Institutional investors need to consider a fundamental flaw in the federal government's new executive pay rules: the ability for minority interests to have a greater say than the majority.
As they stand, the new rules could create more board instability and potentially damage share prices, especially in smaller listed companies.
The centrepiece of the Corporate Amendment (Improving Accountability on Director and Executive Remuneration) Bill 2011, which entered Parliament in February and comes into effect on 1 July (assuming it passes the Senate), is the controversial two strikes rule.
Shareholders of listed companies will have to vote on whether to spill all board positions if 25 per cent or more votes cast are not in favour of adopting the remuneration report at two successive annual general meetings.
A spill resolution must then be put to a vote at the second AGM and if passed with 50 per cent or more of eligible votes cast, will require a spill meeting within 90 days to elect directors.
At face value, the two strikes rule seems like a modest change. In its submission to Treasury, the Australian Council of Super Investors said: "These provisions would, for the vast majority of companies in the ASX 200, remain largely irrelevant and would act as a deterrent for recalcitrant companies that continue to ignore shareholder concerns on remuneration."
The Productivity Commission in its report on executive pay in Australia identified only 11 ASX 200 companies that would have met the 25 per cent threshold between 2007 and 2009.
But the 48 submissions from business and management lobby groups barely considered the issue from the perspective of small and medium-sized listed companies.
Consider a listed company where only 40 per cent of votes are cast for a resolution to adopt the remuneration report. Under the two strikes rule, 10 per cent of votes could trigger the first strike (25 per cent of total votes cast). Simply put, a shareholder with a 10 per cent interest could trigger the first and second strikes, create perceptions of board instability and potentially damage the share price.
The minority shareholders might have a good reason to trigger the first strike - the board is overpaying executives and ignoring their concerns. Board instability can be a good thing if directors are not acting in the interests of all shareholders.
But there is a risk minority interests could use the two strikes rule to create mischief and to serve their own interests. And there is a broader concern as to why the view of minority shareholders should ever override the majority view.
Submissions by the Business Council of Australia and others on the new rules identified this unintended consequence. Yet for all the heated debate, the government pushed ahead with the two strikes rule and toned down other contentious aspects of the draft bill, such as the commissioning and retention of recruitment advisers.
It seemed determined to give minority shareholders much greater say on executive pay, even if small shareholders often use their vote on the remuneration report to send another message to the board, such as their dissatisfaction with lower dividends.
There are also concerns shareholders might be reluctant to vote against the remuneration report at the second AGM for fear of triggering a board spill, creating board instability and undermining the share price.
Whatever the case, super funds and fund managers, which often dominate share registers, will soon face the prospect of minority interests triggering a first strike in some companies, even though the main funds on the share register might vote for the remuneration report.
Still, if the Australian Council of Super Investors is right, the changes will have a modest effect on the top 200 companies, which are the main target for institutional funds. And there is a view that big business has overreacted to the executive pay amendments, which were badly needed in the first place.
The reality is Australia's intense focus on executive pay has given business a governance framework that goes beyond other western countries in this area.
Institutional investors would be wise to watch how the change plays out when the AGMs for companies with 30 June year-ends kick off from October. It is a more significant change than many realise.
Tony Featherstone is a former managing editor of BRW and Shares magazines.
