The brave new world of accountability – using remuneration to drive good governance

This article was written by Andrew Gray and Angela Weber.

As Commissioner Kenneth Hayne observed in the final report of the Banking Royal Commission; culture, governance and remuneration march together.

How boards respond to non-financial risks and conduct issues has been dominating business headlines recently. Since the Royal Commission, the attention of regulators, shareholders and the media has rapidly shifted to 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. The consequences can range from remuneration adjustments through to termination of employment with a worrying trend towards a knee jerk response that "heads must roll", at the expense of stable management through a crisis.

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?

This article focuses on the use of remuneration adjustments as a consequence-management tool for accountability outcomes.

Regulatory framework

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, but still no comprehensive legislative framework.

Nonetheless, there is a growing body of guidance from local and offshore regulators from which boards can take direction, including the Banking Executive Accountability Regime (BEAR), APRA's draft prudential standard on remuneration (CPS 511) and guidance from the UK's Financial Stability Board (FSB). This FSB guidance in its Supplementary Guidance to the Principles and Standards on Sound Compensation Practices (2018) (FSB Guidance) has been particularly influential and has been recognised by both the Royal Commission and APRA in this area. The FSB guidance provides some helpful guidance on the principles and factors that should be considered in determining remuneration adjustments for material risk events. While this guidance is focussed on financial institutions it is also relevant to other institutions looking to meet market and regulatory expectations.

A brief overview of the emerging guidance is provided below.

CPS 510

Prudential standard CPS 510 has required APRA-regulated institutions to design performance-based remuneration to allow for the adjustment of remuneration downwards (to zero, if appropriate) for several years. However, the circumstances in which CPS 510 says remuneration adjustments should be considered are focussed on prudential considerations and are limited to where this is necessary to: 

• protect the financial soundness of the institution; or
• respond to significant unexpected or unintended consequences that were not foreseen by the institution's board.

APRA's Prudential Guidance (PPG 511 and SPG 511) further provides that a prudent policy will require that performance-based remuneration is low, perhaps zero, where the individual has been found to have exposed the institution to risk beyond its risk appetite or control. This is more consistent with the principles which have been emerging in recent times.

Banking and Executive Accountability Regime (BEAR)

The BEAR (effective from 1 July 2018 for large banks) implemented significant change by imposing a statutory requirement on Authorised Deposit-Taking Institutions (ADIs) to map and identify accountability across the organisation and mandates the use of remuneration as a tool for consequence management. The BEAR requires the mandatory deferral of variable remuneration for 4 years, so it remains at risk, and requires the forfeiture of variable remuneration proportionate to an "accountable person's" failure to comply with their accountability obligations.

Although it currently applies only to ADIs, it is proposed to be extended to all APRA-regulated entities and be jointly administered by APRA and ASIC (to be known as the "Financial Accountability Regime").

CPS 511

In APRA's Information Paper: Remuneration Practices at Large Financial Institutions (April 2018), APRA noted that remuneration adjustments "should not be implemented with the primary focus on ensuring a minimum level of compliance with the prudential standards." Instead, institutions should take steps to ensure that "APRA's requirements are embedded into risk management and remuneration frameworks. Remuneration practices should align to the culture, values, risk profile, risk appetite and risk management framework of an institution, as well as its financial objectives".

APRA released draft CPS 511 in July 2019, following the remuneration-related recommendations made by the Banking Royal Commission, as well as APRA's Prudential Inquiry into the CBA and APRA's own analysis of industry self-assessments of governance, accountability and culture. APRA's attention has moved beyond compliance with prudential standards and its guidance is now also focussed on the interaction between remuneration practices and appropriate risk management. CPS 511 remains under consideration by APRA following its period of consultation with industry stakeholders.

Draft CPS 511 proposes significant changes to current remuneration practices including:

•  (financial metrics) APRA proposes that financial performance measures must not comprise more than 50 per cent of performance criteria for variable remuneration outcomes;
• (deferral and clawback) the introduction of minimum deferral periods of up to 7 years for the variable remuneration of senior executives in larger entities, and claw-back periods of up to four years for vested remuneration; and
• (governance) boards must approve and actively oversee the entity's remuneration framework, remuneration policies for all employees (not just senior executives), and their effective application.

The Draft Standard specifies that minimum forfeiture and clawback events must include:

• (malus): significant downturn in financial performance, misconduct or negligence resulting in losses, significant failure of financial or non-financial risk management, breaches of the employer's code of conduct and significant adverse outcomes for customers or counterparties; and
• (clawback): material misstatement in financial statements, failure to meet APRA 'fit and proper' requirements, failure of accountability and breach of compliance obligations including in relation to misconduct risk.

The new mandatory deferral periods and requirement for clawback will only apply to "significant financial institutions" (which APRA proposes will comprise ADIs (with assets >$15bn), general and life insurers (with assets >$10bn) and RSE licensees (with assets >$30bn).

The extent to which any of these measures will be introduced is yet to be seen with significant feedback provided to APRA during the consultation phase for the draft Standard particularly in relation to the proposed limits on financial metrics.

ASIC guidance

More recently, 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.

Market trends

While the regulatory guidance is 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 listed companies when things go wrong. 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.

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 adjustment

A remuneration adjustment can take various forms. 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.

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

Given the adjustment will normally involve the exercise of a discretion by the board, there is a risk of legal challenge to the decision. While the instances of this occurring in Australia are rare, there is a growing of law in this area and this can be expected to continue if the trend in Australia reflects the United Kingdom (where legal challenges to bonus outcomes are more common). While the adjustment is normally at the discretion of the board, this discretion is not unfettered despite it typically being expressed as absolute. Australian courts have generally found that such discretion must not be exercised capriciously, unreasonably or arbitrarily. This requires the board to have a rational basis for a decision and an adequate level of information before it to justify the decision. While there is no general legal requirement for procedural fairness, most companies do typically look to provide executives with an opportunity to have some form of input into the adjustment or an opportunity to respond to the reasons for the adjustment and some companies have implemented formal procedures enshrining these rights. These processes should be considered carefully before they are implemented because they can operate as an impediment to the efficient decision-making required in this area.

Several listed companies (particularly in financial services) 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.

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