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Focus: Executive remuneration – to regulate or not to regulate?

12 March 2009

In brief: Acting on a request from the Prime Minister, the Australian Prudential Regulation Authority is set to release compulsory executive remuneration guidelines in the first half of this year. Executive Partner Paul Quinn (view CV) and Lawyer Ben Ferguson report on the likely shape of these guidelines and other recent developments regarding the regulation of executive remuneration.

How does it affect you?

  • Early indications from the Australian Prudential Regulation Authority (APRA) suggest that boards of financial institutions will need to ensure that they have an executive remuneration policy in place that is consistent with sound risk management or face extra prudential capital requirements.
  • For the majority of Australian companies, which are not regulated by APRA, it is not yet clear how these companies will be overseen or whether any new regulation of executive remuneration will extend to them.

APRA's framework

In October 2008, the Prime Minister, as part of the Federal Government's response to the global financial crisis, foreshadowed the development of a framework to link regulated financial institutions' capital adequacy requirements to executive remuneration and assigned APRA the task of formulating this framework.

Although the proposed framework is still being developed, John Laker, the chairman of APRA, recently gave an insight into the proposed coverage and operation of the framework. In a speech to the British Australian Chamber of Commerce on 26 February 2009, he indicated that the structure or model of remuneration, rather than the quantum or level of remuneration, will be regulated under the compulsory framework. APRA's proposed framework will not seek to cap executive remuneration. Instead, financial institutions that do not adopt what APRA considers to be a sensible remuneration policy will be required to hold extra amounts of capital in reserve to discourage excessive risk taking.

Mr Laker also outlined two principles which APRA would expect to be the centrepiece of a sound remuneration structure:

  • a board should understand and approve the overall remuneration structure of their institution; and
  • a board should extend their stewardship of remuneration matters to all groups of personnel whose performance and activities can materially affect an institution's overall performance. Such personnel could include senior executives, risk management staff, commissioned sales employees and traders.

APRA's preference for a principles-based approach to executive remuneration has received support from the Finance Minister, Lindsay Tanner, who recently indicated that the Government would not mandate executive salaries. Mr Tanner also played down the prospect of binding shareholder votes on remuneration saying that while the Government will review this option, binding votes on CEOs' remuneration packages sound good but could have unintended consequences.1

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The approach of the Australian Institute of Company Directors

In an attempt to pre-empt further regulation of executive remuneration, the Australian Institute of Company Directors (AICD) has recently released their own remuneration guidelines for listed company boards. The guidelines are voluntary and the AICD is firmly of the view that executive remuneration should remain a matter for boards, not shareholders or the government, and that further regulation in this area is unnecessary and counterproductive to the outcomes sought.

The guidelines set out what the ACID considers to be good and poor practice, and issues for further board consideration. Some of the key issues that the AICD identifies for further board consideration are:

  • placing an upper limit on short-term incentive rewards to minimise the potential for surprises in fluctuating markets;
  • considering engaging with major shareholders about the company's approach to remuneration, subject to continuous disclosure obligations; and
  • putting in place arrangements whereby a percentage of a CEO's long-term equity incentive benefits is held for a period that extends beyond the term of the employment contract.

Instances that the AICD consider to be poor practice include:

  • providing additional payments beyond basic statutory entitlements where an executive's employment relationship is terminated for misconduct;
  • changing performance benchmarks midstream unless there is an exceptionally good reason; and
  • allowing double or triple counting of benefits for the same effort because of multilayered remuneration structures.

The guidelines are clearly focused on remuneration setting for CEOs and other senior executives and do not seek to address remuneration setting for other personnel.

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Around the world

The AICD's voluntary guidelines are in contrast to recent developments in the United States where President Obama placed a US$500,000 cap on remuneration for executives in companies that have received federal government bail-out assistance. If affected executives receive any further bonuses, they will come in the form of stock that can't be realised until taxpayers are paid back for their assistance. President Obama has also pledged further reforms in the future, promising that the administration will 'examine the ways in which the means and manner of executive compensation have contributed to a reckless culture.'2

In the United Kingdom, the Financial Services Authority, the British equivalent of APRA, has also released a draft Code of Practice on Remuneration Policies (the Code). Like APRA's approach, the principles in the Code are not concerned with the quantum of remuneration but are designed to ensure remuneration policies are consistent with sound risk management. Once the Code is finalised following industry consultation, it will bind all banks that have joined the Treasury's Asset Protection Scheme, a scheme that insures banks for losses on their riskiest assets. The European Commission has also announced that it will release proposed rules for the regulation of executive remuneration in the second half of 2009.

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Where to from here?

It is clear that executive remuneration is set to come under closer regulatory scrutiny in light of the global financial crisis. However, the impetus for greater scrutiny has also produced a variety of approaches to regulation. Early indications suggest that Australia and the UK will adopt a principles-based approach to regulation; a middle ground between US-style executive remuneration ceilings and the AICD's voluntary approach to regulation. If this is the case, boards of financial institutions will have to ensure that they have an executive remuneration policy in place that is consistent with sound risk management or face extra prudential capital requirements.

Nonetheless, significant questions still remain about the coverage and nature of remuneration regulation in Australia. The majority of Australian companies, including many investment banks, are not regulated by APRA and it is not clear how these companies will be overseen or whether any new regulation would extend to them. While the Federal Government appears to have ruled out binding shareholder votes on remuneration, APRA is yet to indicate what role (if any) shareholders will play under their proposed framework. The APRA Chairman's remarks also imply that 'executives' will include more than just senior management and this may create uncertainty regarding the framework's coverage.

We will keep you updated on the developments in this area, including the APRA framework once it is finalised. If you have any queries about this or any other corporate governance issue feel free to contact us.

Footnotes
  1. 'Action Unlikely on CEOs Pay', Australian Financial Review, March 2, 2009.
  2. 'President Obama's Remarks on Executive Pay', New York Times, February 4, 2009.

Published 12 March 2009

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