There has been much media since last Wednesday around the release of the draft Productivity Commission report on executive remuneration and, more generally this year, on this topic. In this article we discuss the major implications of the draft Productivity Commission report in the context of executive employment arrangements. These include:

  • the proposed reduction in the cap on termination payments without shareholder approval to an amount equivalent to one year’s base pay will likely become law late this year or early 2010. Businesses should review their arrangements with executives in light of this change, and
  • taxation of unvested equity benefits or termination will not likely be a future hurdle for the alignment of executive compensation with the sustainable growth of a business.

Background

On 30 September 2009, the Productivity Commission released a discussion draft of its ‘Review into the Regulation of Director and Executive Remuneration in Australia’ (Draft Report).1

The Productivity Commission was asked by the federal government to report on the framework and structures around the remuneration of directors and executives of disclosing entities (Companies) regulated under the Corporations Act 2001 (Cth) (Act).

While this article focuses on the effect of the recommendations in the Draft Report on the relationship between Companies and executives who are classified under the Act as key management personnel (KMPs), for completeness, we set out at the end of this article a table of the draft findings and recommendations for public consultation.

Termination benefits

Proposed Bill regarding termination benefits

One key issue referred to in the Draft Report relates to termination benefits delivered to directors and KMPs.

On 9 September 2009, the House of Representatives passed a bill relating to executive termination benefits (Bill) which caps termination benefits for directors and KMPs of disclosing entities at one year’s average base pay (unless shareholder approval is obtained). As currently drafted, the Bill will only apply to contracts of employment which are entered into, renewed, extended or varied after the date on which the Bill becomes operational.

The next opportunity to pass the Bill in the Senate will be on 26 October 2009.

Given comments earlier this week by the Financial Services Minister, Chris Bowen, on ABC Radio, there is some ambiguity as to whether the Senate will wait until the Draft Report is finalised (around December 2009) before it considers the Bill.

The Draft Report states that reduction of the cap on the requirement for shareholder approval of termination benefits from seven years’ of annual remuneration to one year’s base pay ‘seems on balance to be warranted’ and that the Bill is ‘unlikely to have significant adverse effects’.

We consider that the Productivity Commission’s view in relation to the Bill will not affect the government’s position relating to the proposed one year cap on termination benefits (that is, the Bill will proceed through the Senate).

Tips for preparing for the Bill

We set out below some suggestions that clients may like to consider prior to the Bill coming into force:

a.Review the terms of contracts

Review the terms of the contracts of employment for employees who are directors or KMPs.

b.Are variations to the contracts likely?

Ascertain whether it is likely that amendments will be made to any of the contracts referred to in paragraph (a) above or whether they contain provisions which contemplate amendments to be made to key terms.

c.Do the contracts adequately protect the company?

Check whether the contracts contain a provision which states that the company is not required to provide termination benefits to the employee if this provision would require shareholder approval.

d.Has shareholder approval already been obtained?

Check whether prior shareholder approval (for example for the issue of shares) is broad enough to cover approval for termination benefits.

e.Review incentive plan documentation

Review the company’s incentive plan documentation to understand whether such documents contemplate the giving of termination benefits. Consider whether there is an alternative form of remuneration that would not be considered a termination benefit?

Taxation on incentives

The Draft Report recommends that employees not be taxed on shares under employee share plans which have not vested, on cessation of their employment, but rather when they are entitled to deal with the shares.

Currently, draft legislation which, if enacted would be retrospective to 1 July 2009, states that employees must pay income tax on unvested shares on the earlier of:

  • cessation of their employment
  • ten years, and
  • when there is not a ‘real risk of forfeiture’ of the shares.

The Draft Report’s view is refreshing given that the current proposed tax legislation provides a disincentive for an executive to receive part of their remuneration in the form of shares in the company. This would also likely be a disincentive for KMPs to agree to a longer period over which their shares will vest.

The draft tax legislation has the potential to substantially change the market for executive remuneration and potentially cost companies higher amounts in up-front cash payments to their KMPs as well as termination payments to pay tax bills for shares they may not ever receive.

The Commission’s view in the Draft Report is also consistent with that of the Australian Prudential Regulation Authority (APRA) and is aimed at encouraging KMPs to hold shares for a longer period of time to align their interests with a company’s growth and success over this period.

We anticipate the views in the Henry Report in relation to tax and the government’s ultimate response will significantly affect the structuring of incentives for KMPs.

Submissions on the Exposure Draft The Productivity Commission is seeking written submissions on the Draft Report by 6 November 2009.

Summary of recommendations in the Draft Report

Recommendations

1 That the Act be amended to only empower shareholders to set the maximum number of directors who may hold office at any one time (ending the ‘no vacancy’ rule).

2 That ASX300 companies be required to have independent remuneration committees comprising at least three members, all of whom are non-executive directors, with the chair and majority of members being independent.

3 That Remuneration committees be required to ‘comply or explain’ their independence (in line with the ASX Corporate Governance Council’s current suggestions).

4 That directors and KMPs be prohibited from voting their shares on remuneration reports and any other remuneration-related resolutions.

5 That the Act prohibit all company executives from hedging unvested equity remuneration and vested equity remuneration that is subject to holding locks.

6 That directors and KMPs be prevented from voting undirected proxies (i.e. proxies which give the board the right to vote shares as it wishes) on remuneration reports and any other remuneration-related resolutions.

7 That proxy holders be required to cast all (i.e. not only some) of their directed proxies on remuneration reports and any other remuneration-related resolutions.

8 That Section 300A of the Act be amended to:

  • specify that remuneration reports improve information content and accessibility of remuneration reports, and
  • reflect that individual remuneration disclosures be confined to the key management personnel (removing the requirement for the disclosure of the top five executives).

9 That where an ASX300 company’s remuneration committee (or board) makes use of expert advisers:

  • those advisers are to be commissioned, and provide advice, independent of management, and
  • the Companies are required to disclose the circumstances surrounding the appointment of, and work conducted by, expert advisers they have used in relation to remuneration matters. 10 That institutional investors disclose, how they have voted on remuneration reports and any other remuneration-related issues.

11 That the cessation of employment trigger for taxation for equity-based payments be removed, with the taxing point for equity or rights that qualify for deferral being at the earliest of:

  • where the executive is free to deal with the shares, or
  • seven years after the employee acquires the shares.

12 That ASIC issue a public confirmation to companies that electronic voting is legally permissible without the need for constitutional amendments.

That the Act be amended to require that where a company’s remuneration report receives a ‘no’ vote of 25 per cent or higher, the board be required to report back to shareholders in the subsequent remuneration report explaining how shareholder concerns were addressed and, if they have not been addressed, the reasons why.

13 If the company’s subsequent remuneration report receives a ‘no’ vote above a prescribed threshold, all elected board members be required to submit for re-election (a ‘two strikes’ test) at either:

  • an extraordinary general meeting or
  • the next annual general meeting.