How the two-strike rule became a big stick

15 November 2012 Myriam Robin

It’s the second year of the two-strike rule’s operation, and already, company boards have felt its impact. But in light of controversial second strikes at Globe International and MZI Resources yesterday, and Penrice Soda two weeks ago, is the rule working as intended?

The two-strike rule is an amendment to the Corporations Act that was introduced in 2009 with the view to curbing excessive executive salaries by empowering shareholders to stand against it.

Now, every year at the annual general meeting, shareholders have to vote on their company’s remuneration report, which lists the pay of key executives. If 25% or more vote against a report, that’s a first strike. Executives and other conflicted parties are not allowed to vote on the remuneration report, even if they have a large shareholding. If this happens two years in a row, a motion on whether to spill the board is automatically triggered. If 50% vote in support of this motion, the company is forced to hold an extraordinary general meeting (EGM), where the current board need to recontest their positions and others can put themselves forward.

The unintended consequences: Four early cases

So far this year, the second year of the rule’s operation, four companies – MZI Resources, Ask Funding , Penrice Soda and Globe International – have received a second strike. Two of them then had most shareholders vote for a board spill, forcing them to hold an EGM within 90 days. At Penrice Soda and Globe International, shareholders appear to have voted against the remuneration report for reasons other than a concern about executive pay.

At MZI Resources, company chair Mal Randall says he has no idea why one major shareholder voted against the remuneration report, resulting in the strikes. “We have had no explanation,” he told the Australian Financial Review. “I have two senior executives who are overworked and underpaid… It is just the system being abused. If people are going to vote against remuneration they should have to give a reason.”

At Globe, the current management owns 67.8% of the company. They couldn’t vote on their own remuneration due to the conflict of interest, but they can vote on whether to allow themselves back on the board at the EGM. For this reason, Globe chairman Paul Isherwood described the second strike at his company yesterday as “an expensive exercise in nothing”.

That’s certainly John Colvin’s view. Yesterday, the managing director of the Australian Institute of Company Directors told media that such use of the two-strike rule was “certainly a big concern”.

“When we argued against the legislation, we warned it would be used for things other than remuneration,” he said. “And that’s certainly what’s been occurring. It’s used as a weapon to oust directors.”

The two-strike rule, combined with a rising tide of regulation surrounding company directors, was discouraging good directors from taking positions in public companies, Colvin said. In its index of director sentiment, released yesterday, respondents said they spent, on average, 26% of their time dealing with compliance issues.

Judith Fox, the research director of Chartered Secretaries Australia, shares Colvin’s concerns about the use of the two-strike rule, saying in some cases it confuses and obfuscates the real causes of shareholder dissatisfaction.

“There is potential for misuse,” she says. “Where it’s being used for matters unrelated to remuneration… we don’t think that’s a good corporate governance outcome.

“When it’s used for issues other than remuneration… the boundaries are blurred, and I don’t think it helps anyone’s understanding, and therefore the governance framework.”

The intended consequences: Executive pay has fallen

Fox says this is a shame because she thinks in most cases, the two-strikes rule has had a beneficial impact on corporate governance.

“I think the rule has largely worked the way it was supposed to. It’s really enhanced shareholder engagement. There’s a consensus across the board about that. Most companies were already placing a high priority on shareholder concerns. But what the rule has done is it’s bought outliers [companies that weren’t engaging], into the fold.”

This draws to light an important consideration. The two-strike rule’s negative effects – the spilling of boards and the like – are very clear. But a lot of the good it does happens behind closed doors. After receiving a first strike, many companies have worked hard to avoid a second, often by lowering or clarifying aspects of their executive pay. In this sense, the rule is working, even if such positive stories are less likely to make the front page.

Stephen Mayne, the research director of the Australian Shareholders’ Association, which represents retail shareholders, is a big fan of the two-strike rule.

On executive remuneration, the rule’s intended purpose, Mayne says the regime is having a “profoundly positive” effect. “Executive remuneration is being wound back.”

He’s dubious about whether its use in non-remuneration power struggles is a bad thing. “It only takes 5% of shareholders to propose a spill motion or call an EGM,” he says. “If 25% use a second-strike to do the same thing in a small number of cases, well, big deal. All it does is trigger an exercise in corporate democracy.”

Mayne’s sentiments are backed by a recent survey of executive pay in the ASX100, conducted by the Australian Council of Superannuation Investors, which found executive pay declined 8.9% in 2011, largely due to a fall in awarded bonuses.

However, Colvin is wary of attributing this to the two-strikes rule, saying the decrease in total salaries is what you would expect in a challenging economic environment.

“It’s the market doing what it’s supposed to do,” he says. “As the tide goes down, so does remuneration. If you don’t hit your hurdles, you don’t get your bonus.”

Revitalising the AGM

But there’s another benefit to the two-strike rule, Mayne says. In September, the Australian government’s corporations and markets advisory committee released a discussion paper questioning whether the AGM still served its function. It cited problems with attendance, and questioned whether the AGM was still an effective vehicle for shareholder engagement.

Mayne, who for years has been one of the few shareholders turning up to AGMs, says the two-strike rule has energised the AGM once again.

“We’ve seen AGMs such as Seven West and Whitehaven Coal, the one at Fairfax, Cochlear and Echo, they’ve all been highly relevant and energised because of the discussion and disclosure triggered by the two-strikes regime.”

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