THIS is the year of the 'second strike'. Australian company boards of directors are quaking at the prospect of getting whacked by shareholders in the coming annual general meeting season.
Arguably, though, that quaking is more being done gratuitously on their behalf by the media and fee-seeking self-promoting governance advisers than actual company boards.
A case in point was a headline over a commentary in The Age - "Directors sweat over 'two strikes'." If they really are sweating, they don't understand the rule.
For, despite being much discussed, the practical operation of the 'two strikes' rule does not seem to be actually understood. That it is, basically, a paper tiger.
At worst, its only impact would be the 'embarrassment factor'. Goodness me, the board of Company X got a second strike from shareholders.
The fundamental reality is that it is only the third strike, so to speak, that matters. Importantly, it always has been only that third strike that mattered.
Again, most importantly, that third strike was always available. In short and in sum, nothing of substance has changed. Boards are no more vulnerable to the wrath of shareholders than they ever were.
Every company has to put its remuneration report to a shareholder vote at the AGM. If more than 25 per cent of votes cast are 'no' a 'first strike' is recorded.
The vote has no effect on the report, far less what's paid to executives. Even if 50 per cent vote to reject it, even if 90 per cent vote to reject it, nothing.
Except that before the rule change, a company could get a 'no' vote every year, even literally forever, and it would have no effect.
Now if there are two successive 'no' votes, while there is still no consequence for executive remuneration, the second 'no' - 'strike two' - triggers a course of action.
Because the rule came into effect before the AGMs last year, and a number of companies got 'no' votes then, those companies will face the prospect of 'strike two' at their AGMs this year.
If they get a 'strike two' at this year's AGM, immediately at that meeting a 'spill resolution' will have to be put. It will be passed if more than 50 per cent vote for it.
If that happens, the company has 90 days to call another meeting, the 'spill meeting,' at which all the directors except the managing director have to stand for re-election.
Oh my God! Strike two and boards will be on course to be sacked! Except for arithmetic and logic.
Shareholders can trigger a 'spill resolution' with a 25 per cent vote against the REM report; but they can only pass it with a 50.1 per cent vote at the same meeting.
So consider two cases: where somewhere between 25 and 50 per cent vote 'no' to the REM report and where 50.1 per cent or more vote 'no'. In the first case, arithmetic tells us that somewhere between 50 and 75 per cent will have voted yes to the REM report.
Logic then suggests that if 50 per cent or more have voted 'yes' to the REM report they are going to vote 'no' to the spill resolution? Why would they want to sack a board which they've just endorsed?
The second case is where 50.1 per cent or more have voted 'no' to the REM report. Yes, arithmetic tells us that if they all stuck to their guns, the subsequent spill motion would pass.
But logic no longer mandates that they all would definitely stick to their guns. Some shareholders would want to make the gesture of opposition to the report, without setting in chain a move to a board spill.
But even if enough votes stuck, it only initiates the process. There has to be a totally fresh meeting, perhaps as long as three months later, for the actual vote on the board.
The vote at that meeting is not restricted to those who attended the first meeting. The board could seek to drum up absent shareholders.
More fundamentally, it is an entirely different proposition for shareholders to vote to sack some or all of the board; as against the earlier votes which were essentially just gestures.
It is this, and only this 'third strike' that really counts.
And that's the fundamental point. If more than 50 per cent of voting shareholders want to go through this extended process to sack some or all of a board, there is - excitable commentators please note - a much easier alternative.
Just vote against their re-election at the AGM. Nominate others to stand for election at the AGM. Call a special meeting to sack some or all of the board. Or some combination thereof.
Yes, a second strike, a spill resolution, a spill meeting, would be embarrassing. But none of this over-rides the basic point.
A sufficient number of shareholders must want to sack some or all of the board. That sufficient number must be prepared to do it and live with the consequences.
It has been ever thus. It remains ever thus. The 'two strikes rule' is an elaborate gesture, but ultimately also a charade.
Much has been written about the executive pay debate and the new two-strikes rule that gives shareholders more power to rein in remuneration.
Less considered is the rule's effectiveness in its first application in the recently concluded annual general meeting season, and what it means for companies that had a strike against their remuneration report and could face a board spill next year.
Shareholders of listed companies now 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 AGMs.
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, requires a spill meeting within 90 days to elect directors.
Investor Weekly (a Morningstar publication) research shows about 9 per cent of ASX 200 companies received a vote of more than 25 per cent against their remuneration report.
That figure is down from a three-year average of about 14 per cent, had the rule been hypothetically in force from 2008 to 2010. In raw figures, only a small number of ASX 100 companies received a strike against their remuneration report.
Politicians and some investor groups claim this is evidence of the two-strikes rule's effectiveness.
That is partly true.
Certainly, there is evidence some boards of ASX 200 companies, especially those with more contentious remuneration policies, made extra effort to communicate their position on executive pay matters to superannuation funds, fund managers, proxy advisers and retail investor groups.
Cynics might argue the two-strikes rule has so far achieved little, other than costing boards huge time and effort to deal with the legislation.
For some companies that received a first strike on the remuneration report there may have been a good reason, such as aligning an executive's pay to non-financial performance, such as safety results, which institutional investors did not favour.
Others that have dominant shareholders may care little about the two-strikes rule, for there is no chance that 50 per cent or more of eligible votes will be cast to spill the board. Board spills from the two-strikes rule seem a remote possibility in many ASX 200 companies, given 50 per cent of the eligible vote is required. The big problem is potential board instability in smaller companies, where minority interests can potentially use the rule for mischief.
One of Australia's most respected remuneration advisers, John Egan, of Egan Associates, says: "The principal and potential unintended consequence [of the two-strikes rule], although not thought through at the time of legislation, is the fact that more than 85 per cent of shareholders may choose not to submit a negative vote in relation to the remuneration report, yet find that their board, about whom they are either neutral or positive, will all have to stand for re-election should a significant minority of shareholders choose, for whatever reason, to vote against the remuneration report." Egan says UGL Limited (UGL), which had noted shareholders' concerns and adjusted its chief executive's pay in the 2010 financial year, and had outperformed its traditional peers, received a negative vote of 30 per cent against its remuneration report, driven by less than 12 per cent of shareholders because of the spread of the share register.
This meant more than 85 per cent of shareholders were not opposing the remuneration report.
The next 12 months will show just how large these 'unintended' consequences from the two-strikes rule are.
The likely outcome is that few ASX 100 companies receive a second strike, and far fewer again have a board spill, which could create instability and hurt the share price.
The other likely outcome is that the two-strikes rule does little to rein in absolute executive pay and improve alignment between pay and performance. Perhaps its greatest contribution might be to force boards to better explain their remuneration strategy to institutional investors and provide a clear remuneration report in the annual report.
That alone would make the two-strikes rule a worthy addition to the legislative landscape. A higher threshold, at least 40 per cent or 50 per cent to ensure minority interests do not have a disproportionate say on pay matters and outweigh the majority, would further strengthen the rule.
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