The credit crisis has led to strong criticism of remuneration practices in the financial services sector. There is a perceived misalignment between the short-term nature of the bonus culture and longer-term interests of shareholders and wider stakeholders. Governments and regulators across Europe and the US are calling for banks to make material changes to the ways they calculate and pay bonuses.  

As a result of the current down turn, companies in the wider economy are also facing difficult issues around short-term incentives. For many companies, cash savings are an urgent priority and remuneration committees will be taking difficult decisions about the appropriate level of bonus payments in the current climate.  

Peter Montagnon, director of investment affairs for the Association of British Investors, recently commented with respect to such decisions: “Companies need to be sensitive to the climate in which they find themselves”.

What are companies being advised to do?

At the end of last year, the Financial Services Authority (FSA) wrote to the CEOs of all UK regulated companies setting out good and bad remuneration practice. The FSA recommends that executives will be better incentivised to manage risk if short-term cash incentives are deferred into long-term share-based awards.  

Even before the current crisis, the practice of deferring a proportion of annual bonus into share awards was becoming increasingly popular, particularly for companies whose remuneration packages comprised high proportions of variable pay.  

The FSA have also recommended that, in certain circumstances, a claw-back of bonus payments would be appropriate.  

How does deferred bonus work?

Deferring a cash award into a performance-related share award is a very effective way of aligning an executive’s interests with long-term shareholder value because the number of shares ultimately delivered to the executive is scaled back if company performance is not achieved and the ultimate value of the reward tracks the market share price.  

Under a deferred bonus arrangement, the company calculates the cash equivalent of the executive’s annual bonus and, instead of paying the bonus in cash, the company grants the executive a conditional award over an equivalent number of shares. The number of shares is fixed at the time of grant by reference to the market value of the company’s shares at that time. For example, if the executive’s bonus would have been £10,000 and the market share price is £1 per share, the executive receives an award over 10,000 shares. However, because the award is conditional, the executive will not receive the shares straight away - the awards vest and the shares are delivered in the future depending on continuing service and possibly further company related-performance conditions.  

The benefit for the executive is the potential upside of the increase in share price and the fact that the number of shares is based on gross, as opposed to net, bonus. This means that the executive has the potential to realise greater value from the conditional share award compared to a straight investment in the shares from net income. In the UK, deferral of a bonus is not a taxable event. Although income tax and possibly national insurance will arise on the eventual delivery of the shares (based on their market value at that time), a statutory corporation tax deduction should be available to the company subject to conditions.  

Many companies operate bonus deferral on an annual basis as a key element of their remuneration packages. In addition, deferral could also be operated as a one-off measure to assist companies in the short-term with liquidity issues arising from the current crisis.  

How is bonus deferral implemented?

Companies may already have in place a long-term share plan which is flexible enough to operate with a deferred bonus arrangement. Main list companies will need to obtain formal shareholder approval for new share plans involving new issue shares or which grant any performance-related awards to directors. Although a deferred bonus plan may be described as discretionary, if the bonus forms a significant proportion of the executive’s total compensation, contractual rights to receive the bonus could be established (either expressly or implied by previous conduct or practice) unless the bonus arrangements are explicitly agreed to be non-contractual.  

In addition, in exercising any discretion under the plan, companies may be obliged to provide the cash bonus if it has been presented as a potential reward for past service and the stated key performance indicators have been achieved. In these cases, the Courts have been willing to construe that the executive has established a vested right even though the company may now wish to determine that the bonus should not be paid for other commercial reasons.  

How could bonus claw-back work?

The FSA have suggested that, in certain circumstances, companies should consider clawing back bonuses that have already been paid out.  

This raises considerable legal and practical enforcement difficulties for employers. An employer’s ability to recoup an already paid-out bonus from an executive depends on the executive having sufficient assets, which might not always be the case. In addition, the reputational and monetary costs of enforcement (particularly where the executive has left employment) may well make legal proceedings cost prohibitive.  

Further, any tax and national insurance liabilities accounted for by the executive and the company in relation to an already paid-out bonus could not then be reclaimed from the tax authorities in the event of a claw-back.  

Due to these difficulties, deferring the payment of bonuses may provide a more practical alternative to claw-back and recently reformed bonus arrangements announced by UBS and Morgan Stanley have adopted this approach.  

For example, under the new UBS arrangement, the cash bonus element will reportedly take the form of a “cash balance plan”. When an executive becomes conditionally entitled to a cash bonus payment, it will be “booked” in the executive’s plan account, rather than paid out immediately.