While unfortunately overshadowed by the Goldman fraud charges, late last week the federal government released its long-awaited response to the Productivity Commission’s report on executive pay. The government response should please shareholders — not only did corporate law minister Chris Bowen accept virtually all of the commission’s recommendations, but he also suggested a “bonus claw-back” rule, which would allow for the recovery of bonuses paid to executives who provided misleading financial information.

Two strikes

The government also angered business groups by supporting the commission’s “two strikes” proposal. The “two strikes” rule provides that if a company receives two consecutive 25% “against” votes on its remuneration report, a subsequent resolution will be put to shareholders giving them the ability to “spill” the board. The rule was criticised business groups with Origin and AGL director John Akehurst telling the Financial Review that the rule will cause “a great deal of difficulty” for companies with good governance arrangements.

While the “two strikes” rule is unnecessary, it is not for the reasons submitted by the powerful business lobby. Despite Akehursts’ claims, companies with strong governance arrangements (such as BHP Billiton or Commonwealth Bank) would almost certainly not encounter two consecutive remuneration reports criticised by shareholders; that is reserved for the likes of Qantas (which paid former CEO Geoff Dixon so much that he was the best remunerated aviation executive in cash terms globally, before paying him millions more for compensation for superannuation changes that  had no effect on Dixon) or United Group.

Rather, the problem with the “two strikes” rule is that it much like using a shotgun to remove an ant. Institutional shareholders will seek to avoid creating the instability that  would inevitably flow from a board spill. What’s more — the mere threat of such a result may even lead to shareholders from not criticising a remuneration report for fear of triggering the “second strike” rule. In addition, the rule is superfluous because even under current laws, 5% shareholders have the ability request an EGM and spill the board if they are unhappy with performance.

The government, however, got it right in other respects when it suggested further strengthening of various Productivity Commission proposals. These included preventing executives from voting on their own remuneration arrangements, restricting the ability for executives to “hedge” equity instruments and requiring proxy holders to cash all directed proxies on remuneration reports. The government also backed the excellent proposal that will ban executives from serving on remuneration committees (many of the worst instances of executive largesse occurred when the CEO also served on the remuneration committee, such as with Babcock & Brown, Leighton and Village Roadshow).

The claw-back

The most significant announcement by the federal government was that it would undertake consultation on the proposal to claw-back bonuses paid to directors and executives in the event of a material misstatement of a company’s financial statements. Specifically, the government intends to return money to shareholders where pay-packets are inflated by incorrect information.

While the claw-back rules are certainly justified, they may prove difficult to enforce. Of particular concern was the claim by Chris Bowen in announcing the proposed rules, that “there have not been any known instances in recent times of this occurring in Australia”. Perhaps Bowen forgot to look through the annual reports of MFS (which paid former CEO Michael King $3.1 million merely six months before the company imploded) or Babcock & Brown (which paid executives almost $300 million over four years before its collapse) or Great Southern Plantations (which paid former founder and CEO John Young upwards of $10 million in cash to run what appeared to be a woodchip-driven Ponzi scheme). Not to mention Centro, Allco, GPT and a host of other companies that provided misleading or flawed information to shareholders while paying bosses millions.

Unsurprisingly, the executive and corporate director trade unions, also known as the AICD and the BCA, criticised the move. AICD mouthpiece John Colvin claimed that the claw-back “may well have unintended consequences, with companies less likely to relate remuneration to reported profit and potentially encouraging higher base pay”. Such comments are hardly surprising, given the primary role of the AICD appears to be to maximise levels of executive pay.

Changes in tax

The one recommendation rejected by the government was the proposed removal of the “cessation of employment trigger for taxation of equity”. The government claimed that accepting this recommendation would “increase the concessionality of schemes, providing a disproportionately large benefit to higher-income employees”.

This decision was criticised by business groups, which stated that the executives would be taxed on earnings that had not been and may never be received. Interestingly, the move was also attacked by corporate governance group Regnan. Regnan head Erik Mather stated that “working Australians who are superannuation investors can rightly feel let down by this approach as it ensures they bear long term risks of decisions made by executives who, simply due to tax rules, can be off the financial hook and risk free the day after they depart the company.” The Productivity Commission had suggested the changes because current rules may encourage short-term manipulation of results.

Legislation giving effect to the reforms will be introduced this year, following public consultation on an exposure draft.

Pigs at the Trough: Lessons from Australia’s Decade of Corporate Greed is in bookshops now and features the full story of ABC Learning Centres, Babcock & Brown, Allco, MFS. Asciano, Toll, Village Roadshow, Timbercorp and Great Southern Plantations