Summary
This article examines the Government's proposed
legislation on directors' pay and the possible implications for company reward
practice. In particular, we consider:
the current voluntary framework on executive remuneration, detailed
in the "combined code", together with the latest guidance from institutional
investors;
the main problems associated with the existing regulatory regime;
and
the details and likely implications of the Government's legal
reforms.
On 7 March 2001, the Government finally revealed
its plans to tackle the controversial, media-hugging issue of "fat cat" pay.
Aimed at delivering greater "independence, transparency and accountability" in
the way executive remuneration is determined, the Government's proposals will
require companies to:
establish and publish details of remuneration
committees composed exclusively of independent non-executive directors;
disclose more details about the performance-related
criteria used in executive reward schemes;
demonstrate how the company has performed against a
number of comparator companies; and
in the light of evidence from the Company Law Review,
the Government will also consider whether to introduce a compulsory shareholder
vote on directors' remuneration.
But how effective these measures will be in curbing boardroom
excess is open to debate. Increasing globalisation has placed UK-based
companies under pressure to match the salaries of their international
counterparts, causing remuneration experts and fund managers alike to predict
ever more lucrative pay packages for Britain's top directors. Institutional
investors, who believe boardroom excess can ruin a company's reputation and
performance (as well as diverting wealth from investors), think that the
Government's proposals do not go far enough. The Association of British
Insurers' (ABI) revised guidelines on executive share schemes call for much
tougher performance criteria, while others, like the National Association of
Pension Funds (NAPF), are disappointed that the decision over whether companies
should put their directors' pay reports to a shareholders' vote was again put
out to consultation. The CBI, while supporting the principle of accountability,
expressed concern that the new rules could lead to the disclosure of
commercially sensitive information.
Present guidelines
The politically-charged issue of boardroom pay continues to hit the headlines.
The uproar over the £481,000 award recently paid to Sir Peter Bonfield, the
ex-CEO of debt-ridden BT, and the proposed bonus of £810,000 to Luc Vandevelde,
chairman of troubled retailer Marks & Spencer, are but the
latest in a catalogue of "fat cat" controversies.
In response to the ongoing commotion about boardroom pay, three
separate committees of inquiry have been conducted since the early 1990s -
Cadbury, Greenbury and Hampel - and their findings have been incorporated into
best-practice guidelines known as "the combined code". This is attached to,
although not a part of, the London Stock Exchange listing rules. Companies are
not required to comply with the code but must state whether they have met its
provisions and give any reasons for not doing so.
The three basic recommendations of the code are that:
executive directors should be paid just enough to
retain and attract those of the necessary calibre, and a proportion of
remuneration should be linked to corporate and individual performance;
the board should not decide their own salary, but
should develop an independent, open and transparent procedure for doing so. Key
to this process is the remuneration committee, consisting of independent
non-executive directors; and
the annual report should contain a statement of reward
policy and details of the remuneration of each director.
Included within the code are more specific guidelines on the
design of performance-related pay schemes. It also advises that remuneration
committees should consider whether directors are eligible for:
annual bonuses, for which
performance conditions and upper limits should be set; and
long-term incentive schemes or other types of scheme that do not include share options. All incentive
schemes should be subject to "challenging performance criteria reflecting both
the company's objectives and performance relative to a group of comparator
companies", the code says. It also recommends that grants under executive share
option and other long-term incentive schemes should normally be phased, rather
than awarded in one large block.
ABI advice
Further pressure on companies to regulate their pay practices
has been brought to bear by institutional shareholders, formalised through
guidelines published by the ABI. The association, which represents institutions
managing around a quarter of the funds listed on the London Stock Exchange, has
issued guidelines on the operation of executive share schemes for almost three
decades. Their advice covers a range of issues, including:
remuneration committees -
these should review share incentive schemes, obtain shareholder authorisation
for any amendments and maintain dialogue with their main institutional
shareholders;
disclosure of remuneration - shareholders should be provided with sufficient data to judge the
appropriate size of the award for any given performance level. Details of share
incentive schemes should include the ceilings, individual limits, performance
conditions and related costs and dilution limits;
performance-related pay criteria - the ABI recommends the use of total shareholder return (TSR),
relative to a relevant index or peer group "provided the remuneration committee
is satisfied that it is a genuine reflection of underlying company performance".
It advises against the substitution of performance criteria by the practice of
setting the option exercise price above that of the share's market value.
the vesting of awards -
payments should not occur before a minimum three-year period has elapsed, to
allow for adequate testing of the performance criteria. The ABI also encourages
the use of longer performance measurement periods; and
performance conditions of incentive schemes - these should require the achievement of not less than
the median/mean performance against a target group, or, where appropriate, an
equivalent performance condition, such as earnings per share growth of RPI plus
X%. The guidelines also advocate the use of sliding scales whereby directors
receive increased rewards for achieving higher targets.
The ABI's latest guidelines, published on 1 March 2001, also
recommend that companies tighten up on some taboo practices, such as:
repricing and other devices
adopted by certain companies to compensate for options going "underwater" - ie
below their pre-set price;
re-testing performance when
targets are not met in the first instance; and
awarding matching shares as
part of annual bonuses with no performance criteria applied.
Impact
The main impact of the best-practice guidelines has been to
influence the way executive pay is determined by improving the transparency and
independence of the pay-setting process. The establishment of remuneration
committees in practically all listed companies has helped to reduce the
conflict of interest caused by directors determining their own reward. In
addition, most companies are now publishing details of directors' pay in their
annual general report, thereby increasing the amount of information available.
(The key elements of executive remuneration are described in the box below)
There have also been moves to introduce performance conditions
on short-and long-term incentives and some progress has been made towards
ensuring that a larger proportion of salary is share-based (in an attempt to
tie the directors' fortune with that of the company). However, the percentage
of the total pay packet that is linked to performance is still much lower than
for US executives.
The rich get richer
But while the regulatory guidelines have
influenced, to some degree, how companies pay their directors, they have had
little effect on how much. Over recent years, Industrial Relations Services has
monitored the inexorable rise in executive pay (see Pay and Benefits
Bulletin 510 and 514). Research conducted
by the TUC in 1997 revealed that the average ratio between pay for the
highest-paid directors (excluding long-term incentives) and the average
employee stood at 16:1, up from 12:1 in 1994.
A recent survey by Executive Remuneration Review1
demonstrates the scant attention paid to the provision in the combined code
that "remuneration committees should be sensitive to the wider scene, including
pay and employment conditions elsewhere in the group, especially when determining
annual salary increases". Covering 1,457 executives in 95 FTSE-250 companies,
the survey reveals that:
directors' basic salary rose by 8% in 2000, more than double the rises typically given to most
employees;
the basic salary of chief
executives in the FTSE top 30 was worth £600,000 at the median, rising to more
than £800,000 when bonuses are included;
the median level of annual bonus was worth 24% of basic salary;
58% of respondents intended to grant share options in the foreseeable future. The median
value of shares optioned last year was 81% of basic salary; and
long-term incentive plans are offered by less than a third of companies. The estimated on-target value
of benefits is set at £81,000, representing 54% of basic salary.
Further examples of executive excess were revealed in research
published recently by the Institute of Management and Remuneration Economics2,
which showed a big increase in boardroom bonuses. The earnings of UK company
directors rose by 12.9% in the year to January 2001 - more than double the
figure for the previous year. The increase is due largely to the boost in
bonuses, which rose from an average of £20,856 in 1999/2000 to £28,071 in the
following 12 months - a jump of 34%.
Main concerns
The impotency of the current
voluntary framework to curb boardroom excess pay has led the Government to argue
that, while companies may follow the letter of the guidelines, they are failing
to comply with their spirit. The Government's main concerns are that boardroom
pay practices lack:
accountability - only
a tiny minority of companies are putting their remuneration report forward for
shareholder approval, despite clear evidence that shareholders do have concerns
about pay-related issues;
transparency - many
companies still fail to provide information on quite basic aspects of their pay
practice while others provide so much information that any intelligibility is
lost in the complexity of the figures. The Hampel Committee, following their
review of companies' remuneration policy statements, concluded that few do more
than mention "anodyne" references to the need to "recruit, retain and motivate"
or to pay "market rates". The committee called for more informative statements
drawing attention to factors specific to the organisation;
a clear link to performance - it is usually very hard to determine what, if any, are the exact
performance criteria upon which merit awards are based. The most common -
earnings per share (EPS) and total shareholder return (TSR) - are rarely taxing.
Moreover, there is still a small but significant proportion of schemes that are
not performance-related;
independence - research carried out by the
Co-operative Insurance Society found that 60% of FTSE-100 companies have
remuneration committees that contain directors who are not independent by the
standards set down by the NAPF (see box ). The existence of
cross-directorships may also provide executives with an indirect interest in
maintaining salary levels.
Performance problems
annual bonuses -
thirty per cent of companies provide no information regarding the performance
criteria on which annual bonuses are based. The most commonly used criteria are
profit (37%) and earnings per share (27%). The research also found that under
half of companies did not specify a maximum limit on the amount of bonus payable
and almost a quarter of companies disclosed that their bonus payment was
unaccompanied by any long-term scheme.
executive share option schemes - nearly all schemes (95%) for which information was given specified that a
minimum period of three years must elapse before options can be exercised. Very
few schemes had a longer minimum period, as encouraged by the ABI. Ninety per
cent of share option schemes use only one performance criterion. By far the most
common is earnings per share. No information was provided on the performance
criteria employed in a quarter of the share schemes analysed and more than 11%
of schemes apparently do not attach any performance conditions to the exercise
of share options. Overall, the report concludes that "eight out of 10 directors
are still receiving bonuses for substandard performance".
long-term incentive schemes - earnings per share was the most frequently used performance criterion
applying to 38% of schemes, closely followed by total shareholder return (33%),
which is favoured by institutional investors and larger companies.
dotcom rewards - the
PricewaterhouseCooper study also highlights the "reward chasm" that still exists
between traditional company practice and developments in the new economy. The
hi-tech and dotcom sector's reward practices seem much closer to the
Government's ideal of accentuating reward through performance, particularly in
the use of share options. The median value of options held by new-economy CEOs
is over £2 million, compared with a figure of only £216,000 for traditional
chiefs. However, when setting aside share-options and other long-term awards,
the average remuneration for chief executives in new-economy companies is
£279,000 - much lower than the old-economy figure of £416,000. The falls in
internet and technology stocks earlier this year graphically demonstrated how
pay packages, less cushioned by high levels of basic pay and bonuses, can be
dented by poor share performance.
A similar study by executive remuneration specialists New
Bridge Street Consultants4 revealed how share-matching schemes still
seem to be immune to performance. Two-thirds of FTSE-100 companies who operate
such a scheme do not attach any performance conditions.
Government consultation
Realising that it would take more than best-practice guidelines
to persuade companies to adopt its ideals on boardroom pay, the Government
finally conducted a consultation exercise in 1999 to pave the way for
legislation. The results (see table 1 )
revealed a reluctance among a large proportion of quoted companies to take any
further steps on revising pay practices, especially in terms of disclosure
requirements. This differs significantly from the views of the participating
institutional investors, who believe only full disclosure on boardroom remuneration
will allow shareholders, on whose behalf they act, to judge whether they will
gain a competitive return on funds invested.
|
Table
1: Government consultation on directors' remuneration - the proposals and
responses
|
|
Proposal
|
%
of comments which were favourable
|
|
|
quoted
companies
|
institutional
investors
|
all
other respondents
|
|
Remuneration committee:
|
|
|
|
|
All quoted companies should be
required to set up a remuneration committee of independent non-executive
directors
|
85%
|
100%
|
74%
|
|
The best practice framework should
be strengthened by its stating that:
|
|
|
|
|
n the chairman of the board should
not be a member of the committee
|
21%
|
29%
|
33%
|
|
n the committee should not employ
remuneration consultants who are also employed by the company's executive
management
|
2%
|
36%
|
39%
|
|
Linkage of award to performance
and disclosure:
|
|
|
|
|
Companies should be required to make
more informative disclosures on linkage to performance
|
48%
|
92%
|
89%
|
|
There should be scope for
simplifying the disclosure requirements on individual directors' remuneration
|
66%
|
46%
|
68%
|
|
Companies should be required to
state:
|
|
|
|
|
n the longer-term objectives that
the company is seeking to achieve in relation to the performance of the board
|
37%
|
100%
|
46%
|
|
n the criteria which the company
will use to measure the performance of the directors against those objectives
|
42%
|
100%
|
58%
|
|
n whether the companies will be
measuring its performance against a comparator group of companies
|
26%
|
100%
|
57%
|
|
n how the company has performed in
relation to the comparator group in respect of its objectives during the
preceding financial years
|
30%
|
100%
|
54%
|
|
n proposed balance between elements
in the package which are/are not performance related
|
41%
|
100%
|
67%
|
|
n the relationship between the
awards made under the incentive schemes and the company's performance in the
year in which the awards earned
|
32%
|
100%
|
64%
|
Despite company protestations, the proposals put forward in the
Government's consultation paper have been broadly maintained - the only
significant divergence being from the requirement that committees should use a
different firm of remuneration consultants than the one employed by the
company. Instead, in response to the concern that this proposal was unfeasible
due to the low number of such experts, reports are only required to name the
consultancy used to advise the committee.
New legal requirements
Stephen Byers, the former trade and industry secretary,
announced the Government's reforms on directors' pay after a six-month delay
caused by a Cabinet dispute over how draconian the new laws should be. When
implemented, the proposals will require quoted companies to:
form a remuneration committee consisting exclusively of non-executive directors;
publish a report on directors' remuneration as part of the company's annual reporting cycle; and
disclose within the report details of individual
director's remuneration packages, the role of the remuneration committee,
remuneration policy as well as specific requirements relating to the disclosure
of information on performance (see box ).
Timetable for reform
No concrete dates for the proposed secondary legislation have
yet been set, as plans were put on hold during the run up to the General
Election. Despite Labour's victory, further public consultation on the measures
may still take place and it is therefore unlikely that legislation will be
passed until 2002 at the earliest. The decision on whether to introduce a
compulsory shareholder vote on the board's remuneration report will be taken in
light of the evidence from The Company Law Review, the results of which were
due to be presented to Ministers after the election. If the decision is
affirmative, the compulsory shareholder vote may also be included in the
secondary legislation and not introduced as part of the new company bill, which
would probably not reach the statute books until 2004.
The future of boardroom pay
The likelihood that the new legislation will prevent top pay
continuing its skyward path is remote, especially when one considers the
increasing influence of American reward practice in this country. New Bridge
Street Consultants report that competition for executive talent is increasing,
with US-based organisations offering much higher remuneration packages. This in
turn has forced UK companies to react with "schemes which would have been
unthinkable only a few years ago".
An indication of the type of new share option schemes being
introduced is provided by their research, which demonstrates that while targets
are becoming tougher - 83% of share option schemes introduced in 2000 had an
EPS target of the retail prices index plus 3% or greater - these new schemes
have been accompanied by higher individual limits.
Even if total remuneration levels cannot be restricted, the
adoption of US-style pay practices, together with the ABI's revised guidelines
and the proposed secondary legislation, will provide hope for the Government
that companies will at least:
continue to attach tougher performance conditions to
the, albeit higher, awards;
encourage executives into share ownership of their
companies to further tie their fortune with that of the company; and
provide clearer information, which will allow
shareholders to judge the merits of the directors' awards and bring pressure to
bear, whether or not through a compulsory vote, on directors' pay packets.
Main
elements of directors' pay
Basic salary - the fixed
element of directors' pay packets is decreasing in relation to variable
performance-related components. However, it still forms a much higher proportion
of total salary than in the United States.
Bonuses - these short-term
incentive-based payments are usually paid annually in cash or shares. Their main
aim is to focus attention on immediate business goals. The most common
performance criteria are corporate rather than individual and are related to
profit and earnings per share (EPS). The calculation for EPS is "pre-tax profit
dividend by the number of shares in issue". So, if a company makes £10 million
and has 100 million shares in issue it's earnings per share is 10 pence. EPS
provides a purer measure of profitability than the overall reported profit
figure.
Share-matching schemes -
executives who choose to invest part of their bonus in company shares receive
matching free shares. Sometimes this process is linked to performance measures.
Executive share option schemes (ESOS) - these are long-term incentives that give the recipient the
opportunity to buy shares at a pre-set price at some future date. If a share
grant is exercised and the share price has risen, an executive can make
substantial gains by selling the shares and making a profit or keeping them to
receive an annual dividend. Since the "combined code", performance criteria for
the exercise of options have generally been applied and are invariably EPS with
a growth target of RPI plus 2%.
Long-term incentive plans (LTIPs) - these schemes were introduced in the mid-1990s to further align
the interests of executives with those of shareholders by attaching performance
conditions. Typically, under an LTIP scheme - such as a performance share plan -
executives receive a notional allocation of shares paid for by the company. The
proportion of the award that vests is dependent on satisfying certain
performance conditions over a specified period, usually three years. The typical
performance criterion is total shareholder return (TSR), which represents price
appreciation plus interest, dividends, and capital gain distributions for a
given investment or account during a specific period. Because it takes into
account all these elements, it is the best way to measure the performance of
similar or different investments. There has been a decline in the use of LTIPs
as ESOS have become increasingly performance-related and are simpler to
administer. LTIPs are most commonly used in FTSE 100 companies.
Pensions - when taken into
account, pensions can substantially increase directors' total remuneration. The
most common type of scheme in FTSE-100 companies is final salary, with directors
usually required to contribute 5%. Half the schemes reviewed in a study by
PricewaterhouseCooper (PwC) were based on final salary, the median value of
which stood at £37,000 for CEOs. The survey by New Bridge Street Consultants
revealed that one-third of pension schemes do not require directors to make
their own contributions.
Benefits - directors'
benefits typically include a company car, fuel payments and private healthcare
insurance. The value of taxable benefits are normally detailed in annual
reports, together with the other components of directors' remuneration. PwC's
research demonstrated that the median level of benefits for chief executives is
£15,000.
Guidelines
on the independence of non-executive directors
The ABI and the NAPF suggest the criteria set out below as
the "minimum likely acceptable to institutional investors", although this is
not an "exhaustive" list.
An individual director's integrity is highly relevant and it is
understood that the level of a director's independence can vary, depending on
the particular issue under discussion. In assessing the independence of a
non-executive director, the assumption is that the individual is independent
unless, in relation to the company, he/she:
was formerly an executive;
is, or has been paid by the company in any capacity
other than as a non-executive director;
represents a trading partner or is connected to a
company or partnership (or was prior to retirement) which does business with the
company;
has been a non-executive director for nine years - ie
three three-year terms;
is closely related to an executive director;
has been awarded share options, performance-related pay
or is a member of the company's pension fund;
represents a controlling or significant shareholder;
is a new appointee selected other than by a formal
process;
has cross-directorships with any executive director; or
is deemed by the company, for whatever reasons, not to
be independent.
Source: National Association of Pension Funds.
Disclosure
requirements under proposed secondary legislation
(a) Remuneration committee
Regarding the remuneration committee, companies would be
required to disclose:
its membership;
whether the board had accepted the committee's
recommendations without amendment; and
the name of each firm of remuneration consultants which
had advised the committee.
(b) Statement of remuneration policy
The company would need to provide a statement of their
remuneration policy, as is currently required in the listing rules, but would
also be required to include the following specific aspects:
details of, and an explanation of, performance criteria
for long-term incentive and share option schemes, or of any amendments, or
proposed amendments, to the terms and conditions of such schemes;
details of, and an explanation of, comparator group(s)
of companies;
an explanation of the balance between elements in the
package which are, and are not, related to performance; and
details of, and an explanation of, the company's policy
on contract and notice periods for executive directors, and on compensation to
former directors.
(c) Details of each director's remuneration in the preceding
financial year
This would broadly replicate the current requirements in the "combined
code", but companies would be required to present the information in a
prescribed, tabular format to facilitate comparison between companies. This
section would also require boards to provide a post hoc justification of
compensation payments.
(d) Performance graphs
The graphs would provide historic information on the company's
performance, together with that of comparator companies, which would complement
the forward-looking policy statement in (b) above. The requirement would be
modelled on the current requirement set by the US Securities and Exchange
Commission (SEC).
