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Focus: 'Two-strikes' rule part of executive remuneration shake-up

29 June 2011

In brief: New legislation introducing a 'two-strikes' rule and making substantial changes to procedures associated with executive remuneration, board limits and determination of proxy votes has come into force. Partner Robert Pick (view CV), Senior Associate Kate Towey and Lawyer Sean Cole look at the key issues in-house counsel need to be aware of when advising boards and senior management of the changes.

How does it affect you?

  • Boards of public companies with constitutions that permit the setting of Board limits will be prohibited from setting such limits from 1 July 2011, unless any proposal to do so is approved by ordinary resolution of the shareholders in a general meeting.
  • The 'two-strikes' rule has longer-term consequences for formulating Board succession plans and preparing for shareholder meetings, particularly where there has been a 'first strike'.
  • From 1 July 2011, a disclosing entity's engagement of remuneration consultants, and the interaction of management and executive directors with remuneration consultants, should be reviewed to ensure compliance with the new provisions.
  • Entry into certain arrangements designed to hedge exposure to risk associated with components of executive remuneration will be prohibited from 1 July 2011.
  • Companies should review meeting procedures to ensure that key management personnel do not vote in relation to remuneration matters from 1 August 2011.
  • Poll procedures in relation to proxies appointed from 1 August 2011 will need to accommodate the requirement that the Chair vote any directed proxies that are not voted by the appointed proxy themselves.

Background

The Corporations Amendment (Improving Accountability on Director and Executive Remuneration) Act 2011 (Cth) (the Act) introduces substantial changes to procedures associated with executive pay, including allowing shareholders to hold directors accountable for decisions regarding executive remuneration; setting new requirements for disclosing entities in relation to the engagement of, and interaction with, remuneration consultants; imposing voting restrictions on management and executives in relation to remuneration matters; and prohibiting certain remuneration practices. Areas not directly related to executive remuneration, such as Board practices in setting Board limits and the determination of proxy votes, are also affected by the Act.

Amendments proposed by the Federal Coalition that would have softened the ability to trigger a Board spill under the 'two-strikes' rule and amendments proposed by the Greens to cap executive salaries both failed to gain the support of the Senate.

Outline of the Changes

The following table sets out a summary of the key changes and commencement details as contained in the Act.

Provision Operation Commencement details
The 'two-strikes' rule' Presently, the Corporations Act 2001 (Cth) requires a listed company to put its remuneration report to a non-binding shareholder vote at the AGM. The Corporations Act, however, does not set out any consequences where a board proceeds with its remuneration policies despite a negative shareholder vote.

The Act provides for a new 'two-strikes and re-election' process as follows:

'First strike' – where a company's remuneration report receives a 'no' vote of 25 per cent or more of the votes cast on a resolution that the remuneration report be adopted.

Where 'comments' were made on the remuneration report that were considered at the AGM where there was a negative vote of 25 per cent or more, the company's subsequent remuneration report must contain an explanation of the Board's proposed action in response, or, if the Board does not propose any action, the Board's reason for inaction.

'Second strike' where a company's subsequent remuneration report receives 'no' vote of 25 per cent or more of the votes cast on a resolution that the remuneration report be adopted.

A 'spill resolution' is to be put to shareholders at the same AGM as the 'second strike'. A spill resolution will be passed if 50 per cent or more of eligible votes cast are in favour.

A 'spill meeting' is required to be held within 90 days of the passed spill resolution. The directors required to stand for re-election at the spill meeting (other than the managing director) are those individuals that were directors at the time the directors resolved to put the directors' report to the most recent AGM. Failure by the directors to hold a spill meeting within 90 days will be an offence.

The term of office of a director who is re-appointed at a spill meeting will run as if the re-appointment had not occurred.
















Applies to resolutions on the remuneration report at listed company AGMs held on or after 1 July 2011.

This has the effect that any negative shareholder votes on the remuneration report before 1 July 2011 are disregarded for the purposes of the two-strikes test.

Engaging remuneration consultants Board approval of remuneration consultancy contracts

Before a disclosing entity can execute a contract to engage a remuneration consultant, the execution of that contract must first have been approved by the directors of the remuneration committee or the Board. A failure to comply is an offence by the company.

Remuneration recommendations – disclosure and provision of remuneration recommendations

Remuneration consultants may only provide remuneration recommendations regarding key management personnel to the directors of a disclosing entity (except the executive directors1), or the remuneration committee, or both. The remuneration recommendation must be accompanied by a declaration that it was free from undue influence of key management personnel.

The remuneration report must contain certain details relating to remuneration consultants. Information about arrangements put in place by the Board to ensure that the remuneration recommendation was free from undue influence from the relevant members of key management personnel and a statement about whether the Board is satisfied that the remuneration recommendation was free from undue influence and the reasons for this must also be included.

What constitutes a remuneration recommendation?

'Remuneration recommendation' is broadly defined, being a recommendation about either or both of:

  1. how much the remuneration should be; and
  2. what elements the remuneration should have,

for a member of key management personnel (subject to limited exceptions, including legal advice, accounting advice and actuarial advice).

Any person external to the company who makes a remuneration recommendation under a contract for services with the company will be a 'remuneration consultant' (subject to limited exceptions for matters that, for example, constitute legal, accounting or actuarial advice).

Key management personnel has the same definition as is currently defined in the Corporations Act.

Applies in relation to:

  • the execution of remuneration consultancy contracts;
  • remuneration reports for financial years; and
  • remuneration recommendations made under a remuneration consultancy contract executed,

on or after 1 July 2011.

Restricted voting on remuneration matters Restriction on voting by key management personnel

Key management personnel (or their closely related parties) whose remuneration details are contained in the remuneration report must not vote on the non-binding resolution on the remuneration report or any spill resolution (except where exercising a directed proxy on behalf of other persons).

A failure to comply will be an offence, and a vote cast in breach of this provision is taken not have been cast, but does not affect the validity of the resolution.

Proxy voting by key management personnel

Key management personnel (or their closely related parties) appointed as a proxy must not vote on a resolution connected directly or indirectly with the remuneration of key management personnel if the proxy is undirected, unless:

  • the relevant member of key management personnel is the Chair of the meeting at which the resolution is voted on; and
  • the proxy appointment expressly authorises the Chair to vote undirected proxies on such a resolution.

A failure to comply will be an offence, and a vote cast in breach of this provision is taken not have been cast, but does not affect the validity of the resolution.

Applies in relation to voting on or after 1 August 2011.

Persons named in remuneration report

The remuneration reporting requirements will be simplified by the Act.

Remuneration disclosures will only be required for the key management personnel of the consolidated entity (or company, if consolidated financial statements are not required), as opposed to the current requirement of providing the remuneration details of the key management personnel and the five most highly remunerated officers (if different) in relation to the parent entity and the consolidated entities.

Applies in relation to remuneration reports for financial years starting on or after 1 July 2011.
Prohibiting hedging of incentive remuneration

Key management personnel (or their closely related parties) of disclosing entities must not enter into arrangements that will have the effect of limiting exposure to risk relating to an element of their remuneration that:

  • has not vested; or
  • has vested but remains subject to a holding lock.

A failure by key management personnel to comply will be an offence.

Applies to entry into arrangements on or after 1 July 2011, whether the remuneration was for services rendered before, on, or after that day.
No vacancy rule

If a public company has a constitution that allows its directors to set a limit on the number of directors lower than the maximum number of directors specified in the constitution (a 'Board limit'), directors must not set a Board limit unless an ordinary resolution approving the proposal to set such a Board limit is passed by a general meeting of the company.

The notice of meeting must set out an intention to propose the board limit resolution and text of the resolution, and be accompanied by a statement explaining the resolution.

The Board limit resolution has effect only until the next AGM.

Applies in relation to the setting of board limits on or after 1 July 2011.
Cherry picking

To curb the practice of 'cherry picking' directed proxies, the Act provides that if a non-Chair proxy elects to vote (whether on a show of hands or on a poll), the proxy must vote as directed.

If a non-Chair proxy holder does not attend the meeting or does not vote the directed proxies, the vote will default to the Chair who has a duty to vote the proxies as directed.

Applies to voting on or after 1 August 2011, whether the proxy was appointed before, on, or after that day.

Applies to appointment of proxies made on or after 1 August 2011.

Practical implications

There are some important implications of these new changes, affecting a range of issues, including:

  • disclosure in the annual remuneration report;
  • Board succession planning;
  • the format of AGM notices and proxy forms;
  • contingency planning for 'spill' meetings;
  • AGM voting procedures; and
  • the engagement of, and dealings with, remuneration consultants.

These implications are discussed in more detail below.

In particular, there will need to be a significant amount of planning undertaken by companies for their annual report and AGMs, especially where the company has already received a 'first strike'.

The 'two-strikes' rule

A relatively low 'no vote' required: The test for the 25 per cent trigger is 'at least 25% of the votes cast on a resolution', not at least 25 per cent of the votes entitled to be cast. With only a portion of the total shareholding generally voted at an AGM, the Coalition proposed that the test be based on at least 25 per cent of the votes entitled to be cast; however, this failed to gain support in the Senate.

Responding to 'comments' on the remuneration report: In relation to the requirement for the Board to 'explain' its proposed action in response to a remuneration report that has received a 'no vote' of 25 per cent or more (or the reasons why action won't be taken), this is triggered where, at the previous AGM, 'comments' were made on the remuneration report that were considered at the AGM (and subsequently received a no vote of 25 per cent). The scope of the reference to 'comments' is not explained further in the Act or the Explanatory Memorandum. The preferred reading is that it was the intention behind the drafting to refer to complaints (as 'comments' could include positive comments), and that each comment does not need to be addressed individually. Rather, a response formulated to address the comments as a whole. Otherwise, the remuneration report may become too long or incomprehensible. Importantly, companies will need to keep a record of 'comments' made at the AGM in respect of the remuneration report to enable them to report against those comments.

Director nominations for the 'spill' meeting: With respect to a person intending to move a resolution relating to the appointment of a director at a spill meeting, any minimum period of notice required in a company's constitution must be complied with. Therefore, if, at the spill meeting, a member wanted to nominate themselves or another person for election, any notice period required in a company's constitution must be observed.

Where a 'spill' would leave too few directors: If as a consequence of voting at the spill meeting there would be less than three directors, the Act deems those candidates with the highest percentage of votes favouring their appointment cast at the spill meeting to be successfully appointed (even if less than half the votes cast on the resolution were in favour of their appointment). For the purposes of this deeming provision, if two or more candidates have the same percentage of votes favouring their appointment, the managing director (who is not required to stand for election at the spill meeting) and a director who has received more than a majority of votes (if any), may choose between those candidates as to who will hold office. There is no deadlock provision in the event that those directors cannot agree. A candidate appointed in accordance with this procedure must have their appointment confirmed at the subsequent AGM.

Contingency planning for a 'second strike': Where a 25 per cent 'no vote' on a remuneration report is passed at the previous AGM, the notice of meeting (and other accompanying materials such as proxy forms) for the coming AGM will need to foreshadow the potential for a 'spill resolution', and cater for this contingency. The mechanics required to convene a company meeting within 90 days, at which to prepare for the replacement of the entire Board will not be contemplated by present succession plans and policies. Contingency planning will be required, particularly if there has been a 'first strike'. One criticism of this proposal is the instability that will be created in trying to organise an alternate team of nominee directors with the right mix of skills and knowledge in such a short time frame.

The 'no vacancy' rule

Explaining the reasons for a Board limit: In relation to any general meeting where a resolution will be put forward seeking approval for a proposal to set a Board limit, the Act stipulates detailed notice of meeting content requirements, including:

  • the directors' reasons for proposing the Board limit resolution; and
  • all other information that is known to the company and any of its directors, and would be reasonably required by members to decide whether or not it is in the company's interest to pass the proposed Board limit resolution.

Keeping a record of proxy votes: If a poll is demanded on the question that a Board limit resolution be passed, for each member that votes on the poll, the company must record the member's name and how many votes the member casts (both for and against the resolution). A similar obligation applies in relation to proxies and corporate representatives. Failure to comply with the provisions relating to the recording of votes is an offence. The company must also lodge a notice setting out the text of the Board limit resolution within 14 days after the resolution is passed.

Impact of non-compliance: Failing to comply with the new provisions will result in every appointment of a director made by a resolution passed at a general meeting being invalidated (where at that meeting, the shareholders were not given the opportunity to pass one or more resolutions appointing a number of directors, as it would exceed the Board limit). It also provides the ability for a 'suffering party' (defined as either the company or a prospective Board candidate) to institute court proceedings seeking orders to compensation for loss or damage, although it is unclear what loss or damage is contemplated under the Act.

Ban on hedging remuneration of key management personnel

The impact of Regulations under the Act: The Act provides that in determining whether an arrangement has the effect of hedging a component of remuneration, regard is to be had to regulations. Treasury released Exposure Draft Regulations and the closing date for submissions was 9 June 2011.

The Exposure Draft Regulations provide that the following are to be considered as hedging arrangements:

  • a put option on incentive remuneration; and
  • an income protection insurance contract in which the insurable risk event affects the financial value of remuneration or equity or an equity-related instrument.

The Exposure Draft Regulations provide that the following are not considered to be hedging arrangements:

  • an income protection insurance contract in which the insurable risk event is the death, incapacity or illness of any of the key management personnel; and
  • a foreign currency risk arrangement.

The Business Law Section of the Law Council of Australia was concerned to ensure that any prohibition was limited to those arrangements that have the effect of limiting an executive's exposure to the risk of non-satisfaction of a performance condition, as opposed to other types of arrangements, such as limiting foreign currency risk. We await the outcome of the consultation process and the final form of the regulations to see if the scope of permitted hedging arrangements are refined further.

Restricted voting on remuneration matters

When is a resolution 'connected directly or indirectly with the remuneration': In relation to undirected proxies and the restrictions on voting by key management personnel or their closely related parties, the Act provides the following examples of resolutions connected directly or indirectly with the remuneration of a member of the key management personnel for the company:

  • resolutions that must be put to the vote under subsection 250R(2) of the Corporations Act (resolution to adopt the remuneration report for a listed company);
  • resolutions that must be put to the vote under subsection 250V(1) of the Corporations Act (fresh elections for directors at meetings arising from concerns about remuneration reports);
  • resolutions determining directors' remuneration under section 202A of the Corporations Act; and
  • resolutions for the purposes of Chapter 2E (related party transactions) affecting directors' remuneration.

Getting proxy forms right: Proxy forms for meetings to be held on or after 1 August 2011 may need to be amended if there are remuneration-related resolutions being considered, a member of key management personnel is to chair the meeting and it is proposed that the Chair be able to vote undirected proxies.

Getting the class of excluded voters right: The changes prevent key management personnel or their closely related parties voting. Those who are closely related parties of key management personnel are family members (spouse, children, children of spouse, anyone who may be expected to influence, or be influenced by, the member of key management personnel in dealings with the company and any company that the member of key management personnel controls). Companies will need to put in place arrangements to determine who these closely related parties are to ensure that their votes are not considered on relevant resolutions.

Engagement with remuneration consultants

Engaging remuneration consultants: Practices relating to the engagement of remuneration consultants and their interaction with management will need to be reviewed.

Taking care that remuneration advice not inadvertently provided to management: The definition of what constitutes a 'remuneration recommendation' is very broad. As presently drafted, if in the course of discussion with management, remuneration consultants provide any form of advice on the nature or amount of remuneration, there will likely be a breach of the provisions.

Establishing processes to avoid undue influence: Given the requirement to ensure an absence of 'undue influence' (a term not defined in the Act) on remuneration consultants by relevant members of key management personnel, and the need for the Board to report on the absence of undue influence (and reasons supporting their views), processes and procedures will need to be implemented to deal with these requirements.

Proxy voting

The new rules regarding the cherry picking of proxies will mean that where resolutions are voted on via a poll, the poll will need to remain open to ensure that any directed proxies that are not voted are cast by the Chair of the meeting.

Footnotes
  1. Unless all of the directors are executive directors.

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