Executive service agreements: AICD Review

Executive remuneration is a vexed issue. In an effort to provide some guidelines, the AICD has released an issues paper on the subject. This is an edited version. Hardly a day passes without newspapers running a story on executive remuneration, often alluding to the excessiveness of salaries, bonuses or options paid to company executives.

AICD believes executive remuneration is an important topic in corporate governance requiring special attention by boards of publicly-listed companies. Difficult judgments are required because the interests of management and corporation often conflict. Those judgments are greatly assisted by the adoption at board level of corporate governance controls and by the avoidance of some practices shown by recent events to be questionable. Issues requiring consideration include: the terms of executive service agreements of the CEO and the manner in which such agreements are negotiated by the boards; the structure and effect of remuneration packages (particularly short and long term incentives); termination of employment arrangements; and, the issue of shares and options to executives. In the creation of agreements, boards should be fully aware of the regulatory requirements, including the Corporations Act, Australian Stock Exchange Listing Rules, employment and industrial relations laws, the company's own remuneration policy and strategies, and the company constitution.

AICD strongly recommends that publicly listed companies have a remuneration committee which is kept abreast of recent developments. The committee should have its own charter and preferably, be comprised wholly of independent non-executive directors. Although the board is ultimately responsible for the employment of executives and their agreements, AICD recommends that the planning and negotiation should be handled by the remuneration committee which should keep the board fully informed and brief it on material decisions required by the whole board. AICD also believes executives should not have control of planning or negotiations associated with their own agreements. For example, instructions to solicitors and remuneration consultants should come from the remuneration committee. However the CEO and other executive directors could make recommendations to the remuneration committee about his/her direct reports and submissions on their own agreements. This should help minimise conflicts of interest, demonstrating to shareholders that a proper process is in place. Apart from regulatory requirements on disclosure, consideration should be given to a summary of the terms of agreements being disclosed to shareholders.

Although most agreements are the subject of negotiation against a background of market conditions, the following comments on some specific items are offered for general assistance.

Length of contracts

Careful consideration should be given to the term of the agreement as well as consequential costs and other impacts of early termination. Such measures as earlier termination provisions, shorter initial periods or indefinite terms with specific termination provisions should be considered. Lengthy terms can be awkward for companies if the relationship does not work out and there is no provision for an early termination within the term. For example, an "unknown" CEO enters into say a five-year term with the company with no effective earlier termination provisions. After six months the board considers it has not worked out properly and terminates the employment. The damages (or payout) are then usually calculated on the unexpired term, (in this case four and a half years), less what the executive could have or should have earned.

The arguments about this "termination payment" can be protracted – even in a relatively amicable situation – and can be prolonged and costly for all if it cannot be settled and a court case eventuates.

Termination

Termination and term provisions must be considered together. As discussed, care should be taken to avoid "double dipping" of payments for unexpired terms and termination payments. Termination provisions should be agreed in advance, with reasonable provisions to minimise uncertainties and disputes later. Nothing seems to get shareholders and other stakeholders more upset than executives gaining large termination payouts when poor performance by the executive was really the issue, or when company fortunes were waning. While these problems may be difficult to avoid, proper planning will minimise the impact of these problems. Obtain advice to ensure that regulatory provisions dealing with takeovers, limits on termination payments, directors' duties and so forth have been complied with.

Remuneration

AICD does not believe it appropriate to mandate levels of remuneration for executives in particular companies. This often comprises a combination of various components, such as fixed remuneration and short and long-term incentives. Public companies are only permitted to avoid member approval for executives if the remuneration would be "reasonable in the circumstances" under the Corporations Act. The AICD recommends keeping the process and results as transparent as possible. In addition companies should keep appropriate records which reveal the manner and process as to how the remuneration structure and level was derived. Independent expert advice may help determine such levels. Furthermore, in the absence of shareholder approval, such advice may be helpful should a board be called upon to show the remuneration has been "reasonable". Remuneration within executive service agreements should be fully disclosed in accordance with relevant regulatory framework and accounting standards. Getting the right balance between attracting and retaining the best talent on the one hand and not unnecessarily dissipating company assets can be difficult. Governance procedures, legal advice and remuneration consultants can be of great assistance.

Equity

When granting shares and options, remuneration committees should seriously consider whether these elements, in particular options, are useful in aligning the interests of executives and shareholders and, if so, their magnitude. Any equity as part of remuneration should also be fully disclosed (and approved by shareholders if necessary) and expensed in the profit and loss accounts.

Incentive/bonus schemes

In setting such schemes, boards will be aware that economic circumstances can change rapidly, making some schemes inappropriate over time. For instance macroeconomic factors may automatically drive share prices up or down irrespective of company and executive performance. Therefore, depending on the structure, an incentive system based on share price alone may not serve as an effective incentive. Another example includes a downturn in a company's fortune where executives have made an extraordinary contribution to turn around a company only for subsequent executives in the resultant upturn to reap the rewards for little effort. Other considerations include whether to set appropriate medium or long-term hurdles. Remuneration committees may wish to use such performance indicators as company peer group indicators, return on equity or return on investment, retrospective analysis, together with many other individual performance criteria.

Post employment restraints

Post employment restraints may be included to prevent confidential company information being used by others. Such restraints are only enforceable if reasonable – and proper legal advice is usually required in this area. Dispute resolution processes Agreements can contain special provisions for dealing with disputes between company and executive. These provisions can be useful particularly if an agreed third party mediator is involved. However they can also lead to both parties getting bogged down in negotiations which may simply be better resolved by the parties exercising their rights under the agreement. Again, this is an area where specialist advice can be an advantage. Other considerations In the event of mergers or takeovers it is important that boards be familiar with all facets of emoluments of executives, including obligations which carry forward in the event of the takeover or merger before such transfer occurs. Restrictions under the ASX Listing Rules and Corporations Act should also be considered in this regard.

Indemnity and access

The board should be responsible for arranging suitable indemnity insurance and deeds of access for executives to obtain access to information in case of subsequent action where appropriate, including such considerations as the necessity for run-off policies. This should be handled by remuneration committees in the same manner as executive agreements. Outside directorships Increasingly executives are being asked to act on external boards. Executives (unlike non-executive directors) are generally in a full-time position and being paid by the company for full-time service and commitment. Only in very limited circumstances should executives be allowed to take on other external commitments, particularly without board approval.

Disclaimer

The purpose of this database is to provide a full-text record of all articles that have appeared in the CDJ since February 1997. It is aimed to assist in the research and reference process. The database has a full-text index and will enable articles to be easily retrieved.It should be noted that information contained in this database is in pre-publication format only - IT IS NOT THE FINAL PRINTED VERSION OF THE CDJ - therefore there might be slight discrepancies between the contents of this database and the printed CDJ.