The issue of how the pay recommendations for the financial sector (as set out in the final recommendations of the Walker Review published in November 2009) should influence the wider listed company sector has been addressed by the Financial Reporting Council (FRC) and the Association of British Insurers (ABI) in the publication, in December 2009, of:
- the FRC's Final Report on its 2009 Review of the Combined Code; and
- revised ABI Guidelines on Executive Remuneration together with a Position Paper to supplement the guidelines and provide some practical guidance to remuneration committees.
This briefing analyses the Walker Review's main pay recommendations for banks and the FRC and ABI responses to these in terms of how such recommendations should influence the wider listed company sector.
The Combined Code Introduction
The FRC Final Report on its 2009 Review of the Combined Code (the Report) responds to the recommendations of the Walker Review. The FRC only aims to incorporate the Walker recommendations to the extent that they are appropriate to all listed companies. Overall, the Report has something of a "not our problem mate" attitude to the main pay issues addressed by the Walker Review. This is mainly because the problems that Walker has diagnosed, and therefore his remedies, are seen by the FRC to be largely restricted to the financial sector.
Consultation on the Code will continue until 5 March 2010 with publication of the revised Code expected in April or May 2010.
The Report's responses to Walker's main recommendations
In summary, the Report's response to the main recommendations of the Walker Review are as follows:
- The Walker Review recommends that there should be disclosure, in aggregated bands (not on a named basis), for £1 million plus "high end" employees in the financial sector. The Report points out that pay disclosure is outside the Combined Code (the Code). Such disclosure is covered, for executive directors only, by the Large and Medium-sized Companies and Groups (Accounts and Reports) Regulations 2008 which now govern Directors' Remuneration Reports (the DRR Regulations). These DRR Regulations (and predecessor regulations in place since 2002) leave few stones unturned regarding the disclosure of pay policy and actual pay. Accordingly, the FRC sees no reason to adopt Walker's disclosure regime.
- The Walker Review's recommendation that the terms of reference of remuneration committees be extended to oversight of remuneration policy and outcomes in respect of all "high end" employees has not been adopted by the Report. The FRC sees no need to extend remuneration committee coverage beyond executive directors.
The position will therefore remain that the setting of pay for senior management and the rest is the responsibility of the executive, other than (as before) the remuneration committee having a limited "recommend and monitor" role for top management below board level. Further, the Code already contains, and will continue to contain, the requirement for the remuneration committee to be "sensitive to the wider scene" in setting board pay. This requirement will become very acute for companies with year ends on or after April 2010 as the DRR Regulations will require listed companies to explain how they have taken into account pay and conditions elsewhere in the group when setting executive pay.
- The Walker Review recommends that in the event that the non-binding resolution on a remuneration committee report attracts less than 75% of the total votes cast, the chairman of the committee should stand for re-election in the following year. The Report does not refer to this recommendation although it is subsumed into the more important issue of annual re-election of all directors or annual re-election of the chairman only.
Changes to the Code
Historically, the Code has not been prescriptive about pay structures, on the basis that specific recommendations on pay structure can quickly go out of date. It is therefore surprising that the proposed changes to the Code are quite far-reaching.
Looking first at changes to the architecture of the Code, there is a new "supporting principle" that performance targets should be stretching, and designed to align executive interests with those of shareholders, and to promote the long-term success of the company. The italicised words reflect wider changes in the Code, but the key point to note is that this supporting principle was previously a Code provision and a recommendation on pay design, and has been upgraded to a supporting principle. As such, it must be applied rather than falling under the "comply or explain" regime.
There are some important changes to the recommendations on design of performance-related remuneration (which continue to be set out in Schedule A of the Code). Most of these changes are sensible, and reflect lessons learned from the financial crisis. These changes are as follows:
- Incentives should be compatible with risk policies and systems, and the criteria for paying bonuses should be risk adjusted. In order for companies to comply with this recommendation, they will need to introduce greater deferral of bonus payments (on the basis that deferred amounts can be adjusted for problems arising in the deferral period) or use performance targets that price for risk by imputing a proper cost of capital in calculating the bonus.
- The remuneration committee should give "consideration … to the use of provisions that permit the company to reclaim variable components in exceptional circumstances of misstatement and misconduct." Provision for clawback in this way is in line with the ABI Guidelines (as discussed below). Listed companies should generally include such provisions without delay – on the basis that shareholders could well be surprised that such provisions were not there before.
- Payouts or grants under all incentive schemes (by implication, therefore, both annual and long-term) should be subject to challenging performance criteria reflecting the company's objectives including non-financial performance metrics (such as strategic performance). So far as annual bonuses are concerned, the requirement that the performance criteria include non-financial metrics is consistent with ABI guidance as well as imported new best practice from the City. However, for long-term incentives this principle is inconsistent with longstanding ABI guidance which envisages that long-term incentive performance criteria be based on comparative performance against a peer group (e.g. total shareholder return (TSR)) or year-on-year internal performance (e.g. earnings per share growth). This new recommendation therefore marks a significant change for listed company long-term incentives.
- Finally – and it is not very clear why – the previous Schedule A recommendation that the remuneration committee should assess performance criteria relative to comparators (such as by reference to TSR) has been deleted.
ABI Guidelines on Executive Remuneration
On 15 December 2009, the Association of British Insurers (ABI) published an updated version of their Guidelines on Executive Remuneration and an accompanying Position Paper.
There are very few changes to the Guidelines. The changes reflect a growing consensus amongst commentators and regulators alike on issues such as the alignment of remuneration policy and practices with the longer term success of the company and in particular, in terms of corporate objectives and business strategy, and that remuneration structures should not encourage excessive short-term risk-taking nor reward failure.
The Guidelines encourage a focus on risk management in executive remuneration. Remuneration policy and practices should take "risks fully into account" and performance conditions should "take account of risk." Remuneration committees "should have oversight of all associated risks arising throughout the firm as a result of remuneration. Boards should consider disclosure of these risks and how they are managed in accordance with the obligations under the Enhanced Business Review." The "Enhanced Business Review" refers to the requirement, under section 417 of the Companies Act 2006, for directors to report to members and help them assess the directors' performance of their duty to promote the success of the company.
In line with both the Walker Review and the proposed provisions of the Code, the Guidelines make provision for clawback in the event of misstatement of achievement of performance targets, the alignment of performance conditions in share-based incentive schemes with the long-term success of the company and deferred vesting of awards.
In contrast to the Guidelines, the ABI's Position Paper, which is intended to supplement the Guidelines and provide some practical guidance to remuneration committees, covers some quite interesting new areas. Although the ABI regard these as topical issues, most of them have continuing relevance, and it is not clear why the Guidelines have not been amended to cover them.
The key points are as follows:
- Remuneration committees are accountable to shareholders, particularly in the exercise of discretion. Remuneration committees are encouraged to seek an open and constructive dialogue with shareholders on remuneration decisions.
- Remuneration structures that seek to implement tax efficient structures (designed to convert income to capital gains) should not result in additional costs to the company. In addition, implementation of such structures could result in reputational damage to the company.
- Scale-back should be used where windfall gains may result if salary-based grants under share-based awards are maintained following a substantial fall in share price.
- Annual bonuses should not be awarded where the company has suffered an exceptional negative event. In such circumstances, any proposed policy and / or payments should be justified and subject to shareholder consultation.
- Although the Paper does not recommend the use of non-financial performance metrics, it does suggest that in relation to incentive schemes, the vesting of share awards should be dependent upon the overall underlying financial performance of the company, and not simply peer-related measures.
- Finally, the Paper discourages the use of retention mechanisms which, it suggests, rarely work.