NEDs need to set the hurdles

The question of how much is too much is often tied up with incentives and the performance hurdles put in place to ensure that a company and its shareholders get a return on its executive remuneration investment. As Owen Thomas* explains, it is the duty of non-executive directors to ensure that the balance is right.

Performance hurdles are measures of the success of a business that need to be satisfied before a remuneration incentive reward can be accessed by an employee. These performance hurdles are designed to focus the activities of the employee and to ensure suitable performance before the employee receives their reward. Setting performance hurdles is predominantly left to the remuneration committee. Generally remuneration committees have, for independence purposes, a majority of non-executive directors (NEDs). Thus, in most cases it is the NEDs responsibility to implement "appropriate performance hurdles". What constitutes an "appropriate" performance hurdle? In theory a performance hurdle should:

1. Be easily understood;

2. Be able to be impacted by the employee without manipulation;

3. Align the interests of the employee and shareholders; and

4. Reflect the long-term goals of the company.

There are examples in the press of incentive payments that are considered as inappropriate. In many cases this can be interpreted as the performance hurdle related to these incentive payments being considered as inappropriate. Often the market does not know the details of the performance hurdles. The market just considers the incentive payment inappropriate given the performance of the companies involved. Examples of payments that are seen as appropriate are not as widely reported. As such, "appropriate" performance hurdles are even more difficult to observe. An analysis of the frequency of performance hurdles was carried out in the RPC Australian Share and Option Plan Report 2001. Performance hurdles were identified in the annual reports of listed companies and the results can be summarised as:

• 38 percent related to increases or comparisons of Total Shareholder Return to an index or group of competitor companies;

• 19 percent had a higher option exercise price than the current market price;

• 17 percent had some absolute profit hurdle; and

• 2 percent unidentified.

Performance hurdle one and two (increase in stock price and total shareholder return) relate directly to the stock price or the stock price plus dividends. Performance hurdle three requires an increase in the share price before the employee gets "in the money" which is effectively a stock performance hurdle (although this also reduces the incentive effect). This leaves us with only 17 percent of the observed listed company performance hurdles being related to company performance outside the stock market. Remuneration committees and NEDs by market practice have chosen performance hurdles that in the main will result in incentive payments only if adequate shareholder returns are reflected in the stock market. This decision is the safe option and should avoid payments when shareholder returns have decreased. However, are these decisions in the best interests of the shareholders and do they "reflect the long-term goals of the company"? The difficulty lies in the fact that certain business decisions that may reflect the long-term goals may impact unfavourably on the company's "short-term" share price. Therefore, a performance hurdle that exclusively promotes a focus on share price may not support such decisions and could in some cases lead to executive behaviour that is contrary to the longer-term interests of the company. An open exchange, although in theory the best determinant of value, has been shown to make errors in the "short-term" and the tenure of "short-term" is open to debate. The stock market may, in the "short-term", not recognise performance that is in the long-term interests of the company. NEDs, in listed companies, are acting as expected and avoiding "inappropriate" incentive payments by linking them to stock market returns. Perhaps in the future with increased disclosure of performance hurdles we will be able to observe performance hurdles focused on fundamental measures of performance other than the stock market. NEDs, with increased pressures to add value, will then look to designers of incentives to create instruments where performance hurdles are based on these fundamental measures of performance. Control of the ultimate value of the incentive could then be attained via relating the incentives final value to stock market returns.

The Australian Shareholders' Association released a position paper last month on executive options in response to what it believes has been constant abuse of this form of executive remuneration. The ASA believes the issue of options to senior executives should be contingent on the following conditions being satisfied.

1. Options should convert on a one-to-one basis into fully paid ordinary shares when exercised, but prior to being exercised should not participate in rights or bonus issues, or any other preferential equity raising.

2. The exercise price should be equal to or greater than the market price current at the date of issue of the option, adjusted for changes to the capital structure of the company that may occur by way of rights and bonus issues.

3. The aggregate number of options and employee shares on issue at any time should not be greater than 5 percent of the total number of company shares on issue.

4. The exercise of all options should be subject to the company exceeding an appropriate performance hurdle over the period between the issue and exercise of the option. This hurdle should ensure that the executive commences to benefit (and then receives pro-rata benefits) from the options only if the company has performed better than the average of its peers in related industries. Appropriate performance hurdles include - relative returns on funds employed or shareholders' equity, relative growth in earnings per share and comparison against a relevant accumulation index.

5. Options should not be exercised before the third anniversary of the date of issue.

6. The company should not provide executives with loans for the purpose of exercising their options.

7. The annual report to shareholders should disclose, in addition to statutory requirements, the performance hurdles that must be achieved before options can be exercised and where options are to be issued to directors full details of their remuneration should be disclosed in the notice of meeting.

8. The notice of meeting should contain

(b) The financial benefit that may be received by a director if the hurdles are achieved, using assumed share price values at the first exercise date.

9. Once executive options have been granted the exercise price should not be re-priced. According to the ASA, the other question arising from the issue of options is whether there is a cost to the company from their exercise and if so, the treatment and quantum of that cost. If the options are being issued in order to reward improved performance they are being issued in lieu of salary. Salary payments are charged against profit and it should follow that payments in lieu of salary should similarly be charged against profit. In these cases options are a cost of doing business and not just a capital transaction. The issue of options in lieu of salary inflates profits because the cost is hidden in the capital account.

This issue is examined from time to time by accounting bodies and the ASA urges these bodies to formulate a policy on this matter as soon as possible. The AICD position Last year the AICD provided guidelines for executive share and option schemes and employee share schemes. The key principles include:

• executive share and options schemes with an incentive component should be designed around appropriate performance benchmarks that measure materially improved relative company performance; and,

• all aspects of share and option schemes must be disclosed to shareholders in a meaningful way to permit shareholders to determine whether to approve the schemes.

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