years, and a key strategy for boards in avoiding a strike has been to establish relationships with them and engage with them (particularly in the lead up to the AGM) on executive remuneration. ASX200 directors were critical of them for forcing boards to design remuneration structures that centre to norms that may not necessarily be suitable for their organisation, industry or individual executives. They reported that this has resulted in increased complexity and, at times, unrealistic expectations being placed on boards by the stakeholders when setting appropriate remuneration structures for their executives.
ASX200 directors are concerned about the significant amount of time being devoted to rem when managing various stakeholders to minimise the risk of a strike. They also reflected having experienced and observed various AGMs where the non-binding vote has been used by investors to express their dissatisfaction with matters other than remuneration, and they feel stymied by the use of the mechanism in this way. ‘Often a first strike is not about remuneration anyway, it’s about performance and rem is the easiest thing to have a go at’ (Interviewee).
Use of the non-binding vote
The consequence of attracting a strike in the non-binding vote was a key risk for directors. As one director noted: ‘You get a strike and then your board gets unstable’ (Interviewee). Here, the director was describing how, after the first strike, the board becomes very unsettled in the 12 months following, fearing a second strike. Once a strike has occurred, significant time needs then to be allocated in the following year up to the AGM in resetting remuneration, including meeting extensively with stakeholders in order to avoid a second strike.
ASX200 directors described feeling uneasy about excessive remuneration for executives, and the increasing disparity with the average wage in Australia.
Directors reflected on some unintended consequences as a result of the rem process (under the current regulations); most significantly the effect that it has had on putting upward pressure on executive remuneration.
As a result of the increased transparency of executive remuneration, directors were concerned that the actual impact has been to place upward pressure on executive remuneration. This effect is counterproductive to the original intention of the legislative change of the non-binding vote. ‘The focus on rem has contributed to the inflation in executive remuneration, so it’s counterproductive’ (Interviewee). Directors noted that, in their view, there is no indication of this trend abating in the current environment, even in subdued economic times.
ASX200 directors described feeling uneasy about excessive remuneration for executives, and the increasing disparity with the average wage in Australia.
Along with the contentious ‘rem’ theme, the other two key areas where ASX200 directors focus their time when reflecting on their practice of governance were ‘relationships’ and ‘risk’.
The presence of strong working relationships between ASX200 directors and key parties and stakeholders is essential in enabling ASX200 directors to govern effectively. The board acts as a team in fulfilling their collective responsibilities, and the team’s effectiveness is dependent on the presence of strong relationships that facilitate dependency, reciprocity and trust.
Relationships within the board…
‘The biggest and quickest destroyer of shareholder value is a dysfunctional board’ (Interviewee). Directors reported being cautious during the recruitment process for new directors, focusing on the necessity of finding candidates who are a suitable ‘fit’ for the board team. The need to be able to work with the person was seen as being critical given the negative impact that conflict can have on decision-making and board effectiveness. This concern and caution heavily influence the appointment process and affects how some boards search for board directors. (There were two distinct schools of thought around director recruitment: selecting from networks to reduce the aforementioned risk, and looking for new talent outside known networks, which some perceived to be riskier). Directors also raised the practical difficulties in removing directors who do not have the right skills and attributes or cannot work as part of the team.
The role of the chair was seen by ASX200 directors as being key in facilitating the effectiveness of the team and fostering the relationships between board members. The chair needs strong interpersonal, social and leadership skills to facilitate discussion and manage the complex nature of relationships between directors and the executives.
Relationships with executives…
In practice, ASX200 boards mostly comprise of non-executive directors who rely on executives for resources and information in order to perform their directing and governing role. Without a good relationship with key executives that enables trust and, thus, the provision of information, non-executive directors are limited in their ability to perform their governing role. Boards and executives must exhibit openness, honesty and trust, all of which are founded on respectful professional relationships, to perform their roles effectively. ‘There is a sense of family between the board and management, we are all in this together’ (Interviewee). The relationship between the board and executives is complex- the relationships must be strong and trusting, but also distant enough so as not to impact independence and the role of the non-executive director.
The risk associated with relationship breakdowns is significant because it can have a major impact on the effectiveness of the governance of the company.
Relationships with stakeholders…
Relationships that boards have with key stakeholders are also critical enablers of good governance and board effectiveness. Stakeholder groups are varied, depending on the organisation and industry, but usually include shareholders, proxy advisers, consultants and regulators. Boards of directors need to identify and understand their major stakeholders and create and maintain respectful and appropriate relationships with them in order to be able to govern effectively. The interviewees made clear that modern ASX200 board governance requires that chairs and CEOs have closer proximity to certain stakeholders, including proxy advisers, who can be key enablers in governance processes, including the setting of executive remuneration. ‘You’ve got to work with your investors to make sure they are onside’ (Interviewee). In respecting the rights of investors, boards must facilitate open and reasonable communications and an avenue for investors to be able to hold the company to account. Despite this, participants made it clear that the traditional AGM format is becoming less effective as a mechanism for facilitating an appropriate avenue for this purpose, as proxy voting by major investors usually means that smaller investors have little influence on the outcomes of voting matters.
Some ASX200 directors also reported that boards are increasingly recognising the benefits of being able to connect effectively with organisational employees. Some companies have used their board diversity strategy to enable a closer resemblance to the employee base in order to be able to better connect with that stakeholder group.
‘Risk is the thing that worries me most… this risk stuff can kill you’
Risk is at the forefront of ASX200 directors’ minds and was prominent in their reflections on governing their companies. ‘Risk is the thing that worries me most… this risk stuff can kill you’ (Interviewee). The third edition of the ASXCGC Principles and Recommendations enhanced the number of recommendations concerning risk, and it is clear that this, combined with other external pressures and corporate collapses has resulted in a significant increase in the focus on risk by ASX200 directors. It is at the forefront of their thinking and is invariably what keeps the ASX200 directors awake at night. ‘The downside is so great, the responsibility is enormous…you can lose your house, and you can go to jail’ (Interviewee).
Risk from internal factors…
Directors interviewed for this research focused on various risks that stem from breakdowns in internal controls when they reflected on their governance practices in relation to the ASXCGC Principles and Recommendations. These risks included unethical behaviours within the organisation, failure to disclose appropriately to the market and inaccurate corporate reporting.
ASX200 directors reported being very focused on the culture of the organisation in their efforts to eliminate unethical behaviour. They are equally aware of the potential for reputational damage from unethical practices in the company. These directors are extremely conscious that it takes a long time to build the reputation of the organisation and that reputation can be destroyed very quickly if the organisation is found to be acting unethically.
The risk of maintaining the integrity of corporate reporting is taken very seriously by ASX200 directors. They are focused on having extensive and varied levels of assurance, and reflected in the interviews on the potential for severe ramifications of making mistakes in reporting, both for the company and for directors.
The risk surrounding disclosure is significant for directors. Extensive judgement is required to determine whether to disclose information and, if so, how, in order to meet disclosure requirements which are only ever tested in hindsight. Directors further have the complication of timing, and often need to delegate some of their disclosure responsibilities to ensure that disclosures take place between board meetings as required. This delegation requires substantial trust to be placed in the executives involved, for which strong, open and transparent relationships between the board and executive are a prerequisite. Some non-executive directors were of the view that the laws on disclosure should be changed because of the inherent difficulties faced in being expected to know everything that must be disclosed without being involved in the day-to-day management of the business.
Risk from external factors…
Directors are also very also focused on various risks that stem from external factors (to the operations of the company) when they reflected on their governance responsibilities; these external factors were also the prominent issues that kept directors awake at night.
In particular, directors are concerned about potential areas of risk they failed to identify; the ‘thing they don’t know’ (Interviewee), or ‘didn’t plan for’ (Interviewee). Unknowns that they are concerned about included becoming obsolete in the market place or being faced with a catastrophic incident that they had not planned adequately for.
Aversion to risk…
ASX200 directors with international experience and perspective shared the view that in Australia directors ‘are not willing to take a lot of risk, they are not willing to put their reputation on the line’ (Interviewee). They further noted the cultural differences in other jurisdictions where there is a greater degree of tolerance when something does go wrong in governing and managing companies. In these jurisdictions, where the markets and stakeholders appeared to be more forgiving, companies were able to enjoy the benefits or upsides of risk-taking more frequently. Despite the existence of the business judgment rule, the interviewed ASX200 directors did not mention this protection in their reflections, and, thus, it was not clearly embedded into their thinking as a protection mechanism when considering risk to themselves or the organisation, or their broader governance responsibilities.
How the rem, relationships and risk (the 3 Rs) intersect
The study further revealed that the three key themes the ASX200 directors focus upon when reflecting on their practice of governance are highly relational. Effective risk management relies on the existence of strong board and executive relationships that are built on trust and openness. Effective rem management requires appropriate relationships with key stakeholders, both internal and external (such as remuneration consultants and proxy advisers). The failure of critical board and executive relationships significantly increases certain risks to the company and can impact judgment at the board level. Further analysis of the three Rs revealed four common elements: trust, values, judgment and rigour. These four elements were frequently described as being essential when describing the three prominent themes of relationships, risk and remuneration by ASX200 directors. The intersection of the three key themes and four common elements are depicted in the ASX200 director governance model outlined below.
Figure 1: The ASX200 director governance model: