As discussed in this PubCo post, in November of last year, the U.K. Government published a “Green Paper” on Corporate Governance Reform, which, in the face of rising economic inequality, sought “to consider what changes might be appropriate in the corporate governance regime to help ensure that we improve business performance and have an economy that works for everyone.” The Paper requested input on several proposals, including pay-ratio disclosure, giving employees more influence on company boards and making say-on-pay votes binding, leading to “a broad-ranging debate on ways to strengthen the UK’s corporate governance framework.” The results are now in. Corporate Governance Reform, The Government response to the green paper consultation identifies nine proposals for reform that the U.K. Government intends to advance. The reforms, many of which would not require legislation, are expected to become effective by June 2018 to apply in the following fiscal years. Whether any of these reforms will have a significant impact—either at home in the U.K. or as an influence abroad in the U.S.—remains to be seen.
Ironically, while the U.K. is looking at enhancing its corporate governance regulation, the U.S. is looking at where regulation can be scrapped or scaled back. In February, then-Acting SEC Chair Michael Piwowar issued a statement directing the Corp Fin staff to revisit the pay-ratio disclosure rules that the SEC had already adopted—although, so far, no changes have yet been proposed and the rule remains in effect for 2018. (See this PubCo post.) In addition, there seems to be substantial interest on the part of the current administration and current Congress in cutting back on Dodd-Frank or eliminating it altogether, including provisions designed to curb excessive CEO pay—such as those governing executive pay and compensation disclosure. For example, the Financial CHOICE Act—which would repeal pay-ratio disclosure and scale back provisions such as say on pay and compensation clawbacks—has been adopted by the House, although, reportedly, it faces a steep uphill climb in the Senate. (See this PubCo post, this PubCo post, this PubCo post, this PubCo post.)
In her introduction to the Government Response, Conservative Party P.M. Theresa May saw the U.K.’s system of corporate governance as “rightly envied and emulated” worldwide and a competitive advantage in a post-Brexit Britain. But, she maintained, it “must continue to improve if we are to retain our competitive edge,” and, frankly, there were problems that needed to be addressed: “In some companies executive pay has become disconnected from the performance of the company itself. In others, some directors seem to have lost sight of their broader legal and ethical responsibilities. There is a worrying lack of transparency around how some large privately-held companies behave. A responsible government must recognise these problems, and show leadership to tackle them.” She saw the changes proposed as “good for business”; in her view, companies that “listen to their workers and are responsive to their shareholders see the benefits on their bottom line. So by giving a stronger voice to those outside the boardroom, we incentivise businesses to take the right long-term decisions and help restore the public’s trust.”
The reforms proposed relate to three specific areas:
- Executive pay;
- Strengthening the employee, customer and supplier voice; and
- Corporate governance in large privately held businesses.
Executive Pay. The Government Response observed that executive pay “has risen faster than corporate performance” and “has continued to be a key factor in public dissatisfaction with large businesses, and a source of frustration to UK investors,” all of which supported the case for reform: “While many companies have responded positively to the reforms introduced in 2013, a persistent small minority of businesses continue to disregard the views of shareholders on pay each year. There are also few signs that many remuneration committees take seriously enough their existing obligations to take account of wider workforce pay and conditions in setting executive remuneration. The Government also recognises concerns expressed by many respondents about the unnecessary complexity and uncertainty of executive pay, particularly around the potential outcomes of long-term incentive plans.” According to the NYT, the “average chief executive of a company listed on the FTSE 100, the country’s benchmark stock index, made 129 times as much as a regular employee last year, according to the Chartered Institute of Personnel and Development. That was up from 45 times as much 20 years ago.”
The proposals to address these executive pay issues offered in the Response include the following:
(i) Amend the corporate governance code to:
- provide specific steps listed companies should take when there is significant shareholder opposition to executive pay policies and awards (which might include, for example, provisions for companies to respond publicly to dissent within a certain time period, or to verify that dissent has been sufficiently addressed by putting the company’s existing or revised remuneration policy to a shareholder vote at the next annual meeting);
- Increase the responsibility of comp committees for oversight of pay and incentives across the company and require these committees “to engage with the wider workforce to explain how executive remuneration aligns with wider company pay policy (using pay ratios to help explain the approach where appropriate)”; and
- Extend the recommended vesting and post-vesting holding periods for executive equity awards from three to five years to encourage a longer term focus.
In this article, posted on CFO.com, two consultants argue that the use of the three-year time horizon frequently associated with performance-based restricted stock grants may not really be long enough, especially where the performance measure is relative total shareholder return (TSR). In fact, they contend, perhaps with a touch of hyperbole, it has the “potential to be dangerous” because the “payouts to executives may reward short- to mid-term stock price volatility rather than sustained long-term TSR performance.” Recognizing that the ideal of a “truly long-term performance period like 10 years or 7 years, which also more closely corresponds to the life cycle of business strategies” is impractical, they suggest that compensation committees “think about a performance period of five years or even four years, which may provide a better balance between executives’ reluctance to wait to receive compensation and shareholders’ concerns that equity awards should reward long-term value creation. Additionally, if there are tenure concerns with five years, it is possible to structure a five-year performance period on an award that only requires three years of continuous service.” (See this PubCo post.)
(ii) Through legislation:
- Require listed companies to report pay-ratio information annually (the ratio of CEO pay to the average pay of the company’s UK workforce), including a narrative explaining changes to the ratio from year to year and “setting the ratio in the context of pay and conditions across the wider workforce”;
- Provide a “clearer explanation in remuneration policies of a range of potential outcomes from complex, share-based incentive schemes.”
(iii) Invite the Investment Association to maintain a public register of listed companies that receive shareholder opposition of 20% or more on say on pay, along with “a record of what these companies say they are doing to address shareholder concerns.”
In addition, the Government indicated that it will also examine “the use of share buybacks to ensure that they cannot be used artificially to hit performance targets and inflate executive pay” and “consider concerns that share buybacks may be crowding out the allocation of surplus capital to productive investment.”
A recurring demand by hedge funds activists is that the target company return capital to its shareholders by buying back its own stock. Data compiled by S&P and Bloomberg shows that companies in the S&P 500 spent 95% of their earnings on repurchases and dividends in 2014, including spending $553 billion on stock buybacks (which can drive increases in EPS), leaving little for alternative uses of capital, such as long-term strategic investment in productive assets, including investment in R&D. (See this PubCo post, this PubCo post, this PubCo post, and this PubCo post. See also this PubCo post, describing the efforts of hedge fund activists to break up a company and the ripple effects of that effort on the surrounding community.) In some cases, conducting a stock buyback can be an ultimatum that also, incidentally, benefits company executives: in some cases where compensation performance metrics are stock-price- or EPS-related, buybacks can juice executive compensation, irrespective of the operational success of the company. See this PubCo post discussing a shareholder proposal from the AFL-CIO asking companies to adjust executive pay metrics to exclude the impact of stock buybacks.
If these measures do not prove to be effective, the Response suggests that there may be more to come.
While these measures may seem like major steps, compared to the types of measures proposed in the Green Paper, they could be viewed as fairly weak tea, depending on your point of view. Remember that the Green Paper had proposed as alternatives the introduction of annual binding votes on all or some elements of executive pay (but also the development of structures for speedily and effectively agreeing to revised compensation when the original pay plan is rejected); stronger consequences for failing an annual advisory vote, such as a subsequent binding vote; requiring pay policies to set an upper limit; and providing greater specificity on how companies should engage with shareholders on pay, including where there is significant opposition to compensation.
However, the Response followed a broad consultation, and there apparently was not wide enough support for measures such as binding say on pay: “most supporters… felt that this would be disproportionate, given that only a relatively small number of companies have experienced significant shareholder dissent on pay in recent years.” And less than a quarter of respondents favored setting a maximum executive pay threshold or introducing more frequent votes on pay policy. However, about two-thirds of respondents supported stronger consequences for companies losing or encountering significant dissent in the annual shareholder advisory say-on-pay vote, along with new guidance in the UK Corporate Governance Code.
Strengthening the employee, customer and wider stakeholder voice. Strengthening the stakeholder voice was considered “an important factor in improving boardroom decision-making and delivering better, more sustainable business performance.” The Government Response indicates that many respondents believed that business “should do more to reassure the public that companies are being run, not just with an eye to the interests of the board and the shareholders, but with a recognition that they have responsibilities to employees, suppliers, customers and wider society.” In contrast to the “shareholder preeminence” theory prevalent in the U.S., under which boards give priority to “maximization of shareholder value” (see, e.g., this PubCo post and this PubCo post), UK corporate law (Section 172) already provides that directors must act in the way they consider, in good faith, would be most likely to promote the success of the company for the benefit of its members (shareholders) as a whole, but, having regard for, among other things, the interests of employees, relationships with suppliers and customers and the impact of the company’s operations on the community and the environment. Respondents thought that this aspect of the U.K.’s governance framework should be enhanced.
The proposals offered in the Response to address these stakeholder issues include the following:
(iv) Require larger companies (private as well as public) to explain how their directors comply with the mandate of Section 172 to take employees and other stakeholders into account, such as explaining “how the company has identified and sought the views of key stakeholders, why the mechanisms adopted were appropriate and how this information has influenced decision-making in the boardroom”;
(v) Develop a “new Code principle establishing the importance of strengthening the voice of employees and other non-shareholder interests at board level as an important component of running a sustainable business,” including consideration of a specific Code provision requiring “premium listed companies to adopt, on a ‘comply or explain’ basis, one of three employee engagement mechanisms: a designated non-executive director; a formal employee advisory council; or a director from the workforce”; and
(vi) Encourage industry-led solutions through various organizations to provide “joint guidance on practical ways in which companies can engage with their employees and other stakeholders,” and invite the GC100 group of the largest listed companies to provide guidance on “the practical interpretation of the directors’ duties in section 172.”
The proposals suggested in the Green Paper included creating stakeholder advisory panels to consult with the board on matters such as compensation, designating existing non-executive directors to ensure that the voices of employees and other key interest groups were heard at the board level, appointing individual stakeholder representatives to company boards, and strengthening reporting requirements related to stakeholder engagement. There was, however, no consensus among respondents as to which of the options was best. Some raised concerns regarding potential conflicts of interest, the creation of two classes of directors and the difficulty of identifying suitable individuals. Others countered by emphasizing, among other things, the need to clarify that “the purpose of a stakeholder director would be to provide perspective rather than represent the interests of a particular stakeholder group.”
Corporate governance in large privately held businesses. The Government Response also addressed improvements to corporate governance in large, privately held businesses, including
(vii) develop a voluntary set of corporate governance principles for large private companies; and
(viii) require companies of a significant size to disclose their corporate governance arrangements in their Directors’ Reports and on their websites, including whether they follow any formal code.
There was also a final proposal (ix) to clarify the authority of the Financial Reporting Council, which oversees corporate governance.