Responding to corporate crises – managing accountability through remuneration

This article was written by Andrew Gray and Angela Weber.

There seems to be an increasing litany of companies finding themselves in the midst of a scandal. 

From the failures laid bare by the Banking Royal Commission, to sexual harassment and various environmental and cultural incidents, the themes of corporate accountability and executive remuneration have been the subject of extensive community and shareholder scrutiny. 

Whilst the conduct under examination will differ, the underlying question remains. How are boards expected to manage non-financial risks, and respond to conduct issues and corporate crises? In recent years, regulatory, shareholder, and media attention has had a sharp focus on how these matters are managed, and what happens when a company falls short of expectations.  

There is now an expectation from both the media and more recently (and significantly) institutional shareholders, that boards must impose consequences for executives who are accountable for material risk failings, incidents or poor conduct.  This can be uncomfortable territory for both boards and the members of the executive team being held to account, often for decisions made deep inside an organisation and outside of executive line of sight.  Common questions for directors include:

• Should accountability and consequences be assessed on an individual or collective basis?
• What principles should be applied to determine consequence outcomes?
• Is there a need for procedural fairness?
• How and when to disclose the consequences?

The consequences for executives held accountable for failures can range from remuneration adjustments through to termination of employment. Noting a worrying trend towards a knee-jerk "heads must roll" responses at the expense of stable management through a crisis, this article asks; 'how might that outcome be avoided?' The answer is by having a consequence-management framework to guide accountability outcomes.

Regulatory framework and market trends

Historically Australia has had no mandatory legal standards governing decisions by boards and companies on variable remuneration. In recent years, there has been a steadily growing focus on variable remuneration practices (particularly for financial services companies and other businesses regulated by APRA), but still no comprehensive legislative framework. 

In June this year, ASIC released an information sheet on variable executive remuneration, following its review of remuneration practices at 21 ASX100 companies (Information Sheet 245 (INFO 245)).

The information sheet emphasises the needs for boards to ensure that discretion is exercised in the best interests of the company.  ASIC suggests boards may wish to:

• adopt practices or frameworks to prompt the use of discretion in the company's variable pay scheme; and
• apply practices or frameworks that guide the exercise of discretion before variable pay decisions are made.

ASIC also encourages companies to ensure they have a "look back" provision so that prior to the vesting of deferred pay the board can:

• consider making adjustments using the discretion principles developed to avoid unintended gain; and
• address significant risk or conduct issues that have occurred since the variable pay award was granted.

ASIC's contribution to the area adds further to the increasing regulatory and public attention on remuneration governance in Australia.

While the regulatory guidance is still emerging, both community and now investor expectations are becoming clear.

Recent media coverage of conduct and other non-financial risk issues in corporate Australia evidences the pressure brought to bear on companies when things go wrong.  This is particularly so for listed companies and other organisations regarded as having a 'social licence'.  What emerges is that stakeholders, including large investors with significant commercial influence, expect that accountability will be determined swiftly and often in a public way.  Further, it is clear that the outcomes will be scrutinised. Where risk or conduct issues arise, boards and executive teams must be prepared to act expeditiously to determine accountability and what (if any) remuneration or other consequences should be applied.

Remuneration adjustments in market practice

In high risk industries with particular a safety-related exposure, variable remuneration has frequently been used as a tool to drive safety outcomes. It is relatively common for executive key performance indicators (KPIs) to incorporate safety metrics including 'zero-fatality' gateways for the award of short-term incentives.

For example, a report published by the Australian Council of Superannuation Investors analysed reporting by ASX200 companies in the 12 month period ending September 2020.  This analysis found that 90 of the ASX200 companies linked safety metrics to executive remuneration (an increase from 85 in the previous surveyed year).  According to this research, health and safety performance generally accounted for between 5% and 25% of the total short-term incentive for executives.[1]

The inclusion of these metrics in the design of variable remuneration frameworks means that pay outcomes are tested against safety performance at the time of the award. Similarly, adverse safety-related incidents can be included in the malus provision as a specific basis for previously-awarded variable remuneration to be adjusted or forfeited.

However, market practice relating to other corporate risks is still emerging. The table below provides an overview of recent remuneration adjustment outcomes implemented in response to risk and conduct issues in large listed companies.  As the overview shows, there is also an emerging trend of directors accepting a fee reduction in some cases.

How to implement a remuneration decision-making process

Several companies have responded to the increased focus on accountability by developing guidelines to assist the board and other decision-makers in the exercise of their discretion relating to remuneration adjustments.  This has been recognised as desirable by ASIC in Information Sheet 245, which aims to set out practical guidance to support board oversight and the exercise of discretion on variable pay outcomes, adding to the growing body of guidance on best practice in remuneration governance. This type of guidance has proved useful to boards looking to implement their response to a significant risk event in a consistent and reasonable manner.

The first step from a legal point of view is to assess whether the malus provision permits the adjustment to be made.  This step should not be overlooked in the rush to apply consequences, as often the adjustment rights are not as broad as a board may expect and may be limited to instances of serious misconduct, material misstatement in accounts or fraud/criminal conduct.  These grounds are not often present when considering consequences for accountability failings, which may not involve any deliberate or intentional wrongdoing.  The ability to extend or delay a vesting period to allow conduct or risk matters to be further reviewed is also an important tool which can provide the board with more time to make an informed decision.

In response to the new focus on accountability and consequences for non-financial risks, there has been a trend in recent times of companies looking to expand the scope of their malus provisions in equity plans to ensure they are fit for purpose.

Key points to note:

• An adjustment of in-year short term cash incentive (or STVR) before it is awarded through the application of discretion or a conduct/risk management gateway is by far the simplest form of adjustment.
• Issues become more challenging when there is no in-year variable remuneration to adjust (for instance, for former employees) and the board is required to resort to a malus or clawback condition to implement the reduction.
• Noting that clawback is rare, the focus is normally on the ability to adjust unvested equity under a malus provision.
• As adjustment will normally involve the exercise of board discretion, there is a risk of legal challenge. To guard against this, boards must have a rational basis for decisions and show they were made with access to adequate information.
• While there is no general legal requirement for procedural fairness, most companies typically provide executives with an opportunity to have input into the adjustment, to respond to the reasons for the adjustment.
• Some companies have implemented formal procedures enshrining these rights.

These processes should be considered carefully before they are implemented, because they can impede the efficient decision-making required in this area.

Given the current climate, companies and their boards should be seeking to get ahead of the game on variable remuneration, and not wait to have a serious incident or conduct issue arise before setting up a consequence management framework to help guide decision-making. In particular, there is a modern-day need for boards to develop consequence management frameworks which clearly articulate the relationship between conduct and other non-financial risks and remuneration outcomes. A robust framework is an essential tool for ensuring boards are well-equipped to make the decisions expected by stakeholders quickly in response to a crisis.

[1] Safety in Numbers: safety reporting by ASX200 companies (September 2020).  Available at: https://acsi.org.au/wp-content/uploads/2020/09/ACSI-Safety-Research-2020_Sep20.pdf