22 Dec 2011

The two strikes rule: how has it played out?

by Karen Evans-Cullen, Jasmine Sprange

Shareholders are using their power under the two-strikes rule as a general protest vote against the board

Executive pay has come under the spotlight this AGM season, with shareholders making use of new laws that allow them to hold company boards to account via a vote on their remuneration reports. Concerningly, there is also a trend for this power to be used by shareholders as a general protest vote against the board.

Although shareholders have been able to vote on remuneration reports for the past five years, the outcome has been non-binding. On 1 July this year, new laws came into effect which include a rule that, if a remuneration report receives a no vote at two successive AGMs, the second AGM will have to vote on a spill motion. If the spill motion receives approval by a simple majority, the company will have to hold a further general meeting within 90 days to vote on whether to keep the existing directors.

Shareholders have demonstrated that they are not afraid to exercise this new power, and 36 of the ASX 500 companies [1], including the 14 major public companies noted below, have had "no" votes of greater than 25% on their remuneration reports this year.

  Company*   % of votes cast against
 the remuneration report
  Signature Capital     41
  Perpetual    26 
  ICS Global   27 
  Pacific Brands   53
  Crown   44
  GUD Holdings    44 
  Watpac     34 
  UGL    30 
  Cryosite    81 
  Dexus    28 
  Sirtex Medical    33 
  Tassal    37 
  Cabcharge    37 
  BlueScope Steel    39 
*This is a non-exhaustive list.

What are shareholders concerned about?

Chief amongst shareholders' remuneration related concerns have been:
  • remuneration packages which are seen as excessive relative to comparable companies;
  • hazy performance targets and/ or inadequate disclosure of those performance targets; and
  • an inadequate link between incentive plans and executive performance – including the payment of incentives to executives notwithstanding a failure to meet their performance targets.

Proxy advisory firms are becoming increasing active in this space, and against the background of market turmoil and portfolio underperformance, the proxy advisory firms views are becoming more influential in the decision-making of major institutional shareholders. One of the key takeouts from this AGM season is that liaison with the major proxy advisory firms that advise on the company is part of the essential preparation for the AGM.

Is the two strikes rule being used as a general protest vote?

For some companies, it seems that shareholders have voted down the remuneration report not because of specific concerns about remuneration but because of general dissatisfaction with the performance of the company and its management, or because shareholders feel disenfranchised by the conduct of the board.

The remuneration report vote is ideally structured to provide shareholders with a "protest vote", because the threshold is only 25% (as opposed to the simple majority required to remove a board member), and because the consequences of the no vote go right to the heart of the tenure of the whole board.

For companies facing shareholder dissatisfaction in the face of underperformance, the no vote can send a clear signal of dissatisfaction to the board, which is not necessarily linked to remuneration. Signature Capital Investments, GUD Holdings and Dexus are all examples of companies that faced this scenario at their AGMs.

For companies that are subject to control proposals at the time of their AGM, there is a risk that the remuneration report vote can be used by shareholders to express dissatisfaction with the manner in which that control proposal is being handled by the board, notwithstanding that this may not be a matter that is formally before shareholders.

What are the lessons for next year?

In preparing the disclosure on remuneration next year, the focus for many companies (especially those who received a no vote this year), will be on communicating the board's position on remuneration clearly to shareholders.

Many remuneration reports suffer from not being user-friendly, because the drafting of the report focuses on "ticking the boxes" and complying with the detailed regulations that apply in this area. Next year, the remuneration strategy will be a key part of shareholder communications messaging for more companies, rather than simply a compliance task. The Corporations Act requires companies to disclose in their remuneration report not only the amount of each executive's remuneration, but also the underlying policy for determining remuneration and the relationship between this policy and the company's performance. Companies should make it clear to shareholders why they have adopted their remuneration structure, particularly in circumstances where incentives will be paid to executives despite financial under-performance.

For those companies that received one strike against their remuneration report this year, if comments were made at the AGM on the remuneration report, they will need to include an explanation of the board's proposed action in response or, if the board does not propose any action, the board's reasons for inaction in their remuneration reports next year.

Because these companies won't know whether their remuneration report will receive a second strike, their preparations for next year's AGM will have to proceed on the basis that there may be another 25% no vote. This means that their notice of meeting, proxy forms, etc will have to make provision for voting on a spill motion.

Trend towards shorter board tenure?

The use of the remuneration report vote as a general protest vote has led to some commentators predicting that this is the start of a move towards full board elections at each AGM, which has been the case in UK for some time. While we see the remuneration report vote as focusing the minds of boards on shareholder views in relation to remuneration, the current retirement by rotation provisions, which require one-third of the board to retire at each AGM, are relatively entrenched in Australian corporate governance, and the remuneration report is unlikely to undermine this principle.

[1] "Radical rethink called for on AGMs" Weekend AFR 3 December 2011.

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.