Dumb Things – How to Clawback the Gravy

Dumb Things – How to Clawback the Gravy

How bad does ‘bad’ have to be for a departing executive to get nothing?

Over recent years, cases of apparent poor executive behaviour (often simmering below the surface for multiple years) and the flow-on effect of company reputational damage have resulted in high-profile executive departures. Given the circumstances of these abrupt departures, the attention of financial journalists and proxy advisers quickly turns to (and shock is often registered in regard to) the Board’s treatment of on-foot short-term and long-term awards for those executives.

In the minds of some, rather simplistically, poor behaviour or company reputational damage equates to a sacking and executives forfeiting all incentives. However, the truth is often more complicated. Whilst there can be clear-cut termination for cause cases which result in the forfeiture of all remuneration incentives, the majority of ‘poor behaviour’ scenarios fall in a grey zone.

The ability to terminate an executive for cause is not a simple process. It requires proof if the company is not to open itself up to a claim for unfair dismissal from the executive involved, which requires more than whistleblower complaints and innuendo.

It is less than ideal for Boards to have a protracted litigation process with the executive involved (nor is the standing down of a CEO during a live investigation much better as it can result in a leadership vacuum). Cognisant of the commercial realities (to minimise the impact on operations and employees, oh and the share price) Boards often seek a swift agreement with the executive involved.

As a large part of any executive’s remuneration package comprises of incentive-based equity awards (some of which may have vested but are restricted, or are part-way through a performance period), the treatment of these items are often the gambit used in the negotiation of that ‘rapid’ departure.

As proxy advisers and financial journalists typically do not see the world in grey (and always with the benefit of hindsight), ASX Boards have the unenviable task of fulfilling their obligation to shareholders, all in the public eye.

Darling it Hurts – Recent Examples

At one end of the spectrum, James Hardie and QBE’s outgoing CEOs had all on-foot incentives (STI and LTI) lapse with only statutory entitlements paid out, to reinforce CEO accountability. Following both CEOs’ departures after external investigations confirmed workplace-related interactions fell short of their employer’s Code of Conduct, the hardline approach displayed the prioritisation of organisational culture.

However, where a more lenient approach has been taken in response to behaviour in the ‘grey zone’, shareholders haven’t always seen eye-to-eye with Boards. At Rio Tinto, where the Juukan Gorge destruction related to reputational damage rather than individual misconduct, as ‘eligible leavers’ departing executives had their on-foot LTI awards pro-rated until termination (albeit their 2020 STI was forfeited). Despite the Board’s additional exercise of downward discretion for the CEO (reduction of £1m for his prior years’ vested equity awards), Rio’s ‘first strike’ (with only 39% of voters supporting its 2020 Remuneration Report) indicated that shareholders expected a greater level of executive accountability, even if no individual was singlehandedly responsible.

On our watchlist is the The Star Entertainment Group’s treatment of its former executives’ incentives following their departures this year, due to alleged breaches of money laundering obligations.

Stumbling Block – What About Executives Who Have Delivered Substantial Financial Returns?

While the generation of strong shareholder returns should not override poor executive behaviour, there is a tension when the departed CEO has generated substantial shareholder returns during their tenure (eg James Hardie (~53% p.a.) and Rio Tinto (~31% p.a.).

As difficult as it may be to digest, the Board’s treatment of these leavers may not always be popular with shareholders who looked favourably upon the returns generated.

Before Too Long– How to Pre-Empt the Unexpected Executive Departure?

Increasingly, companies are incorporating into their incentive plans some type of behavioural or cultural gateway or emphasising the overriding discretion of the Board to moderate incentive outcomes where the ‘how’ results were achieved at the expense of employees, customers, suppliers or the broader stakeholder group. Recent Royal Commissions into the Banking and Gaming industry have fueled this practice. While some equate Board discretion to a free kick, such powers may provide the Board with more nuanced solutions to balance the circumstances.

Recent tax law changes have also provided an ace in the hole for Boards. Cessation of employment is no longer a taxing event for most equity-based incentives, giving the Board the choice to leave LTI awards on-foot to be tested against their original performance conditions at the end of their original performance periods rather than vesting some or all of them early. No longer is there a tax reason to provide a windfall gain to a departing executive.

As companies have increasingly adopted broad reaching malus and clawback provisions into plan rules (with the financial services sector leading the charge in light of APRA’s incoming CPS 511 remuneration standard), alongside the change in the tax laws, this provides Boards with the ability to further adjust incentive outcomes downwards post-departure. This approach also reduces the risk of putting ongoing employees offside by taking away ‘earned’ remuneration before a black and (Everything’s Turning to) White conclusion to the investigation.

New Rules – Which Factors Should Bear Greatest Weight?

Oh the questions this raises!

Should strong long-term financial performance and value creation play any role in decision making? Or does poor behaviour and reputational damage (even if not proven) wholly override outstanding historical returns to shareholders? What message does the Board intend to send to potential recruits and current employees? Do we need to stamp out this culture and set an example? What will our investors expect?

Based on past practice, the prevalence of at least some level of downwards adjustment of STI and LTI awards at the time of the executive’s departure indicates that Boards recognise workforce culture and community reputation are equally important to financial performance in generating long-term company success.

But how much is enough? Should Boards clamp down hardest only once ‘proven guilty’? Once awards have been ‘earned’ by executives at the end of the performance period (eg deferred STI) should they be entitled to keep these awards regardless of skeletons in the closet discovered later?

Unfortunately, there is no magic formula, and it is likely that someone will be left aggrieved.

Whilst Boards have the unenviable task of balancing the business’ commercial realities of the time (without the benefit of hindsight) with the expectations of proxy advisers and financial journalists (formulated with hindsight), if a Board can firmly put hand on heart when fronting up to shareholders come AGM time, perhaps that is the ultimate guiding principle when commencing negotiations with an outgoing executive.