Further storm clouds looming over AGMs

United Kingdom
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

  • Information on the activities of the Remuneration Committee:

    • any advisers or consultants used, whether they were appointed by the committee, and whether they provide the company with any other services. Bearing the marks of the post-Enron debate about audit firms also providing consultancy services, this is designed to highlight to shareholders any potential conflicts of interest for remuneration consultants appointed to advise the Remuneration Committee, and whose independence may be compromised by a desire to keep or win other work;

    • any executive directors who assisted or took part in the deliberations of the Remuneration Committee. If the committee follows the recommendation in the Combined Code that it should consult the “Chairman and/or the Chief Executive” about its proposals, this will have to be disclosed in the report.

  • Statement of the company's policy on the future remuneration of directors:

    • a 'detailed summary' of any performance conditions for the exercise of share options or LTIP awards;

    • justification of these performance conditions;

    • a summary of the methods to be used to assess whether performance conditions have been met, and a justification of these methods;

    • a summary of any factors used as comparators (including other companies or any Index);

    • any amendments to share option or LTIP entitlements (e.g. any re-setting of performance targets or re-pricing of share options); and

    • if any share option or LTIP awards are not subject to performance conditions, an explanation of why not.

  • Explanation of the "relative importance" of those elements of each director's terms and conditions relating to remuneration which are, and are not, related to performance. Although the draft regulations do not indicate the person(s) by whose standards these elements are judged to be 'important', it is assumed that (reflecting the Combined Code) the intention is for shareholders to be told what proportion of the director's total remuneration package is dependent on performance. It is therefore likely that Remuneration Reports will have to distinguish between elements of salary and benefits which are not performance related, and bonus and share option or LTIP awards which are subject to performance criteria.

  • The company's policy on the length of directors' service contracts, notice periods and termination payments.

  • A performance graph comparing Total Shareholder Return (TSR) on the company's shares against that on a suitable Index over the last five years (or as many years as possible for companies less than five years old):

    • TSR takes account of the capital value of the shares (their market value) and any dividends and other income received in the form of cash or further shares; and

    • a justification of the Index which is selected as the comparator.

    The clear intention here is to make it easier for shareholders to assess whether directors have delivered value in return for their pay package

  • Key terms of each director's service contract (whether or not the director is up for election or re-election at the next AGM):

    • the unexpired term;

    • the notice period; and

    • how much it will cost the company to terminate the contract early.

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