Why all executives should read what Hayne has to say about remuneration, governance and culture

First published 12 February 2019

While Commissioner Hayne’s recommendations are rightly receiving much attention from those involved in the financial services industry, his observations in relation to remuneration, governance and culture will ultimately be seen to have much broader application. They contain important messages for anyone involved in a senior leadership or management role in an organisation, including those outside the financial services industry.

Commissioner Hayne was asked to inquire into, and report on, misconduct in the banking, superannuation and financial services industries. In doing so, he make four key observations:

• First, he observes a fundamental connection between conduct and reward. Poor conduct was driven by the pursuit of financial gain by individuals, in almost every case. The individuals involved were financially rewarded by reference to the sales they achieved, and the profit they generated, regardless of the manner by which these results were achieved.

• Second, he observes a gross imbalance of power and information between those selling financial products and services, and their customers.

• Third, he observes the that where someone’s financial interests are in conflict with their duty (to their client/customer), they will almost always put their financial interests ahead of their duty, or seek to strike some compromise, rather than pursue the best interests of their client/customer.

• Fourth, he observes that misconduct will be deterred only if those responsible are held to account. It is not only the regulators that play a role in holding wrongdoers to account. Financial services entities must also hold their employees, officers and agents to account.

These observations (except, perhaps, the second) have application well beyond the financial services industry. They are truisms that apply across many industries.

The reputational risks to an organisation arising from misconduct by its employees, officers and agents are not unique to the financial services industry. All organisations that trade on their reputation need to understand the connections that Hayne draws between the risk of reputation destroying misconduct and an organisation’s remuneration practices, governance and culture.

Accordingly, all entities that trade on their reputation would do well to consider the following questions relating to culture, governance and remuneration:

• Is there adequate oversight and challenge by the board of directors and its gatekeeper committees of emerging risks, including non-financial risks?

• Is it clear who is accountable for risks, and how they are to be held accountable?

• Are issues and risks identified quickly, referred up the management chain, and then managed and resolved promptly?

• Is enough attention being given to compliance? Is it working in practice?

• Do incentive and remuneration practices recognise and penalise poor conduct?

Remuneration

Hayne observes that remuneration practices within the financial services industry have been too focussed on financial outcomes (sales and profit), and insufficiently focussed on customer outcomes, misconduct and other non-financial risks.  

He identifies deficiencies in the design of many executive remuneration arrangements (eg variable remuneration too heavily focussed on short term return to equity, and inability to claw back vested remuneration). But he also observes that misconduct more often resulted from poor implementation (i.e the failure of boards and management to exercise their ability to reduce or clawback remuneration for poor risk management or compliance issues) rather than design. He also suggests that reductions to an executive’s variable remuneration for poor risk management should be communicated within an organisation (but not necessarily publicly) to send a clear message to all staff about accountability and what the board considers to be unacceptable conduct. 

For customer facing staff, Hayne reiterates that how an employee achieves sales is at least as important as the value of sales achieved. He observes that the ends that entities are seeking to achieve via variable remuneration can be achieved through other means (such as positive feedback), with fewer intrinsic risks; and that variable remuneration based on group performance, rather than individual performance, is more likely to encourage collaboration and teamwork.

The issues that poorly designed or poorly implemented remuneration and incentive arrangements can produce are not constrained to the financial services sector. Examples of individuals who have been motivated to put their financial (self) interest above the interests of their clients and customers because of the way they are personally remunerated abound in other sectors, not least the legal and professional services sectors where a legal duty to the client exists. All organisations that use performance based remuneration would be well advised to review their arrangements in light of Hayne’s observations.

Culture

Hayne describes the culture of an entity as ‘what people do when no one is watching’. Given the potential for an entity’s culture to drive or discourage misconduct, he considers it essential for entities to form a view of their own culture, identify any problematic aspects, develop and implement a plan to change them, and then re-assess to determine whether they have succeeded.  

His observations on the responsibilities that entities have in relation to their culture, extend beyond the financial services sector.

Governance

Governance encompasses the processes by which an entity is controlled and run, and the mechanisms by which it and its people are held to account. Hayne connects misconduct to governance failings in three ways.

• First, failings by boards. The evidence before the Royal Commission showed that too often, boards did not get the right information about emerging non-financial risks; did not do enough to seek better information; and did not do enough to challenge management’s approach to these risks.

• Second, failings of entities. The evidence also showed that too often, financial services entities put the pursuit of profit above all else, including the interests of their customers and compliance with the law.

• Third, lack of accountability. The evidence further showed that too often, it was unclear who within an entity was accountable for what. Without clear lines of accountability, consequences were not applied, and outstanding issues were left unresolved.

On the second point, Hayne observes that although companies exist to generate financial returns for their shareholders, there are other things that the boards of financial services entities must consider in the course of exercising their powers and performing their duties. His observations on the importance to the national economy of the long-term stability of the largest entities may not apply to entities in other sectors, but his comments regarding the duties of every director of a corporation to assess the best interests of the corporation over more than just the current or most recent accounting period, have broad application across all industries.

According to Hayne, “the longer the period of reference, the more likely it is that the interests of shareholders, customers, employees and all associated with any corporation will be seen as converging on the corporation’s continued long-term financial advantage. And long-term financial advantage will more likely follow if the entity conducts its business according to proper standards, treats its employees well and seeks to provide financial results to shareholders that, in the long run, are better than other investments of broadly similar risk.”

Take-away

If you think the findings of the Financial Services Royal Commission are only relevant to participants in the financial services industry, think again!