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Article Excerpt
[This article presents an empirical study of the regulation of termination payments found in Part 2D.2 of the Corporations Act 2001 (Cth) and Australian Securities Exchange ('ASX') Listing Rule 10.19, as well as limits endorsed in the Australian Council of Super Investors Inc ('ACSI') Corporate Governance Guidelines. Based on the termination payments contemplated by the executive service contracts of a sample of S&P/ASX 50 managing directors, the empirical results demonstrate the sheer magnitude of the thresholds contained in Part 2D.2 of the Corporations Act 2001 (Cth) and ASX Listing Rule 10.19, and highlight problems with classifying share-based remuneration payments' according to the current Corporations Act 2001 (Cth) ss 200F-200G descriptions. This article also notes the prevalence of contractual or share plan terms that permit share-based payments to be made without reference to the underlying performance conditions.]
CONTENTS I Introduction II Prior Literature on Termination Payments A US Empirical Studies on Retirement and Termination Payments B The Stapledon Study III Regulation of Termination Payments A The Nature of Termination Payments B Corporations Act Requirements C A Brief History of the Part 2D.2 Thresholds IV Methodology V Termination Payments: Prevailing Practice A Contractual Provisions B Categorising Payments: ss 200F-200G C Share-Based Payments D Quantifying the Termination Payments Made VI Thresholds and Exempt Payments A The Maximum Threshold: Model 1 B Varied Thresholds: Model 2 C Comparison of Best-Case Scenario and Worst-Case Scenario with Model Thresholds VII Alternative Thresholds: ASX and ACSI A ASX Listing Rules B ACSI Corporate Governance Guidelines VIII Conclusion
I INTRODUCTION
Publicly listed companies' payments to senior executives and directors are subject to much regulation. Regulation may take the form of mandatory rules requiring companies to disclose all forms of remuneration received by key management personnel. (1) Other rules require shareholders to approve particular payments or benefits, but do not allow shareholders to determine how much is paid or given. (2) Further regulation takes the form of advisory guidelines or principles that companies can choose to adopt or not, with a requirement to explain 'if not, why not' should the company choose to not adopt the practices recommended. (3) Further rules are provided by accounting standards that mandate how items are to be valued for the purposes of the company's financial statements. (4)
For the most part, private and unlisted public companies are spared this regulation. One notable exception is the requirement under Part 2D.2 of the Corporations Act 2001 (Cth) ('Corporations Act')--s 200B(1) of the Act makes it an offence for any company registered under the Act to give benefits without prior shareholder approval to officers upon retirement, unless the benefit falls within one of the limited exceptions in s 200F(1) or the total benefits given fall below the threshold specified in ss 200F(3)-(4) (5) and ss 200G(2)-(3). (6) Regulation of this particular remuneration practice is longstanding, (7) but has received little attention empirically in Australia. (8) As far as we are aware, this is the first study to empirically explore the operation of the thresholds sanctioned by Part 2D.2 of the Corporations Act ('Part 2D.2 thresholds'), ASX Listing Rule 10.19 ('ASX threshold') and guideline 14.1 of the ACSI Corporate Governance Guidelines ('ACSI threshold').
We draw a sample of 28 managing directors from the S&P/ASX 50 index as at 1 July 2005, and use details of the remuneration, service contracts and relevant share plan rules (where available) for each managing director to explore the nature and size of payments that would have been made if that managing director's employment was terminated by the company on 1 March 2006. We then compare the size of these payments to the Part 2D.2, ASX and ACSI thresholds. This comparison highlights the large termination benefits which companies can give while remaining below both the Part 2D.2 thresholds and the ASX threshold. Only four of the 28 termination payments would require prior shareholder approval under Part 2D.2 of the Corporations Act, with payments as large as $129 million sanctioned by the Part 2D.2 thresholds. We find that the ASX threshold is unlikely to be breached by the termination of one executive, but could be triggered if there is some larger-scale termination of a number of senior executives, possibly as the result of takeover or merger and acquisition ('M&A') activities. In contrast, the ACSI threshold would be exceeded by all but one payment. Based on these findings, we question whether a threshold-based approach to deciding which payments are acceptable (in the sense that prior shareholder approval is not required) and which payments should be approved by shareholders in advance may prove unworkable in practice. (9)
In a further contribution to the corporate governance literature, we undertake an empirical analysis of the termination provisions of executive service contracts. Given a hypothetical termination date of 1 March 2006, nine of the 28 companies examined would have made a contractual termination payment of at least 18 months' cash remuneration. These companies would have also permitted some of the accumulated share-based payments to vest. While the remaining contracts allowed for lower levels of cash remuneration to be paid upon termination, these contracts also permitted some, if not all, of the accumulated share-based payments to vest. Shareholders should be interested in how such vesting occurs, especially when no adjustment is made to recognise the reduced period over which performance is measured. If no adjustment occurs, an executive who is in effect sacked is rewarded for performance that has either not actually occurred (because the performance conditions are waived or deemed to be satisfied) or is yet to occur (because the original vesting period is maintained). Hence, the executive reaps the benefits of performance that occurs after they have left the company.
These empirical findings, while shedding light on current practices, raise serious questions about the operation of the Part 2D.2 thresholds. The causal link between a benefit received and the termination is established when paying the benefit is regarded as 'having to do with' (10) the retirement or termination. (11) Merely entering into an agreement that contemplates giving such a benefit does not trigger the requirement for shareholder approval; only the act of payment itself does so. (12) That the payment and the executive's retirement are contemporaneous is relevant to, but not determinative of, the existence of the requisite connection. (13) Establishing this causal link is difficult for share-based payments: does earlier vesting provide a sufficient causal link for the purposes of Part 2D.2? If it does, how should the payment be valued, given that current accounting standards expense share-based payments on a fair value basis measured at the date of grant? (14)
This article is structured as follows. In Part II, we examine some of the existing empirical literature on termination payments, including Geof Stapledon's empirical study of termination payments conducted over the period 1999-2004. (15) Part III explores the nature of termination payments and outlines the operation of the Part 2D.2 provisions of the Corporations Act. We also explore briefly the history of the Part 2D.2 thresholds in an attempt to understand how a threshold based on seven years' remuneration was adopted. The methodology of our study is outlined in Part IV. Part V presents the results of our analysis of executive service contracts and current remuneration practices. Part VI models the thresholds that would apply under Part 2D.2 of the Corporations Act and compares those thresholds with the actual termination payments identified in Part V. Two alternatives to the Part 2D.2 thresholds are provided by the ASX Listing Rules and the ACSI Corporate Governance Guidelines, both of which are explored in Part VII. Part VIII concludes with a series of questions we have in relation to the operation of Part 2D.2 of the Corporations Act. Our further analysis of these questions is the subject of a second article. (16)
II PRIOR LITERATURE ON TERMINATION PAYMENTS
To date, termination payments have received little empirical attention in Australia. The Stapledon study is one notable exception, (17) although we also note the contribution made by The Australian Financial Review's reports on liquidated damages clauses. (18) Many articles on termination payments from United States-based scholars look specifically at golden parachutes and build upon the 1985 article by Richard A Lambert and David F Larcker on this phenomenon. (19) A golden parachute may be triggered as a result of M&A or takeover activity. (20) Thus, the focus of many studies is on whether the presence of a golden parachute influences managerial decisions and recommendations to shareholders on M&As or takeovers. (21) We explore US empirical literature on other types of termination payments and retirement benefits in Part II(A), while in Part II(B) we discuss the Stapledon study and The Australian Financial Review's reports, and highlight how our work extends these studies.
A US Empirical Studies on Retirement and Termination Payments
Studies by David Yermack, (22) and by Lucian Arye Bebchuk and Jesse M Fried, (23) look at termination payments other than golden parachutes. Yermack's study examined the separation payments made to a sample of 179 Fortune 500 chief executive officers ('CEOs') who left their firms during the period 1996-2002. (24) First, he found that only 24 per cent of the CEOs in his sample received some or all of their termination payment in the form of liquidated damages, which is a specific amount for a breach of contract agreed up-front at the time of entering into the contract. (25) Secondly, he observed that many companies deviated from their stated share plan policies in relation to how stock options or other share-based payments would be treated at termination. (26) Observed deviations included 'waiver of forfeiture rules, more generous vesting than usual, and longer exercise periods.' (27) As we report below in Table 1, our research suggests that Australian companies do provide more extensively for termination payments in the form of liquidated damages. However, there is also considerable flexibility in terms of how share-based payments are dealt with. (28) We note that the practices observed by Yermack are frequently provided for contractually or within share plan rules in Australia. This can be seen in the fact that, while all of the managing directors within our sample had employment contracts, only one third of the CEOs in Yermack's sample had written employment contracts at the time of the CEOs' exits. (29) We further note, as Yermack too observed, (30) that it is not uncommon for a CEO to be allowed to retain their right to yet unvested share-based payments after leaving the firm. (31)
Bebchuk and Fried's study examines retirement benefits from the managerial power perspective. (32) This perspective argues that senior executives will seek to avoid having shareholders become incensed over the size of payments made to executives by concealing or camouflaging this pay. (33) In the US, retirement benefits to senior executives are primarily delivered via defined benefit schemes known as supplemental executive retirement plans ('SERPs'). As Bebchuk and Fried note, companies are only required to report the total liability of the company's retirement or pension plans. (34) Accounting standards do not require separate reporting of SERP liability for each executive, and thus shareholders do not see the steady increase in the executive's SERP benefits as another year of service accrues. (35) Bebchuk and Fried do not quantify the potential benefits that such executives will obtain due to a lack of disclosure but suggest that such benefits are likely to be sizeable. (36)
A study by Bebchuk and Robert J Jackson Jr quantifies these payments by undertaking an actuarial analysis of the pension plan benefits of two samples of CEOs: (1) a sample of former S&P 500 CEOs who left that role during a 17 month period from the beginning of January 2003 to the end of May 2004; and (2) a sample taken from all CEOs in the ExecuComp database between the ages of 63 and 67 on 31 December 2003. (37) Their study reports that the average annual pension benefit to the retired CEOs in the first sample was US$1.1 million for life. (38) The current median actuarial value of this pension benefit was over US$14 million. (39) The average annual pension of the second group of CEOs was US$1.5million, with a current median actuarial value of more than US$15 million. (40) They estimate that the median ratio of pension benefits to total executive compensation (including equity-based compensation) received per CEO was 35.3 per cent for the first group and 27.8 per cent for the second group. (41)
In our empirical study, we do not take into consideration accumulated superannuation entitlements. Thus, any amounts we show as a termination payment will not include superannuation. We observed an average superannuation expense of $202 600 in our sample of 28 managing directors, with one managing director's company contributing over $620 000 by way of superannuation. As Bebchuk and Jackson argue, any consideration of executive remuneration that does not take into account the amount of retirement benefits given by way of pensions or superannuation is underestimating the value of executive compensation. (42)
Finally, we note survey research compiled by Booz Allen Hamilton ('BAH') on the reasons behind CEO terminations in its annual study of CEO turnover in 2500 of the world's largest public companies. (43) In its most recent special report, BAH found that turnovers due to conflicts within the board increased from two per cent of turnovers in 1995 to 11 percent in 2004-06, (44) with nearly one in three turnovers being involuntary, including turnovers due to merger or private equity buyout. (45) This suggests that the type of termination we use as the trigger event in our empirical study--a termination initiated by the board for reasons other than misconduct or 'for cause'--is not some remote possibility.
B The Stapledon Study
Stapledon's 2005 study of termination payments to Australian executives was the first such analysis of its kind despite recent public concern over remuneration of company executives. (46) Aside from a comprehensive survey of the academic literature, (47) public policy analysis (48) and good practice guidelines relating to termination payments to company directors, (49) Stapledon's study presented empirical findings based on the termination payments made to 40 executives of listed companies over the period 1999-2004. (50) Stapledon noted that the average termination payment was $3.65 million, with a median payment of $3 million. (51) Moreover, nine of the 40 termination payments observed exceeded $6.5 million. (52) One feature of Stapledon's newspaper-based analysis is that the headline figure reported as a termination payment in the media does not discriminate between the actual termination payment and other accumulated payments legally due to the executive, such as accumulated long service leave and annual leave. (53) Stapledon suggested that one issue to be addressed as part of an informed debate on termination payments is the generosity of the statutory thresholds. (54) He further called for an empirical analysis of executive service agreements, with detailed analysis of the provisions of liquidated damages clauses to inform the debate as to whether such clauses are optimal. (55)
Our work, while building directly on Stapledon's, also has some key points of difference in its focus and methodology. Our study indeed sheds light on current practice, as he suggested, in its empirical analysis of both executive service agreements in Part V and Tables 1-3, and in the analysis of the Part 2D.2 thresholds in Part VI and Table 4. While we also draw our data from company annual reports, as is done in Stapledon's study, our data is taken from 2005 annual reports, the first year of company reporting under the new remuneration disclosure requirements in the Corporations Act. (56) This material provides unprecedented information not only about remuneration payments, but also about contractual termination provisions. These disclosure requirements provide the necessary data to illustrate what the new limits in the Part 2D.2 thresholds might actually allow in practice. As will be explained in Part V, our methodology is based on using real remuneration and contractual provisions to explore the hypothetical situation of a forced termination, whereas Stapledon's study relies upon actual terminations reported. We note in particular that Stapledon's study did not explicitly consider the fate of share-based payments but relied on the termination payment disclosed as such in the annual report. (57) Based on our empirical results in Table 4 and our analysis of the provisions of executive service contracts in Table 1, it is possible that many executives received additional benefits over and above what has been disclosed as a termination payment.
Our work extends the review of contractual termination benefits highlighted by The Australian Financial Review (58) by undertaking a more detailed analysis of the contractual provisions featured in that article. In Part V and Table 2, we analyse how the contractual terms fit into the Corporations Act ss 200F-200G exemptions and thresholds. In Part V and Table 1, we extend the analysis by illustrating how share-based payments will be treated upon termination.
III REGULATION OF TERMINATION PAYMENTS
In this Part, we examine the nature of termination payments and the current Corporations Act requirements; as well as present a brief history of the Part 2D.2 thresholds.
A The Nature of Termination Payments
Of its nature, a termination payment signifies the end of the employment relationship between a company and its executive. As noted above, regulation of executive remuneration is largely disclosure-based rather than being prescriptive or proscriptive. (59) Shareholders may choose to use mechanisms such as the advisory vote on the company's remuneration report, (60) the re-election of the company's directors or voting in relation to the issue of securities to signal their approval or disapproval of current practice. (61) There is no system of shareholder redress against an executive once they have 'left the building' after a termination payment has been made, although the labour markets for executive and non-executive directors will take note of the reasons for the executive's forced departure if and when the executive...
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