As lobbyists mull over the Productivity Commission’s draft reforms to executive remuneration rules, the first non-binding Remuneration Report of 2009 has been voted down by shareholders. Engineering and infrastructure services company Downer EDI infuriated shareholders by handing its CEO, Geoffrey Knox, millions of dollars in cash and bonuses and resetting hurdles relating to the company’s options plan. Yesterday, almost 60% of Downer shareholders voted against the non-binding resolution.
Like most of the engineering sector between 2003-06, Downer was a market darling, its share price rising from $2 to more than $9. However, in 2006 the company stumbled badly, its share price falling to $5 and it was forced to settle a class-action relating to misleading revenue forecasts. Downer’s share price recovered strongly in 2009 as the company benefited from continued government stimulus spending and the prolonged commodities boom.
While shareholders were no doubt relieved to witness Downer’s recovery, they were not at all impressed by the largesse handed out to its executives. Especially since Downer’s performance has basically mirrored that of its peer group since 2006:
Despite its average performance in 2009, Downer paid CEO Geoffrey Knox $4.5 million cash alone (and millions of dollars in shares) — an increase of 67 percent on the prior year. Knox was paid a $2.5 million cash bonus despite Downer’s share price falling by 18 percent during the year (it has risen since then as market sentiment improved). While chairman Peter Jolly claimed that Downer “have a team who … are paid at appropriate market levels”, Knox’s remuneration was the 14th highest of all Australian executives and more than double the pay received by executives of similar size companies. Downer is around the 85th largest company on the stock exchange.
It was not merely the size of Knox’s pay packet that infuriated shareholders but also the decision by Downer’s remuneration committee to allow additional “retesting” of performance hurdles. To explain, when companies grant equity incentives they will usually be subject to what is known as “performance hurdles”. (Option will also have an “exercise price” hurdle, meaning that the share price has to rise to a certain level before the options have any value.)
The performance hurdles may be related to the company’s earnings per share (EPS) or relative shareholder returns. In Downer’s case, the performance shares granted had an earnings hurdle and also a share-price hurdle. That meant for the shares to vest, Downer’s share price needed to be above a certain level. The problem for Downer’s executives was that its share price performed so poorly last year that the shares failed to even meet Downer’s already un-challenging “share price hurdle”. That is part of the notion of “pay for performance” — should the company (and by implication, executive) not perform, the incentives should not be paid.
Downer’s board did not appear to be strong believers in this principle. When it became clear that the hurdles relating to shares granted in 2008 wouldn’t be met due to a sharp decline in the company’s share price, Downer decided to allow the hurdles to be “re-tested” in 2011. That means should Downer’s share price continue to recover, its CEO will almost certainly be granted the shares in two years. Corporate governance experts noted that Downer’s “simple share price hurdle and the additional retest simply serves to de-risk the grant for recipients.” Downer’s scheme became not so much an incentive plan, but a gift to its CEO who is already being paid far more than his contemporaries.
In response to claims that it was giving its executives a “free-kick”, Downer chairman Peter Jollie stated that “we were in a pretty difficult situation in that we had only one [long-term incentive] plan that was current [last year]. We had a global financial crisis come in the middle of the plan that meant we had to adjust the hurdles to allow them sufficient time for them to be realistic.” According to the logic of Downer’s chairman, executives are to be compensated for events that occur outside of their control (like the GFC), but should extraneous events (such as cheap debt and a global infrastructure boom) assist the share price, those same executives are to be handsomely rewarded.
Even worse — Downer shareholders were not given the opportunity to vote on the executive share plan. That was because Downer utilised a loophole in the ASX Listing Rules, which does not require shareholder approval for equity grants to directors where those shares have been bought “on market” (approval is required for the grant of newly issued shares). This tactic was also used by Telstra when it handed former CEO Sol Trujillo millions of dollars of options.
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The Downer remuneration policies neatly exhibit all that is wrong with how boards pay senior executives. There is no point in devising a performance incentive scheme if the scheme is altered when the performance doesn’t meet the relevant hurdles. Shareholders have sent the Downer directors a loud message, although it’s unlikely that any are listening.