Last month, Kevin Rudd took aim at “extreme capitalists” — singling out bank executives for taking undue risks with shareholder funds. Rudd claimed the government will “be examining with APRA what domestic policy actions would be appropriate in pursuit of this objective — that is to deal with the problem of executive remuneration to financial institutions.”

Naturally, since Rudd’s claims, nothing has happened, until yesterday, when Opposition leader, Malcolm Turnbull jumped into the fray. Turnbull told the National Press Club that remuneration reports should be subject to a binding vote (currently, they are non-binding on companies), claiming that “if you are going to ask the shareholders, why should their decision be non-binding? It’s like asking someone their opinion and saying, in the same breath, ‘I won’t take any notice of what you say unless you agree with me’.”

Under current laws, once remuneration for executives has been determined, shareholders receive a “non-binding” vote on the remuneration report at a company’s annual general meeting. Therefore, no matter how outrageous, even if 99% of shareholders vote against the report, there is nothing the directors are legally required to do about it. The remuneration report is retrospective because cash has already been paid to executives. In that sense, Turnbull’s suggestion of making a remuneration report “binding” is probably not workable. For example, if shareholders voted against a remuneration report, the company would effectively need to recover monies previously paid (such as fixed payments or short-term incentives).

That said, Turnbull’s plan is a step above Rudd’s esoteric “extreme capitalist” ambitions. Further, while neither party has got it right first up, it is refreshing that the problem of executive remuneration is at least being considered.

In fact, it wouldn’t actually take that much to rectify many remuneration issues. First, politicians need to acknowledge that the underlying cause of excessive executive remuneration is “agency costs” — that is, the people who determine executive remuneration have very little personal incentive to act in shareholders’ interests because it isn’t their money at stake (further, reducing a CEO’s remuneration would make those boardroom lunches just unbearable).

Agency costs stem from the fact that the owners of capital (public shareholders) do not manage the business. Management is left to a breed of professionals, led by the CEO. In order to safeguard their interests, owners appoint non-executive directors. While from a corporate law perspective, the duty of directors lies with the company itself, for practical purposes, directors are appointed to represent the interests of otherwise-virtually powerless shareholders.

The primary role of directors is to hire and fire senior executives and determine their remuneration (as well as approve corporate actions). Responsibility for determining remuneration is entrusted to a remuneration sub-committee, usually consisting of ‘independent’ directors. It is the responsibility of these men and women to safeguard the interests of shareholders by ensuring that executives are not being rewarded to take undue risks with shareholders’ capital. Remuneration committees will determine how much base salary will be received by senior executives, as well as the method for determining short term bonuses (which are usually paid annually in cash) and long-term incentives (usually paid in options or performance rights).

Therefore, to improve executive pay structure, laws need to be aimed specifically at reducing agency costs. Three steps should be taken:

  1. Directors must take responsibility for remuneration report

    In this regard, Turnbull is on the right track. While making a remuneration report binding has merit, there would serious logistical problems involved. For example, if a remuneration report is rejected, bonuses would need to be clawed back and base salaries adjusted retrospectively. Instead of this, a better option would be to hold the directors personally responsible. Should a remuneration report be rejected, members of the remuneration committee should receive no directors’ fees for the year (perhaps as a quid-pro-quo, members of the remuneration committee should receive materially higher directors’ fees to compensate for such “risk”).

    While such a step may appear draconian, it would certainly serve to compel members of the remuneration committee to ensure that executive pay conforms with shareholder expectations. If Telstra remuneration committee chairman, Charles Macek, isn’t able to receive his $284,274 annual fee, perhaps the committee wouldn’t come up with a remuneration structure which, in the eyes of its shareholders, unduly enriches the CEO. Or if Babcock & Brown remuneration committee member, Elizabeth Nosworthy, faced the prospect of losing her $286,708 annual fee, maybe the Babcock remuneration committee wouldn’t have paid its executives more than $300 million cash over the last four years (Babcock as a whole is now worthless).

  2. Require shareholder approval for termination payments

    A second area for improvement is termination payments. Currently, the Corporations Act requires shareholder approval of termination payments to executive directors which are in excess of seven times total remuneration (worked out as an average over three years). Therefore, Sol Trujillo could theoretically receive a termination of more than $60 million in cash without shareholder approval (by contrast, ordinary employees would receive a termination payment of four weeks pay for each year of service).

    What benefit do shareholders receive for such lavish payments? For example, Crane Group CEO, Greg Sedgwick, is contractually able to receive upwards of $9.5 million should he be terminated even for poor performance. The Crane board even agreed to provide Sedgwick with more than $8 million simply for retiring after five years service. Limiting executive payouts to no more than 12 months fixed salary (without shareholder approval) would effectively clamp down on such outrageous payments.

  3. Ban executives from serving on remuneration committees

    A third improvement would be to impose a blanket restriction on executives from being members of remuneration committees. Unsurprisingly, companies which tend to pay their executives more also have executive input in how remuneration in structures. Leighton boss Wal King, who last year took home $16.5 million, sits on Leighton’s remuneration committee. Former Babcock boss Phil Green, who was paid $14 million cash in 2006, sat on Babcock’s remuneration committee until he resigned. While executives wouldn’t specifically determine their own pay, they would no doubt provide input on the remuneration of other executives like the CFO, effectively setting a floor for their own payment.

To better align executive pay with shareholders, only a few minor amendments to existing laws giving are needed. Neither Rudd, nor Turnbull’s plans would are effective, but shareholders will benefit from a continued dialogue and concerted action in response to overpaid executives and derelict non-executive directors.