2017 will see a large number of listed companies having to approach their shareholders to approve their directors’ remuneration policy for the second time. This is because the first approvals in 2014, when new legislation came into effect, expire after three years.
Against a background of continuing investor, public and political unease, a working group of the Investment Association and the GC100 and Investor Group have both recently contributed papers to the debate. The Prime Minister has also made some unexpected comments.
This Law-Now summarises the issues raised which will no doubt be debated further throughout the autumn and may well develop further momentum.
- Investment Association Working Group
The final proposals put forward by the Working Group (an interim report was published this year before a series of consultations on the draft proposals, click here to see our Law Now on this) do not represent the formal views of the Investment Association, which is still to amend its guidelines in response to them. However, they clearly represent the direction of travel of many activist members and are likely to be the benchmark as shareholders assess companies’ 2017 proposals and annual reports published next year.
The report starts by concluding that the current system of executive long-term remuneration is not working, leading to over-reward and payouts which are not linked to performance. A key problem is complexity, which prevents shareholders having proper oversight of arrangements, and stops companies and participants themselves understanding outcomes, therefore often discounting the value of future payouts and leading to needless pay inflation. Another problem is over-reliance on the LTIP arrangement, which is now the main incentive vehicle for listed company director pay. Remuneration committee behaviour is also criticised as a contributory factor.
The Working Group’s central response is to press for fresh and original thought, saying that the confines of a standard LTIP have been a straitjacket for companies and investors alike. Only if bespoke arrangements, using a wider range of plans, are put in place will balanced incentives be provided.
As possible replacements for LTIPs, the Working Group considered in its interim report:
- extra deferral of bonuses into shares,
- granting free shares on the basis of prior performance but without further performance conditions (so-called performance on grant awards) and
- making share awards without reference to prior or subsequent performance, (so-called restricted shares, which would involve discounting the value of the shares awarded by 50% compared with LTIP awards, to reflect the absence of any performance conditions, because investors would not want to see a performance-free reward without a significant reduction in pay).
However, in the final report the Working Group does not endorse performance on grant awards.
So while LTIPs may well be acceptable in many cases, they should not be the default position any more. Whatever the structure chosen, it would continue to need to be supported in appropriate cases by clawing back payouts in the event of severe personal or business failings, a holding period (where the report adopts a two-year holding period after a three-year vesting period model) and other tools which have been developed in recent years to give symmetry with shareholders.
It is not just a question of structures, however. Other proposals include strengthening remuneration committees, where the Working Group expresses concern that they can be led by groupthink and/or remuneration consultants. A remuneration committee chairman should have at least one year as a NED before taking up the role (and a recommendation is made that the Corporate Governance Code is amended to embody this) and the whole board, and particularly the chairman, should become more involved in remuneration matters. The Working Group also suggests that shareholder consultation on pay before a company’s formal proposals, whilst welcome in principle, needs to improve, with proper information given, avoiding boilerplate and trivial material. It additionally supports greater disclosure on bonus targets and, in particular, retrospective disclosure at a minimum, with clear justification for the use of discretion, where the recent GC100 update (see below) also has relevant commentary. It advocates greater disclosure on the quantum of pay. The Working Group admits, however, that moving to a more flexible model requires companies to trust that their shareholders will support their plans.
The Working Group’s final report can be accessed here.
- GC100 guidance
When the revised directors’ remuneration report and disclosure rules were introduced in 2013, the Government wanted a company/investor code to be developed to set out best practice and to give guidance to companies when drawing up their reports. What was produced in 2013 by the GC100 and Investor Group (referred to as the GC100 in the rest of this Law-Now) has now been updated. It is in effect a reference tool for drawing up the relevant pages in the annual and policy reports in 2017.
In 2013/14, the rules were new and companies were concerned that they could lose votes if they failed to comply with them to the letter. Many of these fears have receded as companies have realised that the rules provide more flexibility than at first thought and permit wide drafting.
After three years of working with the rules, companies have increased the quality and volume of disclosure immeasurably since 2013, even if clarity and conciseness are sometimes still elusive (a common complaint generally with company reporting). Most companies are now generally comfortable operating within the rules, although investors have been pressing for more prescriptive language to be included in the GC100 guidance.
Overall, the GC100 2016 guidance has not changed greatly from the 2013 guidance, but companies would be well-advised to measure their own disclosure and policy report next year against these revised guidelines, as shareholders concerned about any outcome or description are likely to measure them against these benchmarks.
Key areas of change are:
- Maximum pay: The relevant legislation leaves it ambiguous whether companies must have a maximum for each area of pay or whether they merely have to state one if they do (and is then also unclear as to what type of maximum there can be – should it be a hard figure or could it be, for example, "no more than is necessary"?). The GC100 guidance is now emphatic that maximum salary should be stated, though it leaves open what kind of maximum levels can be given, saying that “the maximum must be explained in monetary terms or any other way appropriate to the company (for example, a percentage of salary)”. It says that this is in line with the regulatory intent of the legislation, which it recommends companies respect as a matter of best practice, though implicitly this recognises that the law might not expressly require as much. The guidance also says that the maximum should be disclosed at an individual director level.
- Bonus targets: Tougher guidance is now provided on when disclosure of prospective bonus targets can be omitted on grounds of commercial sensitivity and when details should then be disclosed after payment. Several detailed sections have been added on this on page 7 of the new guidance.
- Discretion: The guidance recommends that as much explanation be given as possible of the circumstances in which discretion can be exercised, rather than a general discretion, though many companies will in practice still be torn as to whether to limit themselves and comply with this. Where any additions to the policy are made prior to the binding vote, by way of examples of how discretion would be exercised which happened on a few occasions in 2014 as the price of shareholder support at the relevant meeting, these should be prominently disclosed and added to subsequent annual reports.
- Linkage to strategy and shareholder concerns: Overall, there is a theme that, both in terms of reporting outcomes and looking to the future, remuneration discussion should be linked where possible to the broader picture. In addition, there is guidance on cross-referring to feedback that shareholders have given (see page 8 of the new guidelines).
- Former directors: Concern still exists that former directors are somehow receiving payments that are not disclosed. To deal with that, a statement that no payment has been made is encouraged even where there are no payments to report.
- CEO pay comparison: Although of relatively little investor interest, the media and political focus on this is high and there has been concern that disclosure does not meet the spirit of what is intended. The guidance now says that a “meaningful” comparator group of employees must be chosen.
- Other points: The guidance also says that dividend equivalents (now becoming very popular with LTIPs so that on vesting of awards, employees receive not just shares but the dividends declared since the award) should be reported as part of the main LTIP vesting figure, as well as some further pensions disclosure. The guidance also has recommendations where post-vesting holding periods are applied, and how share options are treated for the purposes of disclosing the maximum receivable.
The revised GC100 guidance can be found here.
Prime Minister’s announcement
Finally, in an unexpected development, the Prime Minister in her campaign manifesto suggested that employee representatives be appointed to company boards and also that shareholder votes on director pay become binding. More transparency, including the full disclosure of bonus targets and publication of data showing the ratio between the CEO’s pay and the average company’s worker’s pay, would be required. Although little detail was given, there is already a binding vote every three years and so it is thought that the additional shareholder control over pay might be a move to make a policy vote an annual requirement or in some way make payout terms dependent on a vote after the year in question. Both raise obvious issues. No real follow-up has yet emerged and so it is not clear what, if anything, will be put forward as Government policy. The inevitable need for consultation before legislation is proposed means that it is extremely unlikely that any legislative changes will take effect until 2018 at the earliest, and the Government may in any event take the view that the subsequently published initiatives taken by the Working Group and the GC100 now make Government action unnecessary.
The Prime Minister’s speech can be found here.
Taken together, these papers give Remuneration Committees, HR and reward professionals and company secretaries plenty to think about, with short-term and longer-term issues to consider.
So far, indications are that investors are pressing for fuller if not full compliance with the provisions in the GC100 guidance, though this has regularly been said before and only time will tell if this is reflected in actual scrutiny and voting patterns in 2017 and beyond. On the longer-term goals set out in the Working Group’s paper, much more time will be needed for common ground to be established, given the need for confidence on both the investor and company sides, as well as the resources and time that is needed to produce change. It may be optimistic to expect any real action in 2017 in terms of companies changing their whole approach to remuneration, and most companies are, after all, not in permanent conflict with their shareholders on directors’ pay.