This article by me was first published by Complinet.

The Australian Prudential Regulation Authority (APRA) has started a second round of consultation on changes to its governance standards for authorised deposit-taking institutions (ADIs), general insurers and life insurers (currently contained in APRA’s Governance Prudential Standards APS 510, LPS 510 and GPS 510) to deal with the risks involved in remuneration structures of APRA-regulated institutions.

The proposed changes will implement the Financial Stability Board’s Principles for Sound Compensation Practices which were endorsed by the leaders of the G20 in April 2009. The Principles aim to ensure effective governance of compensation, alignment of compensation with prudent risk-taking, and effective supervisory oversight and stakeholder engagement in compensation.

It reflects government, investor and community concern in recent years at excessive risk-taking, conflicts of interest and apparent examples of individual greed taking priority over the interests of shareholders and customers.

The standards will come into effect on 1 April 2010.

Which institutions are affected?

APRA’s remuneration proposals will apply to all APRA Regulated institutions: authorised deposit-taking institutions (ADIs), general and life insurers (including friendly societies) and authorised non-operating holding companies.

APRA‘s remuneration requirements will also apply to Australian branches of foreign ADIs and eligible foreign life insurance companies.

How the standards will work

The new standards will require the establishment of a Board Remuneration Committee and the adoption by Boards of a Remuneration Policy.

APRA has proposed that the composition of the Board Remuneration Committee be consistent with that of the Board Audit Committee:  it must have at least 3 members and all members must be non-executive directors with a majority of independent directors and an independent chair.

The Committee’s functions include conducting regular reviews of the Remuneration Policy including an assessment of its application, effectiveness and compliance with APRA’s requirements. The Committee must also make recommendations to the Board on the remuneration of the personnel covered by its Remuneration Policy.

APRA has the power to exempt a regulated institution from establishing a Board Remuneration Committee.

APRA will allow the use of a group Board Remuneration Committee for regulated institutions that are part of a group.

For foreign ADIs, the senior officer outside Australia must perform the responsibilities of the Remuneration Committee.

Who does the Remuneration Policy apply to?

APRA will require that the Remuneration Policy apply to three categories of personnel:
1. responsible persons (excluding responsible auditors and non-executive directors);
2. risk management, compliance, internal audit and financial control personnel (collectively, ‘risk and financial control personnel’); and
3. all other employees or agents for whom a significant portion of total remuneration is variable and determined by performance measures. A person need not be an employee of the regulated institution to be covered, and may be an employee of a subsidiary or otherwise related company, a consultant, a contractor or an agent.

The key issue is that personnel need to be remunerated in a manner which does not expose the institution to excessive risk, for example if the independence of an internal auditor is affected or if the remuneration arrangements of third party brokers provide inappropriate incentives.

The Remuneration Policy

The Remuneration Policy must form part of a regulated institution’s risk management system.

The Remuneration Policy must outline the remuneration objectives and the structure of the remuneration arrangements, including but not limited to the performance-based remuneration components,of the regulated institution.

The performance-based components of remuneration must be designed to align remuneration with prudent risk-taking, and must allow for adjustments to reflect:
(a) the outcomes of business activities;
(b) the risks related to the business activities taking account, where relevant, of the cost of the associated capital; and
(c) the time necessary for the outcomes of those business activities to be reliably measured.

The Remuneration Policy must provide the Board with discretion to adjust performance-based components of remuneration downwards, to zero if appropriate, if such adjustments are necessary to:
(a) protect the financial soundness of the regulated institution; or
(b) respond to significant unexpected or unintended consequences that were
(c) not foreseen by the Board Remuneration Committee.

The Remuneration Policy must prohibit responsible persons who receive equity or equity-linked deferred remuneration from hedging their economic exposures to the resultant equity price risk before the equity-linked remuneration is fully vested and able to be sold for cash by the recipient.

APRA’s preference is for deferral of both the allocation and vesting of performance-based remuneration to allow time for the outcomes of the business activities to be reliably measured. This involves measuring results retroactively and putting performance-based remuneration at risk until results can be validated.

APRA’s attitude is that Boards need to retain the discretion to make adjustments to performance-based remuneration for two reasons. One is to protect the financial soundness of the regulated institution in adverse circumstances and the other is in circumstances where formula-based bonus calculations create material unexpected outcomes. Both of these discretions are intended to cater for extreme circumstances.

On incoming payments, APRA recognises that competition in recruiting may encourage some regulated institutions to provide cash payments or cash bonuses to incoming staff. APRA nevertheless expects institutions to place suitable deferral and performance hurdles on such payments.

However APRA has stated that its remuneration requirements are not intended to prescribe business decisions regarding pay levels or limit innovative methods of rewarding staff, provided such measures do not compromise the requirements of the prudential standards.

Timetable

APRA expects to release its final governance standards in November 2009. They are unlikely to depart materially from the revised draft standards recently released.

The standards will come into effect on 1 April 2010. By that date, regulated institutions will be required to have:
• a Board Remuneration Committee in place; and
• a Remuneration Policy in place.

Regulated institutions must also ensure that all contracts negotiated or renegotiated after the release of the final standards comply with the standards.

Contracts already in force at that time must be fully compliant at the first opportunity for renegotiation, and in any event by 31 March 2013.

Compliance tips

Companies should review their current executive employment contracts and consultancy agreements (including third party sales and distribution agreements) to identify whether they are with affected persons or groups of persons and, if so, note the review and termination dates to determine when the agreements need to be amended to comply with the standard.

What else?

The Productivity Commission is examining executive remuneration for listed companies in Australia and has announced that it will release a discussion paper outlining its recommendations by the end of September.

Separately, the Government has announced a lower threshold for shareholder approval of termination payments to directors and executives as well as new rules for the taxation of shares allocated under employee share schemes. These changes may have implications for APRA's proposals.

The government is also reviewing continuous disclosure requirements in respect of remuneration.