As an independent director (ID) and member of the remuneration committee (RC), what
would you do if you had "differences in opinion from the management over certain
company affairs" relating to how management should be compensated?
For two IDs at Lian Beng Group Ltd, a building construction and civil engineering company
listed on the SGX, their course of action was to resign in mid-2015. Both had been members
of the board since the company's IPO in 1999, so the decision could not have been made
lightly.
In a nutshell, the differences in opinion centred on how the performance bonuses of the
chairman and managing director, and the two other executive directors (EDs) – who are also
the chairman's siblings – should be computed.
Lian Beng's position was that the pre-existing service agreements for the chairman and the
EDs expressly based their performance bonuses on "net profits of the group before tax and
before extraordinary items". Over the years, this had, in practice, been interpreted as "net
profit before tax and before minority interest", even though the agreement was silent on
the treatment of minority interest.
The company's perspective was understandable, since (a) minority interest falls below the
net profit before tax line in statements of accounts, (b) the service agreements were not
explicit one way or the other on the point of minority interest, and (c) its approach to
determining performance bonuses has historically and consistently been "before minority
interest".
The two IDs, however, took the view that, for the financial year ended 31 May 2014
(FY2014), the performance bonuses for the chairman and EDs should have been based on
group net profit before tax and after minority interest.
In response to a query from the SGX, Lian Beng disclosed that the performance bonus for
the three EDs in FY2014 would have been approximately S$2 million lower had it been
computed "after minority interest".
The IDs' position that the performance bonus measure should have accounted for minority
interests is not unusual. Generally speaking, if minority interests are significant, an "after
minority interest" measure is seen to be better aligned with shareholders' interest.
Profit test
For many companies, the amounts involved are small and using a "before minority interest"
measure has no significant impact on profit before tax calculations. This was the case for
Lian Beng for many years. The difference for Lian Beng in FY2014 was that the minority
interest component grew to nearly S$40 million, or around 28 per cent of net profit before
tax. This was probably not foreseen at the time the bonus measures were first crafted in the
service agreements of the three EDs.
The incident highlights the need for RCs to carefully consider a number of factors when
defining "profit" as a basis for determining management bonuses. The relevant profit test
can be based on one or more of the following:
Before or after tax
Before or after minority interest
Before or after accrual of bonus expense
Before or after revaluation of gains or losses
Before or after foreign exchange gains or losses
For each of these factors, the RC needs to consider management's ability to influence results
and ensure that remuneration is properly aligned with the company's performance and
shareholders' interest. As an example, foreign exchange volatility is dependent on
macroeconomic factors that are beyond management control and thus such gains or losses
would tend to be excluded. However, if management is expected to manage currency
exposure, including deploying appropriate hedging strategies, then this item should be
taken into consideration in determining bonuses.
A more significant factor is the revaluation of gains or losses which can be sizeable, and
include a high level of subjective input from management. As such, there are considerable
risks in including such items in bonus determination. Regardless of the measures used, the
RC should test potential outcomes and calibrate rewards accordingly.
It is common for service agreements to be in place at the time of an IPO. However,
businesses and strategies do change over time. An RC needs to regularly evaluate and
confirm that performance rewards continue to be appropriate for evolving businesses. Thus,
it is important for service agreements to be time bound, and subject to subsequent review
by the RC.
Lian Beng's own annual reports indicate that its service agreements are valid for three years
and subject to automatic renewal every three years. Best practices would suggest that RCs review incentive plans regularly and update them to ensure alignment with market
conditions and business objectives.
Room for discretion
Furthermore, where RCs lack technical expertise in compensation matters, it is advisable to
engage subject matter experts who can provide independent advice.
Finally, while service agreements should be clear on performance measures and incentive
structures, they should not be so formulaic as to leave no room for the RC to exercise
discretion.
A version of this article was originally published in The Business Times on Jan 18, 2016.