Government Corporate Governance Proposals – Executive Remuneration Aspects

On 29th August 2017, the Government published its proposed improvements to the corporate governance regime in the UK, following a consultation paper issued in November 2016. Overall, the proposals it now intends to implement - whether on remuneration or otherwise - are modest in comparison with some of the suggestions originally put forward, which is an approach companies and investors have generally welcomed.

For relevant background, click here for a link to our Law-Now on the November 2016 consultation paper. As further background to the debate, click here for a link to our Law-Now on a report by the relevant House of Commons Committee on the same subject, and here for our Law-Now on the Investment Association Working Group proposals on remuneration issued last year.

The Government proposals fall into three categories. The UK corporate governance framework for executive remuneration is a mixture of legislation, best practice code and investor guidelines. Changes are proposed to all three.

Other points though to note are that the Government is still to consider the effect of share buy-backs on bonus targets and capital allocation. It has also asked the Financial Reporting Council ("FRC") to consult on including a UK Corporate Governance Code provision to have one of the following: a designated non-executive director dealing with employee engagement, a director from the workforce, or an employee advisory council.

1. Legislative changes

It is assumed that the following changes only will affect companies listed on the main market rather than AIM companies, and because the change is being made to UK company law can only affect UK incorporated companies.

CEO/employee pay ratio

The Government proposes that quoted companies should include in their remuneration reports a ratio reporting the difference between CEO pay and average UK employee remuneration. The Government will consult on how the employee figure is to be worked out, but the CEO pay figure will use the existing remuneration figure. Non-employees (such as contractors) in the group and non-UK employees would not be included in the figure. Companies are free to include additional information in the narrative that they will also be required to give explaining changes to the ratio year on year and how the ratio relates to remuneration across the wider workforce.

This a crude measure and whether it will have any impact is highly debatable, but this is the most political of all the proposals. There is therefore little expectation of it not being implemented in the UK.

How this ratio will link into the existing requirement to give relative percentage increases for CEO and employee pay has yet to be disclosed. It would certainly make sense for them to be combined in some way. Ratios on gender pay are required to be reported by next year and so ratios on pay are clearly now gaining increasing significance.

Greater illustration of pay outcomes

The second legislative proposal is that companies will have to give a clearer explanation in their remuneration policies of the range of potential outcomes from “complex” share-based incentive schemes. The Government particularly wants the explanation to include a greater range of share price outcomes. The underlying reported complaint is that investors (and perhaps other stakeholders and the general public) do not readily appreciate the quantum of what can be received under these plans. As with the ratio above, there is also an element of hope that publicity and embarrassment at the high level of pay may reduce remuneration.

Again, there is already a requirement which covers this to some extent, so how this dovetails with the existing provisions will need to be considered. In addition, the drafting for the new proposal will need to be very broad if it is to incentivise the desired effect. For example, what are “complex” schemes? Is it any scheme with performance conditions? Will cash arrangements really be excluded?

Both changes require secondary legislation, which involves less scrutiny than primary legislation, although the Government has promised to consult on the legislation before it is put before Parliament. With the current political uncertainty and occasional peaks of interest in remuneration, Parliament may indeed demand further changes. However, although the Government has said that the changes will take effect by June 2018, quite when the first data will emerge is another matter. The ratio is required only in reports covering accounting periods beginning on or after 1 July 2018, and it will clearly only be the first policy to be put forward after that date which will be covered by the greater award range disclosure requirements, which for many companies will not occur until 2020.

2. Proposed changes to the UK Corporate Governance Code

The Government proposes several changes be made to the UK Corporate Governance Code, though it is clearly up to the FRCwhether to make these changes. The FRC will consult later this year on them (with its own ideas included) as part of its proposed 2017 general review. As these will be ‘comply or explain’ provisions, companies are of course free not to comply so long as they give an explanation.

No long-term incentive shares to be sold by recipients earlier than five years after award date

This is the only change affecting scheme design and, potentially, share plan rules.

The Government proposes that executive directors should not be able to sell shares from long-term incentive arrangements (covering LTIPs and executive options, rather than annual or deferred bonus arrangements) earlier than five years following award. Exceptions will presumably be made for sales to pay exercise price (for options) and taxes.

The UK Corporate Governance Code already recommends that awards have a three-year vesting condition before they can be received. Whether this will remain with the addition of the above, or the two will somehow be combined, remains to be seen.

In any event, the trend for listed companies over the last few years has been to include this provision in relevant plan rules anyway, with many large investors stating that they will vote against plans that do not have these terms, particularly for executive directors. This provision would then reflect emerging best practice for larger companies. However, many smaller listed companies still do not have holding periods beyond the vesting date three years after an award is made and so will have to change their plans to comply with the proposal (although any scheme rule change would not normally need shareholder approval). In the consultation response, it is left open as to whether proposals should apply to all listed companies or just the larger ones, and this may be something that the FRC suggests as part of its consultation exercise.

Broadening the role of the remuneration committee

Remuneration committees have historically just considered the pay of executive directors, though many now supervise senior employee pay and/or the executive share plans. The proposal is that the UK Corporate Governance Code is amended so that the committee takes a broader responsibility for pay within the group and actively explains differentials on quantum and format of remuneration for executive directors and employees as a whole. Those that are already doing this will be identified and held out as examples of best practice. To avoid a boilerplate, minimum compliance approach, committees will need to undertake a major re-think and probably have access to HR specialists and much more data.

Companies to set out steps that they will take when they encounter opposition to pay

Currently, after a shareholder vote has resulted in material opposition, companies explain what their reaction to the vote is relatively soon after the vote. This existing provision is to be expanded to require far more detail on how the opposition will be addressed. Little detail is set out in the Government response. Accordingly, the FRC will need to think carefully about what should happen. For example, how significant opposition needs to be before this provision is triggered, in what timescale should considered reaction be required, should this provision apply only to FTSE 350 companies as it is a relatively onerous commitment to set – and, finally, one of context. Should it apply to shareholder opposition to any vote, remuneration or otherwise?

Remuneration committee chairman to have served at least 12 months on remuneration committee before appointment

The chairman of the remuneration committee should have served at least 12 months on the remuneration committee before becoming chair, except in unusual circumstances. The intention behind this proposal is that the chairman, who clearly leads the committee’s work, should have enough experience of the company and the individuals concerned before taking on the role in most cases. Again, when the FRC consults on this, it will presumably have to address whether the same reasoning should apply to chairmen of other committees, or even to the chairman of the board.

Given that the FRC is undertaking its review of the UK Corporate Governance Code later this year, it is likely to be some time in 2018 that the UK Corporate Governance Code is changed, giving some lead time for these proposals, although early adoption is often encouraged – and, in the case of a five-year holding period, often already required by investors.

3. Investment Association register of shareholder opposition

The Investment Association, which has taken on many of the responsibilities traditionally undertaken by the Association of British Insurers in relation to remuneration, still acts as chief policeman and spokesman for investors on UK executive pay. The Government proposes that it should maintain a list of companies which have faced opposition to their pay proposals of 20% or more, along with a record of what they say they are doing to address concerns. The Investment Association volunteered for this function and so there is little chance that this will not occur. This does, though, beg the question of whether a regulator of executive pay is emerging with Government support, though there is no mention that the Investment Association should comment on what is proposed by the company or follow-up on whether it is actually doing what is promised. The Investment Association’s authority has reduced in recent years, due to the dispersal of shareholdings among international investors and the use of proxy agencies, but it is still the lead investor body in this area.

4. What to do and what is not being taken forward

Many well-run companies will question the value of the extra costs that will necessarily be incurred and also what value the creation of the information and extra processes will contribute. Some proposals require more work than others – particularly changing the directors’ remuneration committee into a group-wide remuneration committee.

As many of the Government proposed changes are happening already, there seems little doubt though that these changes will come into force broadly in their proposed form, albeit with a relatively long implementation lead-time. However, as there will inevitably be lobbying to limit the impact and cost of the proposals, including smaller listed companies being excluded completely from some of the proposals, there is little sense in any detailed preparation for them at the moment.

Finally, it is worth noting the original proposals which are not being taken forward.

These include compulsory disclosure of prospective and historic bonus targets, annual binding votes on pay, employee representation on remuneration committees and formal discrediting of traditional executive option and long-term incentive plans. In the case of bonus target disclosure, the Government has concluded that the trend for this occurring is on track with investors’ general satisfaction and so no action is currently needed, and that the pros and cons of long-term incentive plans are more nuanced than the Government perhaps first appreciated.

Click here to read the Government proposals.

https://www.gov.uk/government/news/world-leading-package-of-corporate-governance-reforms-announced-to-increase-boardroom-accountability-and-enhance-trust-in-business

https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/640470/corporate-governance-reform-government-response.pdf

This article was originally published on 4 September 2017 and is now being sent to additional categories of subscriber.