Over the next twelve months, remuneration committees will need to consider difficult issues in reviewing and approving performance targets for both their short and long-term incentive plans. In particular, they will be asking themselves:
- Given the likelihood of prolonged recession, should performance conditions be different for future awards?
- Is it appropriate to amend performance conditions for existing awards if, as a result of the current crisis, they are unlikely to be met?
Remuneration committees will be aware that, under the Companies Act 2006, all company directors are under a duty to make decisions which they consider will “promote the success of the company” and that this means more than simply acting in good faith. What meaning should be attributed to “success” during periods of economic downturn? In the context of appropriate performance conditions, does success require absolute performance or performance in the context of the expected prolonged downturn?
There is no doubt that balancing short-term, profit-driven measures with long-term growth in value objectives will be more challenging than ever and many companies will be reviewing the measures themselves and their interaction with each other. This briefing considers the extent of the legal powers of remuneration committees to adopt new performance measures or change targets for existing awards.
Selecting performance metrics for annual bonus
It is typical for remuneration committees to have complete discretion to set performance requirements for short-term cash-based plans and, for financial years beginning in 2009, remuneration committees may well be considering lowering financial targets to take account of the more challenging economic conditions.
Although a change to financial targets will not require shareholder approval, main list companies must disclose forward looking executive remuneration policy in their annual remuneration report. This typically means that the lower targets will need to be disclosed in the company’s report and accounts published this year, even though the changes relate to this year’s financial targets.
Some companies may wish to consider mid year changes to their bonus performance measures. If they consider that targets are no longer appropriate or fair or they need to re-focus executives on survival oriented measures such as cashflow.
As with setting new targets, remuneration committees have discretion to change remuneration policy and, subject to the executives’ contractual rights, there is no legal obligation to stick with existing measures (even though they will have been previously disclosed to shareholders in the annual report). However, moving the goal posts has the potential to be highly controversial and investor consultation is strongly recommended. Bellway has recently become the first company since 2003 to fail to achieve shareholder approval for its annual remuneration report. Its shareholders were unhappy that the company had stated in its 2006/07 annual report that bonuses would be based on “challenging” budgets, but disclosed in its subsequent annual report for 2007/08 that bonuses had been paid based on performance compared to its peers.
Selecting performance conditions for long-term incentive plans
Long-term share awards are typically subject to performance conditions relating to the performance of the company over performance periods of more than one financial year, typically three to five years.
In the light of the likely prolonged economic downturn and market volatility, remuneration committees may want to change their long-term performance conditions for future awards to ensure they apply the appropriate stretch and remuneration committees may also wish to consider taking steps to restore the motivational impact of existing awards whose performance conditions are unlikely to be met.
Future long-term incentive awards
There are many design and calibration variations which can be (and have been) applied to performance conditions to adapt them to operate fairly over performance periods where uncertain economic conditions will apply. For example, some of the changes which we have seen companies make include:
- adopting bifurcated conditions where different proportions of the share award are subject to separate conditions, for example 50% comparative total shareholder return (TSR), 50% growth in earnings per share (EPS);
- widening the performance range and reducing hurdle thresholds;
- adopting entirely new conditions aimed at focusing executives on turnaround and which are less susceptible to market volatility, such as absolute growth in TSR, return on equity and cashflow measures; and
- changing membership of comparator groups to include more relevant peer companies.
Most long-term incentive plan rules allow remuneration committees to determine performance conditions for awards (i.e. without any shareholder involvement).
However, it is increasingly common practice for new plans adopted by listed companies to be approved by shareholders on the basis that the “first year” performance conditions are disclosed to shareholders at the time of approval of the plan.
In these circumstances, companies need to consider carefully if it is appropriate to consult with investors or even seek formal shareholder approval before the remuneration committee subsequently changes the performance conditions for new awards in subsequent years.
Changing performance conditions for existing awards
In recent years, companies have adopted increasingly tough performance conditions with no retesting provisions. As a result of such a dramatic market downturn, this will inevitably mean that many existing awards will lapse without meeting their conditions.
Even where it is not yet clear that the performance conditions will not be met, executives may well feel that the goal posts have moved and the conditions are now much more difficult to attain than anticipated at the outset.
Many companies are now focusing on the problem of the loss of motivational impact of existing awards and considering amending or replacing existing conditions or re-calibrating how they are measured. Some of the approaches we are seeing companies consider include:
- extending the original performance period;
- allowing for limited re-testing;
- adopting different calibration provisions such as extending the period over which share price for TSR measures are averaged; and
- changing to a more appropriate condition but applying it only to the remainder of the performance period.
The scope for changing existing conditions will be set out in the rules of the plan or the relevant condition itself and remuneration committees will need to consider undertakings to shareholders as well as the rights of the executive awardholders.
Typically, plans provide remuneration committees with the discretion to amend or vary an existing performance condition provided they consider the condition to be no longer appropriate or fair and provided that the revised condition is no easier or more difficult to satisfy. Whilst it may well be easy to take the view that the nature of the current downturn makes the performance measures inappropriate, it will be harder to assess whether proposed variations are neutral in their effect. For example, should the condition be no easier than it was to achieve at the time of grant or no easier than it is to achieve now?
Companies will need to consult with their shareholders if there is uncertainty and may wish to do so in any event to ensure that investors are not concerned that the company is breaking faith with the overriding spirit of their incentive plan.