A recent case has revealed that some £8 million of bonuses came to be claimed by two executive directors of a private company, without the remuneration committee or the underlying shareholders apparently appreciating that entitlements had arisen on anything like that scale.

Background

In 2005 a company's remuneration committee ("Rem Com") (comprised exclusively of non-executive directors) commissioned some work on the appropriate level of pay for its two executive directors. One of the executive directors suggested to the chairman of the Rem Com that if the company were refinanced it would be appropriate for a share of the refinancing proceeds to be paid to them. This suggestion emerged in signed documentation, the drafting of which was allowed to be supervised by the two executive director beneficiaries. The documentation gave a minimum entitlement to 1% and 2% respectively of the refinancing proceeds if and when a refinancing occurred.

By late 2006 a refinancing was actively being considered and the actual quantum of the bonuses started openly to be discussed. Members of the Rem Com claimed that they were shocked at the size of what could be paid because they had never intended these amounts to be payable. The case report does not disclose what ended up being paid to the executives but it is clear that the size of the bonuses came near to derailing the refinancing.

A number of points emerge which are of interest for members of Rem Coms and advisers on remuneration generally.

Role of non-execs on a Rem Com

The case report sets out the lack of attention to detail on the part of the non-execs on the Rem Com, with suggestions that they themselves had failed in their duties. These include failure to read committee papers where the proposed arrangements were clearly set out and saying that the papers had been read when they had not been (or at least not been understood or appreciated).

What was unusual in this case was that there was no company secretary or HR function at this company (the finance director, who was a recipient of the bonuses, was also company secretary). Accordingly there was no one with a professional interest in the subject at the company, who had both attended relevant meetings and was able to check that the executed documents reflected openly discussed issues accurately. This check will exist in most companies but, where it does not, there is clearly a case for someone on the Rem Com taking extra steps.

Although this case is not about directors' duties, it does give rise to obvious questions as to what non-executive directors should then do. The response of any non-exec will be that time constraints mean that it is virtually impossible to read all papers thoroughly and inevitably some non-execs will rely on others, particularly the chairman of the Rem Com. The Combined Code and other corporate governance literature are often cited to emphasise the independence that needs to be brought to the relevant issues, but as important is the need to give due attention to them. In retrospect, the other non-exec directors may now wish that they had not relied on the chairman of the Rem Com to do so much alone and she and they must also regret relying on the executives to supervise the relevant documentation (particularly as another undiscussed change was also inserted). Assumptions were clearly made all round. The chairman of the Rem Com said it was not her job to read through legal documents, a comment which will gain sympathy all round from non-execs when faced with lengthy contracts to read but, all in all, there is clear evidence that there was just continual rubber-stamping rather than challenge, either in debate or through reading even summary paperwork.

This case is therefore a salutary lesson that members of Rem Coms need to keep on top of what is happening otherwise they will, at the very least, face questions of reputation and competence.  The disputed terms here related to quite simple issues of the actual percentages due and base amounts to which those percentages were applied, which were readily understandable and were not complicated or technical legal drafting.

Finally, initial advice on broad proposals was taken from an external firm of remuneration consultants. However, that and their subsequent papers which were circulated to the Rem Com, made clear that it did not consider the refinancing bonus. The inclusion in papers of advice and data from an external consultant can often (wrongly) give the impression that there is overall blessing of all arrangements from them as refraining from commenting on something can be seen to be as good as approval. Rem Com members always need to challenge how external advice has been presented to them as it may only be used (or have been commissioned) selectively.

Questions to raise when considering cash bonuses

The case also gives rise to some interesting remuneration points.

Clients regularly want to link bonuses to a refinancing. Aside from whether a refinancing should be seen as a success for the company which should be rewarded, which is always a difficult issue, careful drafting is needed as to the amount that is to be included. Is it just the amount released to shareholders - or the gross refinancing amount (as was an issue in this case)?

One of the Rem Com members said he had no more than £1 million in mind. Although this was not discussed in this case, a cap is often a useful anti-embarrassment measure as incentive arrangements are now regularly judged not just when they are made, but also when there is a pay-out. It seems likely in this case that the size of the actual refinancing which occurred was considerably greater than had been envisaged at the time the refinancing arrangements were initially discussed, even though no more than a year had elapsed between the two times. Expectations can therefore very quickly change without any change to the underlying bonus targets.

While there was no cap, there was a minimum payment, which is also unusual.

One final learning point from this is therefore always to conduct modelling on likely outcomes and check whether shareholders would be happy with the results in different scenarios. Modelling does not need to be that complicated and always acts as a useful stress test for arrangements.

Please click here to read a report of the relevant case.