Chapter 16 - Remuneration of Directors & Senior Executives Flashcards
Why is remuneration a corporate governance issue?
- Attraction/retention of talented executives
- Difficulty aligning incentives with the interests of shareholders / to ‘promote the long-term success of the company’
- If excessive reward for poor/even average behaviour- company starts being run in management’s own interest
- High levels of executive pay diminish public trust in larger companies
- Directors should not be able to decide or influence their own remuneration
- Directors should not be rewarded for failure.
- Shareholders have greater control if have role in settting director remuneration policy#
List 5 difficulties that might arise when linking reward to performance
- PERFORMANCE MEASURES - RIGHT ONES
- TARGETS - should ensure short-term incentives promote the long-term success of company
- BAD BEHAVIOUR - not encouraged by the targets set for incentive schemes
- THRESHOLDS - challenging but not unobtainable
- CAP - whether to set one, if so what
- PIGGY-BACKING/LEGACY EFFECTS/DRAG DOWN - preventing these
- SHAREHOLDERS must be SATISIFIED with the scheme
- EXPECTATION - of bonuses by directors/senior execs - regardless of performance
What are relevant sections of CA2006 relating to the remuneration?
- ss.226A & 226B - a quoted company cannot make any payments to a director unless they are consistent with the latest policy approved by shareholders or where the payment has been specifically approved by shareholders.
- s.420 - quoted companies to make detailed disclosures re remuneration in ‘directors’ remuneration report’, separate part of Annual Report & Accounts
- s.422A - the policy that shareholders are invited to approve must be a policy that has been approved by the directors either as part of the directors’ remuneration report or separately as a revised policy.
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s.439 CA 2006
- Annual remuneration report (implementation report) must be put to annual vote by shareholders at AGM
- If resolution defeated - must put existing rem policy/revised policy to vote at next AGM
- Shareholders must be invited to approve policy at least every 3 yrs (revised or not) - s.439(A) - directors must invite shareholders to approve their policy at least once every 3 years whether or not it has been revised and must obtain shareholder approval for any revised policy before they can make any payments under that new policy.
Policy should be available on company website - either as part of Annual Report and Accounts or, separately, if revised separately.
What are malus & claw-back provisions?
Remuneration schemes and policies should enable the use of discretion to override formulaic outcomes. They should also include provisions that would enable the company to recover and/or withold sums or share awards and specify the circumstances in which it would be appropriate to do so.
PROV.37
‘malus’ provisions allow the company, in specified circumstances, to forfeit all or part of a bonus or long-term incentive award before it has vested and been paid (also known as ‘performance adjustment’); and
‘clawback’ provisions allow the company to recover sums already paid.
the current market standard triggers for malus and clawback are gross misconduct or misstatement of results (IA Principles, Nov 2020)
List measurements of performance.
- Earnings Per Share (EPS)
- Total Shareholder Return (TSR) Share price & Dividend
- PBIT / EBITDA
- Return on Capital Employed (ROCE)
- Others / KPIs (including Non Financial)
What elements can executive remuneration can be divided into?
FIXED (Regardless of performance)
Basic Salary
Pension scheme payments
VARIABLE (Performance based)
Bonus (short-term incentive)
Share options and other long-term incentive schemes (long-term performance)
What are some potential Issues regarding the use of remuneration consultants?
CONFLICTS AND CONNECTIONS - May have conflicts of interest by virtue of the fact they are also engaged by the executives to advise the company on other aspects of remuneration or may have another connection with an individual director (e.g. an executive director who serves on another company’s remuneration committee).
EXEC FAVOURING - There is a risk that they will make recommendations which favour the executive directors and are not necessarily in the best interests of the company
OWN INTEREST- May be inclined to recommend complex remuneration schemes in order to increase their fees and make it more difficult for the remuneration committee to dispense with their services in future years.
PRESSURE X 2- May put pressure on the remuneration committee to accept their advice (e.g. by failing to come up with any credible alternative).
Executive directors and senior management may also put pressure on the remuneration committee
What are the significant points in UKCGC addressing directors/executive remuneration?
UKCGC: - remuneration committee has delegated role in the process of determining directors’ remuneration (listed)
(Principles - P, Q, R / Prov - 32-41)
Required listed companies to establish a remcom of independent NEDs
o To set pay/benefits for execs, chair & snr mgmt within fwork of approved remuneration policy
o Design the exec remuneration policy - a significant part of the policy that is put to shareholders
Includes broad recommendations on overall level of pay/design of incentive schemes
o Supplemented by guidance from institutional investors & their representative bodies supports this
Includes several measures seeking to prevent rewarding directors for failure
What does CA2006 state regarding compensation for loss of office?
New legal threshold for directors’ service contracts which now states that they must not exceed two years’ duration without shareholder approval, compared to five years before (s. 188).
What do L.R. 9.4.1/9.4.2 require of premium-listed companies in regards to executive remuneration?
shareholder approval for most long-term incentive schemes/discounted share options in which directors may participate
What are some potential components of directors’ remuneration?
- Basic salary
- Payments into pension scheme (or in lieu)
- Annual bonus (usually linked to company’s financial performance)
- Long-term incentives (ex. share options/share awards - “restricted stock awards”)
- Other perks/benefits - ex. medical insurance/company cars/accommodation etc.
What can the auditor and audit committee do to prevent against manipulation of financial targets (re incentive schemes)
- Be on guard to potential manipulation of critical performance measures
- Pay close attention where key judgements/estimates are made by management
- Most importantly - targets should be aligned with the interests of stakeholders.
What is a deferred annual bonus scheme and, generally, what conditions?
- Deferred annual bonus scheme - entitlement to use some/all cash bonus on shares
- Shares may be in trust for 3 yrs - after which may be entitled to free matching shares subj to a target growth objective for the company within that specified period.
Overview points on short-term incentive schemes
- Usually 1 or more cash bonus
- Paid where actual performance reaches/exceeds predetermined targets
- May depend on both individual targets and the performance of the company as a whole
- Review period usually linked to financial year
- Targets liable to manipulation - audit/AC should be on guard to avoid this (ex. Tesco profit overstating)
- Could use a deferred bonus scheme - use all/some cash to buy shares (shares then be held in trust - then individual entitled to reward of free matching shares) - depending on a target for the period (for example, growth)
Overview points on share options
- Usually conditional on director/senior exec meeting certain performance targets
- Option - gives holder right to a new share at a fixed price on/after specified date in future (typically 3 yrs) as long as they still work for company
- Purchase price for new shares = exercise price (typically market value)
- L.R - exercise price must not be less than current market price on date option is granted
- If market price goes up between issue of option and exercise date = immediate profit to exercise option and sell shares received.
- Options do not usually require exercising immediately- can be held onto but will subj to max period (10 yrs typically) - when they will lapse.
Overview points on grants of shares (‘performance shares’)
- Grant of existing shares (bought back from shareholders)- provided in job after specified period (typically) 3 yrs.
- At time of grant - will not receive/acquire ownership of shares, will not happen until they vest, which will be conditional on the achievement of certain performance targets
- Grant of shares are usually made on annual basis.
Do executives automatically benefit from share options and share grants?
- Share options - exec gets no benefit of share price remains below exercise price
- Share grants - exec benefits even if share price falls because shares still have some value
Key points on use of benchmarking when determining executive remuneration.
- Use of comparative pay data to decide exec remuneration, based on rewards in comparator group
- Information will usually be provided by company’s remuneration consultant
- Remuneration consultant would also make recommendations on choice of comparator group- this can have a significant effect on remuneration outcomes (ex. higher director pay in USA)
- Even if appropriate group picked, inherent issue is if every company does this (benchmarking to the market) salaries spiral out of control
- FRC G.B.E - “avoid designing pay structures solely on benchmarking to market, or solely based on the advice of rem consultants, as there is a risk this could encourage an upward ratcheting effect on executive pay.
What are the drawbacks of share option schemes?
- re Dividends
- Misalignment of interests
- Bull/Bear runs (prices rise/fall regardless of company performance)
- Underwater/out of money options (market value under exercise price) - incentives become meaningless
- Grant of shares may be preferred- will always have some value
- IFRS2- share awards an expense against profits from time options granted - may discourage some companies from using options as an incentive
What company targets may be used as a basis for fixing annual bonus payments to a CEO?
Bonus payments may depend on the achievement of both individual targets and the performance of the company over the previous financial year.
