Note: This is the second in a series of articles on remuneration.
By Mak Yuen Teen
On 21 December 2021, the Government announced that another S$400 million in Jobs Support Scheme (JSS) payouts will be disbursed to employers from 31 December 2021. This will bring the total amount of JSS support to S$28 billion since the scheme was introduced in February 2020.
The intention of the JSS is to offset local employees’ wages and help protect their jobs during this period of economic uncertainty caused by the pandemic. However, last year, JSS and other government grants contributed to increases in the remuneration of directors in some companies.
For example, at Old Chang Kee, these grants helped boost the amounts paid to directors to S$5.5 million in FY2021, nearly double the amount in FY2020. When questioned by the Securities Investors Association (Singapore) in its “Q&As on Annual Reports” initiative, the company said that its “Remuneration Committee (RC) considered it unnecessary to exclude government grants, as the Company had made use of government support measures to continue maintaining staff morale, including paying year-end bonuses, sustained employees’ jobs, and had increased or maintained staff salaries during FY2021. The outsized company performance was not solely due to government support measures. It was also due to other initiatives to improve profitability, including growth in new non-retail revenue streams, and proactive cost containment measures across all departments.”
The fact is that increases in government grants, including from JSS, contributed S$6 million to a S$8.1 million increase in the company’s profit before tax for FY2021. Meanwhile, total salaries and bonuses (excluding amounts paid to directors) fell by nearly 15% and total CPF contributions by 23%, suggesting that ordinary employees had faced job and/or salary cuts.
The RC of Old Chang Kee added that it “has reviewed the bonuses for the Executive Directors. Performance bonuses are based on the service agreements signed with the Executive Directors, which included a percentage of profit sharing based on the adjusted profit before tax as elaborated above”.
Performance bonuses
Unfortunately, bonus terms in service agreements are often ambiguous, simplistic, formulaic or opaque. RCs may be unable to make discretionary adjustments once the service agreements are in place.
Where management are controlling shareholders or their family members, one way for IDs to be “retired” prematurely is to do a proper review of service agreements.This happened at Swissco and was also the first case of “noisy” resignation of IDs in SGX-listed companies. It was discussed in my article “Clarifications that obfuscate” (Business Times, 15 April 2008).
In that case, the annual bonus of the executive chairman was based on a percentage of the profit above a minimum threshold, with no upper limit. The two IDs, Dr Chiang Hai Ding and Mr Rohan Kamis, had pushed for a change in the bonus formula in the new service agreement. They felt that achieving the profit threshold was reasonably assured and a bonus was therefore essentially guaranteed. Return on equity, they felt, was a more sensible way to determine the bonus.
In response, the executive chairman, who was also the major shareholder, wanted to re-appoint the two IDs for just one-year terms and at the end of each year, he would decide whether he was satisfied with their performance, and if not, the IDs were to resign. To their credit, the IDs resigned immediately as they believed this would compromise their independence, but not before writing detailed resignation letters setting out in considerable detail the circumstances of the disagreement and insisting that their resignation letters be made public. This case shows the challenge that truly independent IDs face in changing service agreements of management who are major shareholders even when these agreements are up for review.
Swissco filed for judicial management in November 2016 and is still under judicial management today. Could the profit-sharing arrangement rewarding management a share of the profit without taking into account the level of investment and risk have contributed to its demise?
This is certainly a possibility in the near collapse of China Aviation Oil (Singapore) (CAO) in 2004. On 10 August 2003, Straits Times ran an article titled “The modest millionaire” featuring Mr Chen Juilin, the then CEO. It was reported that he stood to collect more than S$7 million that year, thanks to a profit-sharing arrangement. I was quoted as saying that “Mr Chen’s remuneration seems a bit high relative to CAO’s profit”. I should have added that his potential remuneration could be enormous.
CAO was in the business of oil trading and procuring aviation fuels for airports throughout China, and enjoyed an effective monopoly over jet fuel imports into China where air travel was on the rise.
Under the four-year service agreement signed by Mr Chen before the company’s IPO in 2001, he was paid an annual salary of S$480,000, an annual wage supplement of three months’ salary for every 12 months of service, and a share of the profits. No long-term incentive plan was put in place. The profit-sharing arrangement entitled Mr Chen to 7% of the first S$8 million of profit before tax above a minimum threshold of S$12 million, 9% for the next S$15 million of profit, and 10% of any additional profit above S$35 million. There was no upper limit. His income tax was paid by the company.
Rather fortuitously, soon after that Straits Times article, I was at a seminar on remuneration and happened to sit at the same table for lunch as someone from CAO’s RC. I asked about the profit-sharing arrangement – specifically, why the company had such a generous profit-sharing percentage for the CEO when the company effectively had a monopoly.The reply was that they wanted the CEO to be more entrepreneurial. He demonstrated his entrepreneurism by betting on derivatives and the company lost US$550 million. If he had betted correctly, he could have immediately retired since he was entitled to 10% of any profit exceeding S$35 million. The profit-sharing formula used to determine his bonus could have encouraged him to take on excessive risk.
Balanced scorecard or just profit?
Between FY2012 and FY2021, the remuneration of the EDs of Old Chang Kee – who are uncle and nephew, and later joined by a niece – total S$31.15 million, or 56% of cumulative profit before tax over that period (as a percentage of cumulative profit before tax and before directors remuneration, it is 35%).
According to the company, the performance conditions used for the short-term and long-term incentives (such as performance bonus) “were chosen for the Group to remain competitive and to motivate the Executive Directors and key management personnel to work in alignment with the goals of all stakeholders”. The qualitative performance conditions are leadership, brand development, overseas business development, current market and industry practices, and macro-economic factors. Quantitative performance conditions are annual profit before and after tax, return on equity, relative financial performance of the Group to its industry peers and sales growth”. This looks like a good balanced scorecard and Old Chang Kee is more transparent than many others in disclosing performance measures/conditions.
However, when we compare the remuneration components, including performance bonus, as a percentage of total remuneration for the Executive Chairman, Mr Han Keen Juan, and his nephew, Mr Lim Tao-E William, who is ED and CEO, they are identical or nearly identical over each of the last 10 years. The difference in percentage, if any, for each particular component is never more than one to two percent. This may suggest a lack of measures of individual performance and both are assessed entirely or almost entirely on measures of corporate performance which are identical for both. One wonders if the RC of the company has considered whether their remuneration does indeed “takes into consideration his or her individual performance and contribution towards the overall performance of the Group” and whether the variable remuneration “is determined based on the level of achievement of corporate and individual performance objectives” as the company said in its annual report.
RCs should consider whether the performance measures in balanced scorecards are in fact linked to remuneration. The Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry in Australia found that while most financial institutions claim that they use a balanced scorecard, it is often only sales and profits that matter when it comes to remuneration.
Unfortunately, like most companies here, Old Chang Kee does not disclose the profit sharing percentages for the EDs under their service agreements.
Mr Han and Mr Lim together own about 66% of the total shares, so they are able to appoint all the directors, including the IDs who approve their service agreements and their remuneration. It may be challenging for IDs to change the terms of the service agreements even when they are up for review – as the two IDs at Swissco discovered.
What is profit?
In 2015, Lian Beng Group was in the spotlight over over how profit used to determine the latter’s bonuses in the service agreements should be computed. The disagreement with the EDs over this matter led the two IDs to resign. While the EDs believed, based on their service agreements, that profit attributable to non-controlling (minority) interest should be included, the IDs thought otherwise.
There were deeper issues revealed by the dispute. The service agreements stipulated that the performance bonus was based on “net profits of the group before tax and before extraordinary items as reflected in the audited accounts of the group”. As I pointed out in my article “Performance bonus spat may just be tip of an iceberg” (Business Times, 25 August 2015), the concept of “extraordinary items” has long been expunged from accounting standards, which suggests that details in the service agreements have not been updated.
While I agree with the IDs’ views about the profit figure which should be used, I also understand that service agreements once agreed to should be followed. The problems boil down to the ability of IDs to change them even when they are up for review, what is stated in the service agreements, or lack of clarity in these agreements. Where there is a lack of clarity, disagreements over interpretation may arise.
In September 2021, it was déjà vu when Lian Beng again found itself defending increases in bonuses for its EDs. These increases were partly due to the inclusion of government grants in calculating profit used to determine bonuses, like at Old Chang Kee.
Problems with profit-sharing
One of the Lian Beng EDs is responsible for procurement and contract management, while the other has responsibilities for areas such as finance and human resources. Their bonuses are also based on profit-sharing. In my view, it is inappropriate to pay bonuses based largely on profit-sharing to individuals with such functional responsibilities. In professionally-managed companies, such individuals are likely to be rewarded mainly for achieving performance objectives and targets relating to their job functions.
While the original service agreement at the time of listing in 1999 for the chairman and managing director of Lian Beng stipulated a performance bonus amounting to 1.5 per cent of profit, the current profit sharing percentages for him and the two other EDs, who are his siblings, are not disclosed.
Family and founder-managed companies here often rely solely or extensively on profit-sharing in determining the bonuses of EDs. Such remuneration policies are deeply flawed, as already pointed out in the CAO case. Further, companies are generally not transparent about what the profit-sharing percentage is, and what is included in computing profit is often not well considered.
At Raffles Education Corporation, the Chairman and CEO, Mr Chew Hua Seng, is paid a bonus based on profit sharing. In dollar terms, his bonus for FY2021 is the second highest in the past 10 years, based on estimates from REC’s remuneration disclosures. As a percentage relative to profit before tax, it is the highest over the last 10 years. The board’s justification is as follows: “In spite of the challenging conditions as a result of the Covid-19 pandemic globally, the Company has been able to deliver a commendable group profit before tax of S$29.9 million.”
However, although the board said that the profit was “commendable”, the external auditors had flagged a material uncertainty relating to going concern through an emphasis of matter paragraph in its opinion. While the auditors’ opinion was not modified, there is a risk of insolvency on the horizon.
More bad news followed shortly after when the company announced its results for the first quarter of FY2022, which show an operating loss before tax of S$4.7 million compared to an operating profit before tax of S$3.5 million for the comparative quarter in the previous year. Loss after tax widened from S$1.5 million to S$10.2 million.
In other words, Mr Chew received the second highest ever bonus in dollar terms and the highest in percentage terms over the last 10 years, when the company is facing concerns about its future. It would generally not be prudent to increase or even pay dividends to shareholders under such circumstances, but companies often show far less prudence when it comes to remuneration.
Uneven odds
To be clear, Mr Chew’s bonus was for FY2021 performance, and if the poor results continue through the rest of FY2022, he may not be entitled to a bonus for FY2022. But herein lies a major problem with bonuses based solely or mainly on annual profit.
Let’s assume that in FY2022, Raffles Education makes an operating loss which is exactly equal to its operating profit for FY2021, and Mr Chew receives no bonus. Over the two years, he would have received a total bonus of S$1.88 million while the company has made a zero cumulative profit. This is because the payoffs from annual bonuses are asymmetric – there is a positive bonus when the company is profitable but no negative bonus if there is a loss. As a controlling shareholder, there is no risk of him being fired by the board due to losses.
Raffles Education was profitable for seven out of the past 10 years. Based on an analysis of his estimated profit share relative to profit before tax for those seven years, there is no clear discernible pattern.
An absolute increase in profit also does not mean that management has performed better or that shareholders are better off. In Raffles Education’s case, cumulative profit before tax from FY2012 to FY2021 total S$213.6 million and Mr Chew earned total estimated bonuses of nearly S$10 million over that period. However, shareholders have seen the share price fall from about 35 cents to 6.6 cents over that period and last received a dividend in October 2015 of 1 cent per share.
Fair or unfair values
The profit used to determine Mr Chew’s incentive bonus includes fair value gains or losses on investment properties and one-off gains or losses on disposals of assets, and this has been consistently followed over the years. For FY2021, REC’s reported profit before tax of S$29.9 million included a fair value gain from investment properties of S$13.8 million and gain on disposal of non-current assets held for sale of S$28.4 million. Without these unrealised or one-off gains, REC would have reported an operating loss before tax of S$12.3 million for FY2021.
Over the past 10 years, REC has reported a fair value loss on investment properties in only one year, S$6.3 million in FY2012. Since then, it has reported nine consecutive years of fair value gain on investment properties. Cumulatively, the net fair value gain is S$208.6 million over the 10 years.
According to REC’s annual report, fair value of investment properties is considered “Level 3 recurring fair value measurements” with “unobservable inputs for the asset and liability”, which means it is highly subjective.
However, Raffles Education would not be alone in including unrealised fair value gains and losses when determining bonuses based on profits. RCs should consider whether it is appropriate to include such gains and losses.
One-off gains and losses
RCs also need to consider how to treat one-off gains or losses in calculating profit, such as those related to disposals of investments or other assets and accounting policy changes.
On 19 December 2019, I wrote an article (“’Tis the season to be wary for minority shareholders at three companies”, Business Times) where I flagged numerous issues at ASTI Holdings Advanced Systems Automation (ASA) and Dragon Group International (DGI), where Dato’ Michael Loh Soon Gnee was concurrently executive chairman and CEO. All three companies were in deep financial trouble, with each having racked up five successive years of losses from continuing operations from FY2014 to FY2018. ASTI and DGI were on the watchlist, and DGI was to be mandatorily delisted. ASA was not on the watchlist only because it is Catalist-listed.
ASTI’s financial performance improved dramatically in FY2019, with a loss from continuing operations of S$22.9 million in FY2018 turning into a profit from continuing operations of S$20.4 million in FY2019. However, the improvement was short-lived as it reported a loss from continuing operations of S$2.4 million in FY2020. DGI reported the same trend of a dramatic improvement from a loss to a large profit in FY2019 and then a reversal back to a loss in FY2020, while ASA continued to make losses in both FY2019 and FY2020.
The improvement in the profitability of ASTI in FY2019 was due to a gain on deemed disposal of subsidiaries of S$28.4 million included under other income. Note 7 to ASTI’s FY2019 financial statements states: “On 20 May 2019, DGI’s subsidiary EoCell Limited issued 999,999,930 shares representing 40% of enlarged share capital of EoCell Limited to Yinlong Energy Co., Ltd for a consideration of US$20,000,000 and 4999,999,895 shares representing 20% of the enlarged share capital to a company representing the key management of EoCell Limited. As a result, DGI’s shareholding in EoCell Limited was diluted to 40% from 100% and DGI has lost control over EoCell Limited. As DGI has significant influence over EoCell as an associate, the results of EoCell Limited are equity accounted from the date of loss of control.”
Similarly, DGI’s improvement in profitability was due to the same transaction, and it recorded a gain on deemed disposal of EoCell amounting to US$20.96 million. In other words, the profits in FY2019 at ASTI and DGI were boosted by the sale of shares in a subsidiary (including 20% to a company owned by key management of the subsidiary) and it was then deconsolidated.
In this case, Dato’ Loh’s remuneration was not directly affected as his remuneration in FY2019 at ASTI and DGI had no bonus component and his total remuneration at the two companies was essentially unchanged compared to the past few years. However, his total annual remuneration for FY2019 at ASTI was still a highly respectable S$1.91 million and he also received S$745,000 at DGI.
Risks of poorly-designed remuneration policies
Poorly designed remuneration policies have real consequences – and profit-sharing arrangements can be downright dangerous. Poor disclosures often hide poorly designed remuneration policies.
The reliance on annual profit as a performance measure creates incentives to boost short-term profits at the expense of longer-term growth. Research has also found that the greater the importance of accounting measures such as profits in determining remuneration, the more likely are management to engage in creative accounting.
One research study has found that managers tend to manipulate Level 3 fair values. Further, the study found that executive remuneration is significantly related to changes in fair value but the relationship is asymmetric. Increases in remuneration due to positive changes in fair value are higher than reductions in remuneration due to negative changes in fair value.
This is unsurprising because as explained earlier, payoffs from traditional bonus plans are asymmetric, with more upside than downside. Impairments of fair value are also likely to be lumpier in nature compared to increases in fair value. A large impairment may wipe out the bonus for one year but this may be less than the cumulative bonuses that have been earned through past fair value gains.
The inclusion of fair value changes in awarding bonuses further increases risks of inappropriate remuneration and questionable accounting practices which RCs and audit committees (ACs) should be mindful of.
You get what you pay for with remuneration policies, but it may not necessarily be what you want.
In the final articles in this series, I will discuss other issues with remuneration policies and the “hot topic” of aligning remuneration policies with environmental, social and governance (ESG) factors.
