You, yourself and your peer group

Remuneration committees typically benchmark various elements of an executive’s remuneration package against what is paid at a group of comparator companies. Known as the company’s peer group, the comparator companies may be in the same industry or have similar market capitalization. Benchmarking is done to ensure that companies are able to compete with their peers for talent by paying similar amounts. The benchmarking exercise was cleverly coined an arms race by Michael Kagan, a senior portfolio manager at ClearBridge Investments. When one peer increases its remuneration packages, all of the other peers can justify following suit.

A little known fact about the arms race is that some executives sit on the remuneration committees of their peers. While an executive would not be permitted to determine his own pay directly, he can influence what he is paid by increasing his peer’s remuneration. By ratcheting up pay at the peer company, the executive is able to justify a larger pay package for him or herself.

For example, while he was the CEO of eBay, John Donahoe was also a member of the compensation committee at Intel Corporation. eBay’s annual report lists Intel in its peer group. This problem is not limited to American companies. Ian Cheshire, the now former-CEO of Kingfisher, sits on the remuneration committee at Whitbread. Kingfisher’s annual report indicates that it benchmarks itself against companies in the FTSE 25-75, a group that includes Whitbread.

Finally, Michael Roney, CEO of Bunzl, was on the remuneration committee of Johnson Matthey. Johnson Matthey’s annual report does not disclose its peer group for the purpose of benchmarking salaries, but it does describe it as a group of UK companies that have substantial operations overseas. Additionally, the report discloses a list of 40 comparator companies used for determining whether incentives should vest. This list includes Johnson Matthey and is described as “40 UK based companies…that have substantial operations overseas and…similar levels of revenue, profit and market capitalisation as Bunzl.”  Given that the description of this peer group is very similar to the one used for benchmarking salaries, it is probably safe to assume, although one cannot be sure, that Johnson Matthey is also considered a peer for the purpose of benchmarking salaries.

Some remuneration committees specifically exclude companies from the peer group when an executive sits on that peer’s remuneration committee. For example, Diageo specifically excludes Unilever from its peer group because Paul Walsh, Diageo’s CEO, sits on its remuneration committee. This should be seen as best practice – it is not appropriate for executives to sit on the remuneration committees of peers used to determine that executive’s remuneration. Other remuneration committees should take a page out of Diageo’s book and exclude these peers from consideration.

Additionally, the UK Corporate Governance Code should be amended to either prohibit this type of situation or at the very least to require its disclosure to shareholders. Currently, many shareholders will have no idea if an executive sits on the remuneration committee of a peer. While companies must disclose whether directors sit on the boards of other companies, as we have seen with Bunzl, there is no requirement to list which companies are contained in their peer group. This lack of information permits this problematic practice to continue without appropriate shareholder scrutiny.

The arms race continues, but some executives have an unfair advantage. Shareholders should be provided with information about company peer groups. Executives should not sit on the remuneration committees of companies within their peer group. These steps will not stop the arms race, but at least they will remove a tactical advantage.

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Hey ump, a strike is a strike

Patrick Durkin, a bureau chief at the Australian Financial Review, reported this week that Australian companies have found a way around the two-strikes rule. The two-strikes rule provides that if 25% of votes are cast against a company’s remuneration policy for two consecutive years, the company must put a spill resolution to shareholders that, if passed, could see the entire board standing for re-election. Two strikes and you could be out.

Since this rule was introduced, there have been few second strikes and spill resolutions. The reason for this is now clear – while some companies actively engage with shareholders to avoid a second strike, other companies are able to ignore a second strike entirely. A provision in Australia’s legislation allows companies to call for a show of hands at shareholder meetings to pass resolutions. If the board sees in advance that it has received a large proxy vote against its remuneration resolution, a decision to hold a show of hands instead is all it takes to wipe the slate clean. A ball, not a strike.

The Australian Financial Review gave evidence of this practice to the Australian Securities and Investments Commission, which in turn denied that companies were flouting the two-strikes rule. This, despite the fact that the intent of the two-strikes rule was to hold boards accountable to shareholders for a failure to respond to negative criticism of remuneration practices. If directors are able to protect their place on the board by holding a show of hands when the overwhelming evidence points to discontent, boards can continue the status quo with impunity. Government action requiring a poll for remuneration resolutions (or in fact all resolutions) will be needed in order to prevent this practice.

This is just one more example of companies finding a way around regulations that are inconvenient. We recently saw similar creativity employed by banks when the EU capped banker bonuses at a multiple of fixed pay. Banks merely shifted the money they would have paid as a bonus into a “fixed pay allowance,” thus getting around the cap. These examples highlight a common problem with regulation: legislators have failed to anticipate how companies will respond to regulations before forging ahead.

It is much easier to draft a regulation right the first time than it is to find the willpower to change a flawed, but already enacted, regulation. Any country considering enacting a two-strikes rule similar to Australia’s should take note and close any loopholes that would allow a board to ignore a second strike. Hopefully the Australian government will take steps to rectify the situation in Australia. Until then, we will wait for the umpire to call a strike a strike.