The damage that the recession is doing to UK plcs and the wider economy will influence executive pay decisions over the next few months. The symptoms include: deep uncertainty about the future; steep share price falls; widespread job losses and pay freezes (or even reductions) for the survivors; and bank directors leaving without compensation payments, with many survivors waiving bonuses. Institutional shareholders in UK plcs are caught up in the same whirlwind as the financial services sector. Inevitably, the performance of fund managers has come under greater scrutiny. As owners of UK plcs, they want to ensure that pay practices align the interests of executives with those of shareholders.
The need for plcs to obtain shareholder approval for their directors’ remuneration reports (DRR) means that directors’ pay is not just an internal matter for the company. As a result, the DRR gives an opportunity to challenge pay policies and to scrutinise existing practices. The DRR regulations (now in regulation 11 and schedule 8 of the Large and Medium-sized Companies and Groups (Accounts and Reports) Regulations 2008) require remuneration policies for directors of listed companies, and the main details of individual directors’ packages, to be disclosed annually in a DRR. The 2008 regulations replaced the existing regime found in schedule 7A of the Companies Act 1985 in April 2008. The new regulations do not materially differ from the previous DRR regulations, which remain relevant for companies with financial years ending up to 5 April 2009.
Despite the ordinary resolution on the DRR being only an advisory vote (that is, nothing is repaid if the resolution is voted down), failure to secure shareholder approval is a serious matter and would generally amount to a vote of no confidence in the remuneration committee. (New long-term incentive plans require a separate resolution to comply with the Listing Rules.)
Practical guidance in this area is in the sections of the Combined Code on Corporate Governance relating to remuneration and in guidance issued by the Association of British Insurers (ABI), the National Association of Pension Funds (NAPF) and other shareholder bodies. The DRR regulations set out detailed content requirements, but do not give any guidance on good or bad practice. There is little relevant black-letter law on the matters covered below. This briefing highlights some areas of potential difficulty.
Should base salaries be frozen?
Base salary increases are important to executives, both intrinsically and because the level of base salary usually drives the main elements of the remuneration package – short and long-term incentives (LTIs) and pension benefits. While most committees are likely to be cautious this year, the Combined Code requires that they should be ‘sensitive to pay and employment conditions elsewhere in the group, especially when determining annual salary increases’ (Supporting Principle B1). Similarly, the only material amendment in the new DRR regulations will, for DRRs for financial years beginning on or after 6 April 2009, require listed companies to state how pay and employment conditions of employees in the group were taken into account when determining directors’ remuneration (regulation 4).
What about directors’ pension arrangements?
Many commentators expect the downturn to accelerate the existing trend away from final salary pension schemes and it is hard to see that directors will be immune. Care needs to be taken on disclosure of pension arrangements, such as additional costs associated with enhancements to which executives are entitled on redundancy.
Committees will need to think carefully about bonuses for 2008. Institutional shareholders will scrutinise directors’ bonuses for 2008 and may oppose (or already have opposed) DRRs where bonus targets have been varied or side-stepped (or where there is insufficient information on targets to know if this has happened). Many companies will look at arrangements for awarding deferred bonuses in shares, with vesting being conditional on remaining in service for two or three years. In rare cases, it may be possible to use new-issue shares for this purpose to conserve cash (this would generally require shareholder approval).
For companies in the financial sector, committees will need to look at the interim recommendations issued by the Financial Services Authority (FSA) in October 2008. The focus was on the alignment of remuneration policies with sound risk management systems and controls. Two key recommendations are that: committees should have control ?? of remuneration policies across the firm. This means that
- committees should understand the parameters of the group’s bonus schemes, including the strengths and weaknesses of all arrangements relative to FSA and other guidance. This would cover not only design matters but also weaknesses in valuation methodology, assessment of other risks and management of conflicts; and
- payment of a major proportion of bonus should be deferred, so that the effect of one year’s performance on the firm’s long-term profits can be established – in other words, so that payment based on a bad bonus decision in one year can be recouped in a subsequent year.
This may come as a surprise to many committees.
Effect on existing LTIs
LTIs are usually the critical element in the pay package and the most difficult for committees to get right. They are usually assessed over a three-year performance period and vesting is dependent on achieving a preset performance target. The targets need to be described in the DRR. Once set, it is unusual to change targets and any revised target would require disclosure.
The kneejerk reaction to a sustained share price fall is that existing LTI awards are rendered worthless. This is often not the case because the position depends on:
- the nature of the incentive instrument. There are two broad alternatives – performance shares (free shares that vest if a performance target is met) and options to acquire shares at an exercise price equal to market value at grant (where the executive’s return is dependent on the share price being above that exercise price during the exercise window following vesting); and
- the nature of the performance target that must be met for vesting to occur. In broad terms, this will either be an ‘external’ target (where the company’s performance is assessed relative to its peers, usually in terms of total shareholder return (TSR) achieved by each company) or an ‘internal’ target (which compares the company’s year-on-year growth in relation to a key metric, such as earnings-per-share growth). Institutional shareholders generally prefer external targets.
In the past ten years, performance shares have become the main form of LTI for larger plcs. Provided the performance target is met, performance shares can deliver value even if the share price falls over the performance period. Further, if there is an ‘external’ target (eg TSR growth) and the company achieves good relative performance against its peers, there can be a full vesting even where share prices have fallen (although the ‘currency’ of payment has depreciated). In practice, most plans are not solely TSR-based, or involve an underpin to the TSR target (requiring the committee to conclude that the company’s financial performance has been satisfactory).
For other kinds of target (such as EPS growth), the downturn may mean that targets will not be met – possibly for several years’ awards. In that event, the committee may wish to consider special action in 2009.
What about repricing options?
For those companies that operate market-value option plans, it is tempting to consider repricing options so that the revised exercise price is reduced to reflect the current share price. Various techniques are available but, as this would involve a breach of ABI guidelines, proposals to reprice options are seldom implemented.
What special steps can we take on LTI awards in 2009?
Many committees will wish to treat 2009 as an exceptional year – either because business conditions are too uncertain to apply customary LTI targets or because the pipeline of historic LTI awards no longer achieves any worthwhile retention or incentive purpose. Committees may consider the feasibility of the following:
- making cash-based LTI awards, rather than using shares. In practice, there is usually no advantage in this approach as shareholders prefer a linkage to shares (to achieve alignment with their own interests). Further, the use of cash does not justify a softer performance target;
- increasing annual bonus potential (and reducing LTI levels) but requiring a larger proportion of bonus to be invested in shares. This addresses the uncertainties of a three-year horizon, but tends to be distrusted by shareholders (partly because shareholders favour the LTI designs described above and partly because annual bonus targets escape the disclosure regime that applies to LTI under the DRR regulations); or
- granting restricted shares (where vesting is dependent on future service only) in addition to conventional performance share awards. This is fine below board level, but several major plcs did this for directors in early 2008 and attracted criticism under such headlines as ‘pay for respiration’. But this approach may be the best of a bad lot.
Should we make better use of tax-favoured options?
Conventional LTI arrangements do not attract tax breaks, so awards granted in 2009 will attract 45 per cent income tax (for those earning £150,000 plus) when they vest after 6 April 2011. Higher national insurance contributions (NICs) rates will also apply for employer and employee.
Remuneration committees – which usually supervise share plans across the group – have usually been slow to make use of the tax relief available under Her Majesty’s Revenue and Customs-approved ‘company share option plans’. Although there is a £30,000 ceiling on the aggregate exercise price of unexercised options, the differential between the capital gains tax rate (now 18 per cent) and the future income tax and NICs rates makes this worth looking at.
Two design approaches are to use such options:
- across the group, potentially in substitution for an element of annual bonus; or
- as a ‘foundation layer’ for conventional LTI. Even where performance shares are used, it is relatively straightforward to use approved options to deliver the upside (ie growth in value) element on the first £30,000 of an award and to make a separate (fully taxable) arrangement to deliver the shares representing the £30,000 exercise price.
Should we review our directors’ service contracts?
For many companies, the answer to this will be ‘yes’. The terms of directors’ service contracts are likely to be an area of friction in 2009, as shareholders express dissatisfaction over termination costs for departed directors and benchmark existing service contracts against perceived best practice.
This is a complex area. A gold standard service contract – which probably does not exist across UK plc – would provide for:
- a termination payment in lieu of notice (PILON) equal to 12 months’ base salary in the event of a no-fault termination by the company. This involves a pre-set contractual payment in respect of the notice period rather than an assessment of damages. By restricting the payment to base salary (rather than compensating for the rest of the annual package), the company reduces the headline termination cost;
- a right for the company to offset ?? some or all of the executive’s monthly earnings from any new job during the 12-month period against monthly payments under the termination clause (a contractual mitigation feature); and
- a mechanism in the contract to ensure that the executive is not ‘rewarded for failure’ in the event of termination, along with a legally robust definition of failure in the contract.
Most service contracts fall short of this standard in one or more of the following areas:
- sometimes there is no PILON provision in the contract, so normal damages principles apply on termination (in which case the termination payment would, before mitigation, relate to all contractual entitlements that would have fallen due during the notice period);
- where there is a PILON in the contract, it normally goes beyond base salary to compensate for loss of pension contributions or accrual, other benefits and prospective bonus during the notice period. These additional items in the PILON ‘shopping list’ can have the effect of doubling a base salary PILON. Of these further items, institutional shareholders tend to be particularly unhappy about the bonus element;
- even where there is a PILON provision, there is often no right to achieve contractual mitigation by offsetting replacement earnings from a new job. In consequence, a full termination payment could be required even if the director is immediately re-employed; and
- it is exceptionally unlikely that there would be a provision denying or reducing a termination payment in the event of unsatisfactory individual performance (not amounting to gross misconduct). The Combined Code and ABI/NAPF recommendations that contracts should prohibit rewards for failure have been largely ignored, partly because the concept is difficult to translate into practical benchmarks of ‘failure’. But the sight of bank directors leaving without compensation has re-ignited this debate.
Problems on directors’ pay issues can often be avoided by plcs consulting with key shareholders before the DRR is published and engaging promptly if there are queries after publication. But it is important that committees and advisers are aware of the likely flashpoints.
A variation of this briefing first appeared as an article in the January/February 2009 edition of PLC Magazine.