Scrutiny of Directors' pay packages is likely to increase
following the introduction last week of new Regulations on
Directors' pay
Who will be affected and when?
The Directors' Remuneration Report Regulations 2002
("Regulations"), came into force on 1 August 2002. The Regulations
apply to all companies which are formed and registered under the UK
Companies Acts, and whose shares are listed on the Official List,
the New York Stock Exchange, NASDAQ or certain EU stock exchanges
(quoted companies). They affect the accounts of quoted companies
for financial periods ending on or after 31 December 2002. Quoted
companies whose current financial period ends on or after this date
therefore need to start considering now how they will deal with the
changes which are likely to follow from the Regulations.
What are the main things covered by the
Regulations?
All quoted companies are required to produce a
'Remuneration Report' containing detailed information about
directors' remuneration. The Remuneration Report will form part of
the annual report and accounts, and certain information in the
report will have to be audited by the company's auditors.
The information which the Regulations require to be
disclosed falls into two categories:
- information on each director's remuneration which, broadly,
companies whose securities are listed on the Official List
("listed") are already required by the Listing Rules to have
audited and to include in their accounts; and
- further information on the remuneration committee, how the
company determines its policy on directors' remuneration, and how
remuneration has been, and will in future be, related to the
company's performance.
The other key change introduced by the Regulations is the need to
put the remuneration report to an advisory shareholder vote.
The current regime
Summary of the relevant legal and other
requirements
At present, all companies which produce accounts
are required by Schedule 6 of the Companies Act 1985 to disclose
the aggregate emoluments paid to directors (salary, fees,
bonuses and the cash value of other benefits) as well as the
aggregate amounts paid by the company in contributions to
directors' pension schemes, awards made under Long Term Incentive
Plans (LTIPS) and any gains made by directors on the exercise of
share options. In addition, all companies are required to disclose
the aggregate amounts paid by way of excess pension benefits to
directors and past directors, amounts paid for loss of office, and
amounts paid to third parties for the services of any director.
Separately, companies are obliged to disclose details of the
emoluments paid, company pension contributions, LTIP awards and
gains made on the exercise of share options in respect of the
highest paid director, but there is no legal requirement to provide
this information for any other individual director (although this
may sometimes be done as a matter of best practice).
Listed companies are subject to more onerous
disclosure obligations under chapter 12 of the Listing Rules and
under the Combined Code. These require the company's accounts to
include this type of information for each director, as well
as certain information about the terms of each director's service
contract and the value of their pension benefits. The information
about each director's emoluments, share options, LTIP awards and
pension benefits must be audited. The company must also set out its
policy on executive directors' remuneration and on the grant of
share options and awards under LTIPs, and a justification of any
changes to the policy or any departures from it. The Combined Code
states that "the performance-related elements of remuneration
should form a significant proportion of the total remuneration
package". The Listing Rules do not, however, require companies to
justify the policies adopted, or explain how they are put together,
and many statements of policy go little further than saying that
the company intends to reward its directors according to their
performance and the going market rate.
In terms of shareholder input into remuneration
packages, under the Listing Rules share option schemes and LTIPs
must generally be approved by shareholders before they are adopted.
The Combined Code does not require listed companies to put the
remuneration report to shareholders, but the Board must consider
whether "the circumstances are such that the AGM should be invited
to approve the policy set out in the report". These 'circumstances'
do not appear to have arisen very often.
Changes introduced by the new
Regulations
- A variety of new information will have to be included in the
remuneration report of quoted companies. Further details are given
below.
- In addition to disclosing details of the aggregate
emoluments and other remuneration paid to the directors as a whole
(as all companies are currently required to do by law), quoted
companies will be required by law to disclose this type of
information in respect of each director. This part of the
regulations effectively adopts and puts onto a legislative footing
the existing disclosure and audit requirements under the Listing
Rules and is not discussed further.
- The Remuneration Report of quoted companies will have to be
approved by the Board and signed on its behalf by a director or the
company secretary. The auditors must confirm whether the 'auditable
part' of the Remuneration Report (essentially that containing the
information referred to in (ii) above) has been properly prepared;
this confirmation will form part of the auditors' report on the
annual accounts.
- The Remuneration Report will form part of the annual report and
accounts and will have to be sent to shareholders with notice of
the AGM, and laid before the meeting. A copy will have to be sent
to Companies House.
- Resolutions put to the AGM must include an ordinary resolution
to "approve" the Remuneration Report, but since the Regulations do
not specify any consequences if approval is not given, the
resolution is simply advisory.
New information to be included in the Remuneration Report
What could all this mean in practice?
- In order to be sure of keeping in tune with the market and the
views of major shareholders, the remuneration committee is likely
to want to take soundings before terms are agreed and, in some
circumstances, to obtain advice from remuneration consultants whose
position is demonstrably independent. If the company takes
accounting or tax advice from an accountancy firm which also has a
niche practice advising on remuneration packages, it is unlikely
that advice given by the firm to the remuneration committee will be
perceived by investors to be impartial. If the same firm also acts
as the company's auditors, further questions will surely be asked.
- The job of the remuneration committee can only be made more
difficult - and accountable - by the new regulations. The committee
would be well-advised to keep full minutes of their deliberations,
since they may be required to justify each part of a director's
package to investors or corporate governance bodies. They may also
need to revisit existing packages which might be a source of
embarrassment, perhaps where figures have been 'rounded up' or a
proportion of bonus turned into salary. In short, the task of
fixing directors' pay is going to require more documentation and
will require a greater time commitment for non-executives on the
committee. Their own pay may need to be increased as a result.
- The need to seek in advance informal approval of major
shareholders and corporate governance bodies (such as the NAPF and
the ABI) to executive remuneration will reinforce the current
practice in which this is commonly done before share option schemes
and LTIPs are adopted. Discussions with major shareholders will
probably need to cover salary, bonus, pension and other benefits as
well as share options and LTIP awards.
- Although the regulations require that the Remuneration Report
must be circulated with notice of the meeting and put to the vote
of shareholders as an ordinary resolution, the regulations do not
stipulate what happens if the report is not approved. The
government's position is that while there must be a vote, its
status is "advisory". This was a concern raised during the
consultation process which has not been satisfactorily resolved.
Since the regulations state that they do not have the effect of
making any entitlement to remuneration conditional on shareholder
approval, and since it is expressly the report which is to
be approved and not the company's entry into or variation of a
particular service contract, it must be assumed that a negative
vote will not affect the legal validity of any existing or proposed
remuneration. However, the practical effect is likely to be the
undermining of the position of any executive director whose package
was criticised - who will be perceived to be over-rewarded - and of
the non-executives on the remuneration committee - who will be
perceived to have given the executives an easy ride - and damage to
the company's market standing.
- Since the regulations do not require a separate vote on the
remuneration package of each director, if shareholders dislike the
package which has been paid to one director over the past year, or
part of the policy for the future remuneration of one or more
directors, the only option under the regulations is to vote down
the Remuneration Report as a whole. As the directors' package is
therefore approved or rejected as a whole, this may lead to board
members encouraging a director who is holding out for more to
accept less - a form of boardroom peer pressure.
- In the event of a negative vote, an executive director whose
package was criticised is likely to come under pressure to accept
more challenging performance criteria in the following year.
- There is of course a danger that a negative vote on the
Remuneration Report may be used by shareholders to express general
disapproval with the company's management or strategy, or with
particular matters unrelated to remuneration.
- Since all key elements of a package will be subject to
shareholder scrutiny and 'approval', all concerned may be left with
rather less room for manoeuvre over packages, service contract
terms and, of course, any severance or compromise payments.
- To the extent that they have not already done so, companies
will need to crystallise and set down in writing their policies on
directors' remuneration and service contracts.
- If the AGM is likely to be stormy, companies should obtain
guidance from their lawyers on what can and cannot legally be done
to manage meetings effectively. Legal advice should certainly be
sought if the company is considering taking the extreme step of
excluding from the meeting everyone who is not a shareholder, as
British Land did for its recent AGM battle with Laxey Partners.
- When producing the graph showing the TSR on the company's
shares against a comparator Index, companies are likely to be
tempted to select an Index which casts the performance of the
company in the best possible light. It seems likely that any
shareholder intending to rely on the performance graph will need to
spend time assessing whether the Index selected by the company is
an appropriate comparator - and this may well lead to the same
research being done by institutional shareholders as would have
been done prior to the introduction of the regulations. For biotech
companies and others whose value is in their future potential
rather than their current earnings the TSR performance comparison
is unlikely to offer investors much reliable or meaningful
information.
- Without being too complicated or confusing, the Remuneration
Report will have to provide sufficient information to allow
investors to understand the rewards made. This is likely to be a
difficult task.
- Listed companies and their auditors preparing the remuneration
report will now have to check for compliance with the regulations
as well as the Companies Act, Listing Rules, Combined Code, and the
relevant accounting standards and actuarial guidance notes.
If you would like further information on this topic
please contact any of the following:
Andrew Crawford
Corporate Partner
Phone: +44 (0)20 7367 2867
Email: andrew.crawford@cms-cmck.com
Simon Jeffreys
Employment Partner
Phone: +44 (0)20 7367 3421
Email: simon.jeffreys@cms-cmck.com
Peter Bateman
Corporate Professional Support Lawyer
Phone: +44 (0)20 7367 3145
Email: peter.bateman@cms-cmck.com