NZSA Best Practice

Chief Executive Pay.
New Zealand Shareholders Association Inc.(NZSA) Discussion Document.
16 June 2004

1. Executive Summary:

1. The NZSA supports performance-based remuneration for CEOs.

2. The NZSA would strongly encourage the use of incentive based reward programmes throughout company structures.

3. The NZSA will request, and will lobby for it to become a requirement, that full disclosure of the basis for reward of all CEOs and top management is provided in sufficient detail to understand the basis of payment of all and each component of executives rewards.

4. The NZSA recommends that the company auditors be engaged to audit the CEOs reward package and each performance indicator against which the executive is rewarded, and if appropriate report to shareholders independently.

5. The NZSA is opposed to short term incentives based on share price movement be they cash based, or otherwise. We are equally opposed to restricted share schemes, where grants are made regardless of performance. Regardless of vesting provisions we are opposed to the granting of share options except in limited circumstances where a company’s cash flow and share liquidity eliminate any other possibility.

6. The NZSA favours the use of restricted shares as the bridge between short term and long term reward.

7. The NZSA proposes a mixture of at risk, base rewards for CEOs together with a bonus Programme based on the meeting of customised KPIs (Key Performance Indicators) appropriate to the company’s business and circumstances, with such KPIs being consistent with the delivery of sustainable shareholder value creation.

8. If key performance hurdles are met, the at risk portion of base reward should be paid out in cash with no retention. Conceptually this is the executive’s reward and should not be held captive as a retention tool. Executives should of course be free to buy shares if they wish outside of the restricted period and subject to the disclosure requirements now in place.

9. Any bonuses should be paid out, net of tax, totally in shares that vest immediately but are subject to trading restrictions for 3 years on a rolling basis.

10. Under only exceptional circumstances should a retiring CEO be released from any share lock up agreements.

11. Wherever possible the share component of executive reward programmes should be purchased on market, whether out of the executive’s own cash, salary sacrifice or bonus.

12. In the event that shares are issued rather than bought on market, the precise details of the pricing of such issues should be disclosed and if the issue appears to be at a discount to market of 20% or more the issue should be subject to shareholder approval. Further consideration should be given to applying an overall cap on the percentage of the company available to such schemes.

13. The overall reward structure for the CEO should be referenced to the company’s performance and the reward regime for the company’s team as a whole. Averages for the “market” are deceptive and create ever increasing expectations and long term harm. As a guideline it is our view that harm may be done to the organization if the CEO’s base pay, including any at risk portion but not bonus, is greater than twice that of the highest paid reportee to that CEO.

2. NZSA Fundamental Beliefs.

It is appropriate to summarize again some of our fundamental beliefs so that our support for performance based pay regimes is seen in context.

1 All business, corporate or otherwise, is about teams of people that come together to do or provide something for reward.

2 Companies are just a form of partnership between capital and labour providers.

3 Companies have no soul or values, and are incapable of being ethical or otherwise; such is the prerogative of the people who operate in those companies.

4 People have integrity based on what they do and whom they associate with. If people do bad things or associate with bad people then words don’t make up for it.

5 An organisation’s purpose or its strategy is best measured by what it does rather than what is says.

6 Shareholders are the only parties in the corporate business landscape that have the power to fire management, therefore inevitably  managers are accountable only to shareholders and therefore it is to be expected that business will be run for the benefit of shareholders. Therefore shareholder values are of ultimate importance.

7 All shareholders have different values but collectively all shareholders want to maximize long-term business value.

8 It is the job of shareholders to behave as good business owners and as responsible stewards over the resources committed to such business.

9 A company’s share price is the result of shareholders trading with one another based on information provided by management. It is therefore irrelevant to the company’s management except in situations where the company is raising or redeeming equity on market. Management should focus on running the business not the share price. If management does the former with distinction the share price will eventually look after itself.

10 The best associations come from those who associate based on free will, and do so for a commonly shared purpose, carried into effect with common values that are respected with integrity.

3. Background.

Executive reward is the front line on the battlefield between shareholders and management.

Executive remuneration has become a hot topic and has become a common ground for shareholder disquiet.  When the debate is at its worst, shareholders allege that executives are greedy and executives allege that shareholders are envious.

This topic is set to become even more hotly contested over the coming decades due to the simple issue of demographics. In the West the population is aging resulting in fewer workers and more retirement-aged citizens. There is already a growing trend to later retirement paralleling longer life. Simple supply and demand issues will push up the cost of labour and reduce the cost of capital. Those not working will rely on either the state or investment income to sustain themselves in their retirement. Either way management will be under pressure to pay higher taxes and/or higher dividends or returns to shareholders. In the absence of higher returns retirement aged citizens will have no choice but to partially liquidate their capital which in turn reduce share prices and/or make it harder for business to raise capital.

In addition there is the social issue. If returns on investment capital decline then more will seek state support and then taxes go up, returns go down and so the cycle continues. If we are to encourage self-reliance it must be based on enterprising and profitable business carried on between willing partners where management accepts willingly the social responsibility to provide decent returns.

The issue of social trends and demographics will affect all players in share markets and as a result the interface between managers and owners will become more not less tense.

Research indicates that no incentive is best!

When it comes to Executive reward there are as many approaches as there are Boards to think about the issue with the full spectrum from flat pay with no incentive to highly incentivised structures being in evidence internationally. Interestingly research to date, admittedly largely out of America, indicates that there is no correlation between incentive based reward and shareholder value performance. Such research as is available indicates the contrary view that better shareholder rewards are derived when Executives are not strongly incentivised. Of course that research is historical and is based on incentive structures that were poorly designed and based on lack of symmetry of information which in effect put executives in competition with owners rather than the alignment sought

The case for No incentive.

The case for a flat salary with no incentive rests on the premise that a person should be recruited for the job who has the utmost integrity and who completes the job for which they have been engaged for the joy of the job itself. Certainly intelligent and industrious people exist who also have integrity, and will do what is required of them without the need for incentive regimes. The difficulty for any Board engaging a new CEO is that intelligence and work ethic are relatively easy to judge but integrity is almost impossible to judge with foresight and easily judged with hindsight. Then of course it is too late.

The fundamental premise behind performance remuneration.

The case for incentive based reward has historically been made on the basis that alignment with shareholder values will produce the best performance from executives who have been assumed to strive to maximize their own self interest. While this may well be true for some or even many it is not true for all

Human Empowerment an alternative case for Performance based rewards.

A further case can be made for performance-based reward based on employee empowerment. When executives are paid high base salaries, performance expectations are in turn heightened. More is expected from someone paid $1m than someone paid $100k. As executive rewards grow higher so too do performance expectations. The end outcome is that executives are overworked and over stressed. Employers that encourage such work practices are hardly responsible employers and further might have statutory liability to boot. Lower base salaries and sensible performance based pay regimes allow executives to design their job around their willingness to work, and if they choose to work less they then also earn less reducing the risk for the employer. In essence the work place becomes a work place of partners that associate with each other based on levels of choice that effectively can empower all participants in the process.

Managing the Conflict, Believable Transparency is the best disinfectant.

When performance based reward programmes are extensively used for CEO and other management, who have control over both performance and the information arising out of that performance, the situation arguably puts such executives in conflict with organisation’s owners. It is this conflict that gives rise to the most significant governance threats. Interestingly it is this situation that has given rise to the largest corporate collapses, particularly where incentives have been short term and options based.

This “conflict” can simply be avoided through absolute transparancy, an absolute commitment to independent audit in substance form and appearance, and clear strategies of aligning shareholder interest with executive reward.

Alignment with Shareholder value, which shareholders, which values?

A further difficulty most boards face is understanding shareholder value, and without an understanding of this it is not possible to achieve alignment. All shareholders are different and have different values and investment horizons, some are short term focused on share price and others are long term focused on business development and growth. Often the short term and the long term are in conflict. For example do we cut research and improve this quarter or year’s profits and cut projected new product launches in year 5?

Who are the shareholders and what do they want?

Generally shareholders fall into 3 broad categories and the objectives of each category are different. From time to time share registers will be dominated by one group or another and this in turn drives Board strategy, and the challenge is to move the CEO’s thinking and reward packages as these competing objectives evolve.

1 Punters.

These are the share market, share price focused investors, including momentum traders, day traders, and hedge funds. These shareholders get their rewards out of short-term share price movement, either way if short trading is included. They want short-term news that will move the share price. These guys are punters not proprietors. Attempting to align CEO rewards with the objectives of this class of shareholder is always dangerous. The Executive control the flow of information, and regardless of continuous disclosure, Boards can only disclose what they know, and it is what you don’t know that can hurt. Selective reporting should never be encouraged. It was the abundance of these shareholders in capital markets in the late 90’s that drove at least in part Enronists when the performance based remuneration consultants provided CEO’s with excessive rewards based on share price movement.

2 Bank term deposit Holders.

This group of shareholders fall into the “I want a broad portfolio to mitigate business risk” category. The balance diversified portfolio holder, including passive funds, super funds and diversified individuals fall into this category. These shareholders want stable returns that beat fixed interest, and regardless of what they say they are loss averse. This group’s time horizon depends largely on demographics and the need for cash at defined times, intermittency theory in the extreme. Aligning executive rewards with the objectives of this group will stifle innovation and risk taking which is what business is about. When these types of holders dominate a share register, the CEO in essence has to become a custodian on a flat salary, and the company has to focus on consistent yields.

3 Business Owners.

The final group of shareholders are those that behave like owners. These shareholders want Boards to take risks and get it right more than they get it wrong. They want the CEO to build long-term business value through sustainable growth. They want to understand the business and the CEO. These shareholders want to see rising long-term earnings and cash flows, clear understandable strategy and honest execution of that strategy. These shareholders want a balance between short and long term performance and they want the CEO to share in these rewards. The challenge is how.

4. Transparency.

As a matter of principle the NZSA will seek disclosure of the full details of the CEOs package, including base pay, sign on handshakes, golden parachutes, pension arrangements, option plans, share purchase schemes, fringe benefits and any other benefits provided to the CEO. For the avoidance of doubt we do not care how an executive chooses to take his or her pay, just how much in total is paid in one form or another. We are entirely comfortable for disclosure to be made on the basis of Total Employment Cost. (TEC). Clearly what employees choose to do with their reward package is to a degree their private business. We will also request full disclosure of performance based payments and incentives including the amounts paid, the basis of computation and the performance criteria for each payment. We will seek clear and consistent descriptions of short and long-term incentives.

The counter argument to this is that the CEO is entitled to some privacy and the basis of payment may be commercially sensitive intellectual property of the company. Both fair comments. However if a CEO chooses to work for a publicly accountable body, he is implicitly becoming a public figure and in respect of the TEC level, privacy has gone out the door. Commercial sensitivity also goes out the door if everyone discloses. At that point how a company pays ceases to be a basis of competitive advantage as the playing field is leveled, if it ever was a basis for commercial advantage.

The advantages of full disclosure are these.

4 The greed/envy debate ceases, provided proper alignment is achieved as everyone has a full belly, and the basis of what appears excessive is then understood by all.

5 Shareholders can get a true feel for a company’s strategy, as how the CEO is paid should be closely aligned with strategy. Mission statements, vision statement and all that stuff are just cheap PR words if not backed by a chequebook.

6 If shareholders understand a company’s strategy and its business and through transparent disclosure on issues upon which there might be a conflict, begin to understand the people with whom they are investing, rational investment decisions can be made more effectively improving capital allocation and reducing resource wastage.

5.  NZSA Position on Executive Remuneration.

We strongly support performance-based rewards for CEOs and for that matter all workers within the company.

Our reasons are as follows:

1 Flat pay discourages risk taking and encourages flat performance in our view. Such regimes rely on integrity to obtain value and this is almost impossible to judge with foresight.

2 Performance based pay allows executives to design their job around the other priorities within their life and ensures that the financial cost of these life trade offs are shared.

3 Performance based pay if managed well reduces stress in the work place through allowing employees to perform at a level that they are comfortable with and be rewarded for that level of performance and no more. High base salaries drive high base demands.

4 Performance based rewards if well constructed should drive shareholder value and increase business efficiency.

6. Basis for CEO Reward.

The overriding principles should be believable transparency, simplicity and consistency.

Participants must have clear objectives and deliverables that they can monitor and against which their superiors can judge their performance. These objectives must be consistent with long-term shareholder value. For each employee critical  KPIs should be developed. If you like bottom up is in our view best.

For the CEO all of these diverse KPIs should come together to arrive at a basis for measuring performance in terms of the organisations delivery of long term shareholder value.

If performance based pay is to be used in an organisation it must be based on alignment of long term shareholder values, therefore inevitably a balance between long and short term reward must be achieved.

Each organisation is different and the KPIs that are developed for each business will be different. On one point however we are adamant, no short term executive reward structure should be based on share price activity, in whole or in part.

For the CEOs the KPIs that should be used are those that transparently relate to shareholder value. In our view shareholder value is achieved through predictable earnings per share growth.


7. Appropriate KPIs?

Set out below are some thoughts on KPIs that might be relevant to monitoring a company’s long term economic performance. In looking at these KPIs I have divided them into groups around the following categories:

1 Earnings.

2Growth.

3 Predictability.

Broadly each KPI can be looked at as a hard number in isolation or can be looked at as a trend over time; both of course are relevant at different times.

1 Earnings:

Common indicators are reported profit, earnings before interest and tax (EBIT), Earnings before interest tax and amortization (EBITDA). Profit before abnormals, dividends, all measured on a per share basis Return on Equity (ROE), return on total assets, Economic Value Added (EVA), cash flow per share, or sales or revenue per share. In isolation none of these are truly reflective of earnings and can even be misleading. Clearly profit on its own is a meaningless number however computed if it is not related to the capital deployed to earn that profit.

For example earnings per share can be manipulated by simply retaining earnings and not paying dividends, so if earnings per share are to be used as the KPI, it obviously needs to be subject to maintaining return on equity, or EVA. Further either of these indicators can be manipulated by changing the debt equity ratio of the business to use “cheaper” debt funding. Obviously increasing the financial leverage of the business can increase the return on equity, but it also comes with an increase in the risk associated with the enterprise. So regardless of the earnings number per share that is used, further KPIs should be in place around dividend and financial leverage to ensure that the short term earning number is not materially affected by financial engineering.

Obviously profit and even operating cash flows can be manipulated by the assumptions made on what is an expense versus what is capital. A further option is to look at the operating cash flow relative to capital deployed. This obviously then provides an incentive to increase operating cash flows and reduce capital expenditure or funds deployed. At the start of any regime of this nature a start capital figure needs to be established. If you are using equity earnings, then book equity is as good as any other measure. If you are using EBITDA, then gross assets is an appropriate measure. Going forward however complexity sets in when the CEO is selling down assets. Do you then reduce the funds deployed by the book value of the asset sold or by the amount realized? In our view you should reduce the capital by the book value of the asset sold and treat the excess as income. This then begs the question of what you should do with lock in goodwill at the commencement of the arrangement. We highlight these points not as answers but just as illustrations that there is no one golden bullet.

Another option is to ignore reported profit entirely and take profit to mean the improvement in the shareholders’ equity from one reporting period to the next and add to this improvement the dividends paid and deduct any capital raised. On this basis shareholders have either had their return in cash or improved the net asset backing per share. This would be fine if we did not have to deal with share buybacks on market. Pro rata buybacks of course can be treated as dividends for the purpose of this calculation. Again such a simple formula of asset improvement plus dividends is also not a golden bullet, but at least it picks up the things that go directly to reserves which are easily ignored  e.g., exchange reserves.

One thing is certain however, and that is dividends. It is cash, it is paid out and it is hard to manipulate. When a CEO joins a company there will be in place an existing dividend policy. If under a CEOs stewardship dividends are increased then the increase is a good indicator of performance, so long as earnings per share is also increasing and financial leverage is not increasing and return on equity is being maintained.

EVA is also not a bad measure, but it does require some assumptions about cost of capital which if applied in the pure way in which it has been designed, will reference cost of capital back to share price volatility. For this reason it is not our preference as it assumes that share market price risk efficiently real time, and we do not believe that this base assumption holds true in New Zealand, if anywhere. Be that as it may EVA on its own is no worse than any other measure on its own.

In summary we believe that a mixture of ROE, or EVA when related to earnings per share and dividends, cross checked to financial leverage will provide  a reasonably robust measure of earnings performance.

Before leaving this point it is worth mentioning off balance sheet leverage. Financial leverage should also include an analysis of operating lease commitments perhaps to revenue. Shareholders would not appreciate a repeat of the Tranzrail experience.

2 Growth:

When we look at growthm, shareholders are in essence looking at the long term trend in the ratios identified above. In our view the historic 5 year trend in key ratios is a good guide to historic performance, the future likely growth is far more subjective. Certainly improvement in key ratios over time is what shareholders are looking for.

One overriding factor however is growth in total revenue. Obviously if profit is rising over time and sales are not, there is only so much that can be achieved through margin improvement. Obviously profit growth without sales growth is not sustainable going forward. The issue is then how sales are being grown, as clearly sales revenue can grow organically or through acquisition. If it is through acquisition either financial leverage will increase or more equity will be raised.

So in addition to other indicators, sales revenue per share is important in assessing long term growth prospects, subject of course to the financial leverage trend within the business.

3 Predictability:

Predictability is about historic earnings volatility but it is also about sustainability. While we do not believe that Triple Bottom Line as it is currently reported adds too much to the sustainability argument at least from a shareholder’s perspective, there are some key ratios that can be extracted from this process which are useful.

A good guide to financial stability is the Audit cost relative to either gross assets or equity.  Ignoring rising audit costs due to market circumstances, if the cost of Audit is rising relative to assets or equity it is an indicator that the auditors are finding it increasingly difficult to audit the enterprise. This will be due either to the auditors finding more risks in the business on which they have to satisfy themselves or it may be due to inadequate reporting or internal risk management systems. This ratio and the trend should be monitored. When we are talking about audit costs we mean audit plus associated consultancy whether completed by the auditors or others, and we also believe that internal audit costs should be factored into this ratio.

If it is accepted that people are a company’s most important asset then ratios and trends in staff turnover and absenteeism are also useful. To be really meaningful however such a ratio should be calculated in meaningful bands. We do subscribe to the view that motivated and loyal people are a company’s most valuable asset.

If it is also accepted that all businesses are in the business of selling, customers are just as important as the internal team. For this reason trends in market share, and customer turnover are important. Also customer concentration and turnover in key accounts may also be a significant KPI, if not for the CEO then certainly for appropriate team members.

If shareholders have a feel for staff and customer retention and market share they will have a better feel for the sustainability of the enterprise.

The final matter out of Triple Bottom Line is the issue of environmental concerns. The number of prosecutions under environmental law may also be a KPI and again the trend in this would be useful.

8. Share Price as a Key performance indicator.

It is the NZSA’s position that share price is not an appropriate short-term performance indicator. Our reasons are as follows:

1 Share price is a function of willing buyers and willing sellers (shareholders not managers) trading their positions based on their own needs and information provided by management.

2 Despite academic beliefs share markets are not efficient arbiters of a company’s risk, real time. To a significant degree share markets reflect human emotion at least as much as the efficient pricing of risk.  Interestingly alternative research out of human science departments is now beginning to emerge to dispute efficient market theory.

3 Even if efficient market theory could be established to be operative it requires full information and high liquidity. With continuous disclosure it is hoped that we might get close to the former, but the latter is beyond all but a small group of NZX listed companies.

4 In any event information is under the control of management and if management are incentivised based on share price an implicit conflict of interest is created whereby management can attempt to manage the share price through the selective control of information.

5 Share price for listed companies is an instantaneous barometer. Shareholders and managers alike can look up the share price of a company real time all the time. It is hard enough to get shareholders to focus on the business rather than the share price. If managers can see the result of their decisions and the communication of them real time, the natural instinct is to look for short-term gratification particularly where a significant portion of a manager’s reward is based on share price. Such short termism creates the environment in which situations like Enron and WorldCom can occur.

6 In the absence of deliberate manipulation by management, share price is beyond the control of management, unless they are also significant shareholders. A fundamental of any successful performance based pay regime is that the KPIs selected must be simple, transparent AND within the control or responsibility of the person being monitored.

9. Long term incentives.

Inevitably short term rewards are usually based on Annual results. Business is a continuous activity broken into accounting periods for administrative and reporting convenience. There is always the risk when executives are overly rewarded based on short term results that executives will manage the information flows to maximize their own position. Clearly in preparing Financial Statements on a period-by-period basis assumptions are required to be made in valuing assets and calculating liabilities. New Zealand’s regime is a descriptive regime. This allows flexibility to management to present data in a way which describes the business in a true and fair way. Equally it allows manipulation. The alternative of a more prescriptive regime also has its problems in that compliance with a prescriptive standard is a defence for management at the expense of owners if the result is still misleading.

Where one party controls information and the way in which it is conveyed, and is rewarded significantly for positive results, we have a classic moral hazard situation. This is one of the significant arguments against performance-based rewards.

The old saying that you can fool some of the people some of the time and all of the people none of the time is the basis for providing a mixture of short and long term incentives. There are a number of ways in which this can be achieved.


Long term KPIs.

One common mechanism is to have short-term rewards paid on long term KPIs on the basis that these are harder to manipulate than short-term indicators. While this is true there is always the problem that each time leadership changes in an organization, or within a business unit the accountability and responsibility for long-term indicators gets blurred i.e. long term indicators are only a useful incentive for long term employees.

Another variation on this theme is the high water mark approach. What this says is that a portion of an executive’s reward comes from beating the company’s previous best. I wonder how Theresa Gatting would feel if this approach were taken at Telecom when she took over.

High water marks only really work in conjunction with other long-term incentive arrangements but are again prone to manipulation.

The NZSA does not generally believe that long term KPIs can be readily set that are fair to incoming and outgoing management.

Be that as it may, long term trends should be part of the reward structure for any CEO.

Bonus Banking.

Another method is to calculate reward based on short term KPIs, and only pay out a portion of the earned incentive, retaining the balance in an internal bonus bank. In subsequent years the bank gets further credits or perhaps gets debited as well when there is under performance.

Bonus banking provides companies with the means to hold back short term incentives until they have seen if the performance that has occurred is a sustainable improvement, or is otherwise the subject of management managing information.

The negative with bonus banking is that unless each employee maintains a separate account in the bonus bank you can have arguments from current performers about covering past shortfall, or from historic performers having their performance docked by the work of others. Again it is the same problem as the long term KPI issue. To some degree this can be dealt with by team members having their own “account” within the bonus bank.

A further useful by product of bonus banking is that it can be used as a tool to assist in locking in key staff. We however believe that taking executive remuneration captive is not an appropriate way to achieve lock in. Teams do not function well if they include members who would prefer to leave but are locked in financially and whom the balance of the team wants to be rid of. While there is a role for using reward as part of a lock in strategy, value and objective alignment will achieve the same outcome in a more positive manner. Remember the prime purpose of bonus banking is to ensure that the information upon which short term rewards are paid is reliable and to share the consequences when this is not the case.

Issuing shares.

Another mechanism is to use shares as part of the reward package. Historically option grants with long exercise periods and medium term vesting periods were used, on the premise that share price growth responded to positive short-term performance indicators and that the resultant improvement was an appropriate basis for reward. As stated above we do not agree with this premise.

Of late, in New Zealand at least, options have become less common and a practice is emerging whereby executives are issued with restricted shares. Every scheme is different but common features include:

1 An element of base reward or at risk reward is forfeited and then paid net of tax with shares.

2 The vesting of the shares is contingent on performance hurdles and sometimes longer-term hurdles. In other instances there are no performance hurdles.

3 Once the shares are vested their ability to be traded is restricted for a period of time either as a lock in or to ensure that the performance hurdles are met on a sustainable basis.

While we believe that there are rare circumstances in which options are an acceptable form of reward due to the inordinate emphasis of that reward on share price action, these arguments are less compelling with restricted shares due to the lesser leverage.

With options the incentive is share price improvement, and nothing else. If the share price does not improve there is no reward and the options can then become a disincentive. With restricted shares, so long as the employee lasts the distance, there should always be at least some element of recovery.

10. NZSA Model.

While one size does not fit all, we believe that the following model is robust for many companies.

1 All executives should have a portion of their base remuneration at risk.

2 There should be a comprehensive reward programme based on sensible KPIs, which each executive is measured against. Those KPIs should be within the executive’s control. In the case of the CEO those KPIs should be publicly reported and perhaps even the Continuous Disclosure Regime should dovetail into those KPIs. If the KPIs are met the “at risk” portion of the base reward should be paid out in cash. In addition if the KPIs are exceeded there should be a bonus plan over and above base reward that has no limit. Bonus rewards should be paid out entirely in company shares. Obviously the KPIs should be devised around long-term shareholder value as discussed in this document.

3 The shares issued on account of the bonus component should be blocked from trading but not otherwise for a minimum period of say 3 years. If the executive leaves the restriction should still apply and should rarely be waived. This ensures that the executive’s short-term reward is paid in a manner that puts that reward at the same risk that shareholders suffer if the KPI achievement was not sustainable or was otherwise manipulated. If audit raises issues of manipulation all shares subject to restriction should be subject to forfeiture. In the meantime the executives should have full voting rights over the stock and should receive all dividends and the right to participate in all rights issues and bonus issues available to shareholders. In effect the executives should be shareholders like any other with restrictions on trading only.

4 It is unacceptable for CEOs to resign and then exercise all of their options or sell all of their restricted shares and leave the mess for the next person to clean up. Sure the retiring CEO might think that the next CEO will do badly and may want to sell for that reason. This is a valid concern however the greater risk is that the CEO has milked the cow dry to maximize his KPIs and then passed an empty parcel to his successor. For this reason we believe it will be a rare circumstance for a CEO’s restricted shares to be released early.

If rewards are to be paid in shares there are clearly two options.

1 The company issues new Shares

2 The company buys shares on market.

On Market Buyback.

Shareholders particularly large shareholders will be concerned about dilution and therefore our preference wherever possible is that the shares be bought on market by an independent trustee in a nominated period within the unrestricted envelope available to insiders.

The key constraints regarding a buy back option are as follows:

1 The need to obtain shareholder approval. However under both the Companies Act 1993 and the NZX Listing Rules the only requirement is that of an ordinary resolution, which subject to full disclosure of the purpose and intent of the proposal should not create any shareholder issues. Issuing shares however does not require such approval subject of course to the Company’s Constitution. Generally up to 10% of the Company’s issued stock can be created in any 12 month period by the Board and issued without shareholder approval, that however is another issue of concern to shareholders.

2 The company’s cash flow and its ability to meet the cash payments for executive rewards. It is however fair to say if rewards are payable and there is insufficient cash or borrowing capacity then it is likely that the KPIs upon which the rewards are calculated are flawed.  Be that as it may, it is a constraint. Regardless however, taxes must be paid on the reward programme in any event and only the net can be converted to shares. So if cash is a real problem it may well be that there is no alternative to using options that avoid tax until the options are exercised. An alternative is now available to deal with the cash problem of the tax payments at the time of the bonus payment. Employee share option trusts are worth exploring in detail, for this issue alone, but such structures also have other benefits. These structures have been developed for the Australasian Market by the TMG Kenneth’s Group a prominent Australasian Consultancy on reward and remuneration programmes whose clients include the Australian Federal Government. (Disclosure of interest Bruce Sheppard has a shareholding in the New Zealand Affiliated Company of this Group)

§ The liquidity of the Company’s share is also a fundamental issue. If the level of buying is likely to move the Company’s share price and or reduce the freely tradeable float to any significant degree on market buy backs are not appropriate. While the determination of this issue is not a precise science, it is fair to say if the buy back programme in any 12 month period is likely to reduce the free float by more than 2.5% or is likely to account for more than 10% of the average daily volume over the nominated period in which the buying activity will occur, then the Company’s stock is not sufficiently liquid to sustain an on market buyback.

Issuing Stock.

Where it is not feasible to buyback stock on market, it is considered acceptable for the company to issue new stock. An added advantage of this option is that over time such a Programme will increase the free float and liquidity of the company’s shares which is of benefit to all non-strategic shareholders. Major shareholders who hold say 50.1% are unlikely to be happy losing their majority.

The key issues under this alternative are dilution, pricing and timing.

Timing should be at a nominated time each year following the announcement of results and the determination of the KPIs giving rise to the reward payment.

The pricing should be referenced to the current share price as quoted on the NZX. However if a stock is illiquid this might not give a true measure of the company’s worth either way. Therefore some flexibility will be required to enable the board to price the stock in a manner that is fair to the employees and to the existing shareholders. Regardless there must be full disclosure of the pricing regime used for the issuance of stock. If a price other than the current market price or the weighted average of the stock price since the date of the announcement of the result and the date of issue is used, the Board should fully disclose it’s rationale and have this verified by an independent expert. If the price is more than a 20% discount to the prevailing market price at the date of issue, the mater should be submitted to shareholders for approval.

In the event that shareholder approval is not forthcoming, the executive reward would then be payable in cash but subject to an appropriate bonus banking arrangement.

11. Team Cohesion.

A further valid critisim of performance based rewards when spread though an organisation is that it encourages individual performance at the expense of team cohesion.

In some organisations it is not possible to separate individuals. For example in a steel mill the whole production line is effectively one operating unit. Therefore team performance hurdles are also important and team reward programmes should be entrenched as part of a firm’s reward structure. If well done this can over time provide share ownership through the whole organisation, which means in the words of John Day, founder of TMG Kenneth’s Group, we will have a company of “share milkers”.

12. How much is enough.

Once upon a time a promise to pay someone his or her weight in gold would have been beyond even the wildest of expectations. Now even if an executive was seriously obese, it would be hard for an executive to walk out with much more than $2.5m pa. How times have changed.

The amount of a CEOs bonus should not matter so long as it is transparently disclosed and it is seen to be fair. Shareholders won’t care too much who gets the incentive so long as it is a portion of shareholder value added, to a point. It is however fundamentally important that the rewards of success are perceived by all those who earned it to have been fairly distributed. If it is not, team cohesion and motivation will be adversely affected as will long term shareholder rewards as a result.

The CEO’s base pay must have some reference point to the economic reality of the company in which they work, and the team with which they serve. 20 years ago a CEO’s salary on average was about 10 times the average for the company as a whole. Now it is nearer 30. Have the risks gone up that much? How much is one-person worth relative to another? These are fundamental questions of social justice and sadly shareholders are at the front line on this issue. If rewards for the CEO are perceived to be at the expense of the team, the team will fall apart and long term shareholder value will be destroyed. Therefore when shareholders are considering CEO reward they should consider the reward structure for the company as a whole to ensure that long term interests are served.

Often when seeking a pay increase Boards will trundle out “experts” who inevitably report that an executive is paid below average. Never do they compare the reward structure for the company as a whole with the rewards proposed for the CEO. They then usually suggest that the CEO is an above average performer and recommend that he should be paid an above average pay. Have you ever seen a report that tells shareholders that a CEO is a below average performer?

Then of course the new salary is factored into the averages, which of course perpetually rise, and then another report is generated recommending yet another increase and so the cycle goes on.

Other experts suggest that high differentials are desirable based on “Trophy Theory”. This theory basically surmises that if CEOs are paid excessively it provides an incentive for the next level to work harder in the hope that they will be the one to win the Trophy of succession. Is it fair to expect second level mangers to bet their life in a lottery? This theory could only ever have a modestly sustainable position if most companies promoted from within. In NZ this is not the usual model.

Executive overall reward has to have some common sense correlations to the rewards of shareholders and the rewards of other members of the CEO’s team to be socially and or economically sustainable. In this regard we believe that the CEO’s base reward, including the at risk portion of that base reward should not be higher than twice the base reward paid to the highest paid team member reporting directly to the CEO. We also believe that the at risk portion of the CEO’s base pay should be approximately 50% of the total base reward, and for second tier management the level should be about one third at risk, reducing in sensible steps as we move down through the organization.

13. Role of Shareholders.

There has been some debate over the role of shareholders on the issue of executive reward. All business is a partnership between owners and workers and therefore the reward structures of workers is as much the prerogative of owners as it is of workers. Directors are the agents of the owners and are charged with carrying into effect the wishes of and representing the interests of owners. It therefore behoves Directors to understand the position of shareholders on this matter.



Acknowledgements:

Bruce Sheppard Chairman of the New Zealand Shareholders’ Association authored this paper.  Des Hunt Director corporate relations for the NZSA and previously a director and senior executive with Tru Test has  co-developed and  the KPI sections of this paper which are the drivers of shareholder value. Oliver Saint, retired Auditor, Merchant Banker, and Professional Investor; Ross Dillon, Commercial Barrister; Chris Curlett, company director; Malcolm Dunphy retired lawyer; Russell Hodge employment consultant, and Graham Wilson, educator have all reviewed and critiqued and refined this paper prior to external distribution. Together they are the executive Board of the NZSA.

Prior to external publication the paper has been released for comment to Massey University and the comments of Professor Martin Delvin (Massey University),  are attached.

The paper has also been reviewed by John Day FCA, from the Kenneth’s Group and Liam Forde, business culture  advisor and strategist. Their comments are also attached.

Finally this paper was released on a preliminary basis to selected members of the business community prior to its public release.

The comments of Bill Falconer, Chairman Hellaby and Restaurant Brands, Mark Verbiest, Legal Counsel for Telecom, Phil Pryke, Chairman of Contact Energy, and Gary Paykel,  past CEO and Current chairman of Fisher and Paykel  Appliances and Healthcare, Simon Botherway, Brooke Asset Management, Graham Brand, Morgan and Banks Australia, Roger Kerr, Business Round Table, Sir Dryden Spring, now past Chairman of Tenon, Ralph Waters CEO FBU and  Nicki  Crauford, CEO of the Institute of Directors.