UK: Employee Incentives - Corporate Governance Update

Last Updated: 12 January 2011
Article by Mahesh Varia

Today, the Government published the "majority" of the Finance Bill 2011 clauses. These may have implications for the tax treatment of employee incentives and we will publish any news of changes in a future bulletin. In the meantime, hardly a week passes without the announcement or publication of a new code or set of guidelines relating to corporate governance. Some of these are confined to companies within the financial services sector but others have a wider application. In this Update, we summarise the most significant developments and identify themes that we believe are likely to emerge in executive pay.

The UK Corporate Governance Code

The UK Corporate Governance Code (UKCGC) replaces the Combined Code for financial years beginning on or after 29 June 2010. It applies to all companies with a Premium Listing of equity shares on the main market of the London Stock Exchange, regardless of where the company is incorporated. One of the headline changes in the UKCGC was the new requirement that all directors of FTSE 350 companies should be subject to annual election by shareholders. This could have an impact on remuneration committees as these are the bodies most exposed to shareholder criticism if executive pay is deemed to be too generous. It may also become an indirect means by which shareholders can protest against a company's remuneration report, the direct vote in respect of which is purely advisory.

The UKCGC has a change of emphasis as regards the performance-related elements of directors' remuneration. Rather than stating that these should align the interests of directors with shareholders and give them "keen incentives to perform at the highest levels", the UKCGC says that these elements should be "stretching" and "designed to promote the long-term success of the company".

Clearly, the Financial Reporting Council (the body that oversees the UKCGC) is concerned that executives should not be encouraged to take risks that give rise to personal gain at the expense of the long-term success of the company. It has been a long established principle of the Combined Code that, generally, nonexecutive directors should not receive share options. This is because options, unlike shares, are often viewed as a "one-way" bet and something that could compromise a nonexecutive's independence. The UKCGC goes a stage further by extending this prohibition to "other performance-related elements".

Schedule A to the UKCGC sets out guidance for remuneration committees when designing performance-related remuneration plans for executives. This is largely unchanged from the version in the Combined Code however there is further emphasis on the need for incentives to encourage a company's sustained future growth. There is a move away from using comparator groups when measuring performance and guidance that non-financial performance metrics should be adopted where appropriate. A reference is also made to the use of "claw-back". This is where a company can call for vested awards to be paid back where, for example, performance is later found to have been overstated.

Remuneration Committees introducing new employee incentives will need to be mindful of how institutional investors will react to the proposals. Since 1 August 2010 a new Stewardship Code has replaced the sections in the UKCGC on institutional investor relations. The Stewardship Code builds upon the Institutional Shareholder Committee's Statement of Principles and prompts institutions (and those managing assets on their behalf) to engage with investee companies. It has always been advisable for companies to discuss their executive incentive arrangements with key investors at an early stage and companies should expect a greater level of shareholder interest in future.

The Association of British Insurers (ABI)

Listed companies in the UK will generally have regard to the ABI's guidelines on executive remuneration when introducing new incentive plans. The guidelines themselves have changed very little in the last three years and the ABI has announced that it does not propose to make any alterations until next year when, hopefully, the pay debate in Europe will have settled. Nevertheless, earlier in the year, the ABI published a "Position Paper" on executive remuneration that was intended as an aid to help remuneration committees apply its guidelines in the current environment. Key themes are avoiding structures that encourage risk or reward failure and preventing over-reliance on benchmarking with companies within a peer group. The paper also discourages the use of schemes that involve "aggressive" tax planning that might damage a company's reputation and give rise to excessive costs. Traditionally, performance periods (at the end of which awards will vest) have been three years. The Position Paper encourages the use of longer performance periods with perhaps holding periods for vested shares. We understand that the ABI does not favour a highly prescriptive regime as regards pay and is keen that companies should continue to be able to self-regulate in this area.

Financial Services Authority – Remuneration Code

Pay levels in the financial services sector have been the subject of recent political and press scrutiny. The UK's regulator for the financial services industry, the Financial Services Authority (FSA), is in the process of amending its Remuneration Code ( the Code) to take account of changes in European law from 1 January. Very broadly, the overall purpose of the Code is to ensure that firms establish and maintain remuneration policies, procedures and practices that are consistent with and promote effective risk management. Part of the Code ensures that "Code Staff" (broadly those individuals whose activities have a material impact on the firm's risk profile) are remunerated in such a way that they are not incentivised to take excessive risks.

In its current form, the Code applies to only larger banks, building societies and broker dealers (27 institutions in all). The impending changes under European law mean that the FSA has been forced to re-consider the Code's scope and content. In a consultation paper issued in July, the FSA stated that the amended Code will apply to a greater number of firms (around 2,500) including all banks and building societies as well as most brokers and investment managers (including hedge fund managers). The FSA expects firms to apply the Code to affiliates who fall within their "consolidation group" for regulatory capital purposes, including subsidiaries outside the UK or the EEA.

A key emphasis of the revised Code is on bonuses and the fact that these should neither promote short-term attitudes amongst key staff nor prompt them to take unnecessary risks. The Code proposes that at least 40% (rising to 60% for those earning more than Ł500,000) of any bonus should be deferred over at least three years and that elements of the bonus should be clawed-back if the firm's or an individual's performance proves to be disappointing. One of the most contentious proposals is that 50% of any element of variable remuneration should be paid in shares or share-linked instruments. This could create practical difficulties for (i) companies that seek to limit the number of shares that they issue in the course of employee incentive arrangements and (ii) those firms, such as limited liability partnerships, that do not have any share capital. Guaranteed variable remuneration is prohibited under the Code unless it is exceptional, occurs in the context of hiring a new employee and is limited to the employee's first year of service.

The FSA announced a delay in publishing the new Code because much of it depends upon European guidelines that are yet to be finalised. Some important features of the Code remain to be confirmed and this will leave many firms in a state of uncertainty with the implementation date of 1 January only a couple of weeks away. The Code is specific to firms in the financial services arena however we expect to see a number of the trends in remuneration (deferral, claw-back and so on) filter down to other sectors.

On 11 November, European institutions finalised the text of the Directive on Alternative Investment Fund Managers. Once in force, this Directive will mean that the managers of hedge funds, private equity funds, commodity funds, venture capital funds, real estate funds and investment trusts will be subject to rules on remuneration that are broadly similar to those to be set out in the Code. It substitutes payment in fund units for payment in employer group shares. Its precise impact remains to be seen. The rules are badly drafted, but implementing guidelines are to be published.

Recently, the European Commission published a document summarising the responses it had received to a Green Paper it published in June 2010 on corporate governance in financial institutions and remuneration in listed companies. One of the questions raised in the Green Paper was whether directors' share options should be regulated by the European Union or even prohibited. Fortunately most respondents have stated that they are in favour of share options as a useful tool for aligning the interests of directors and shareholders in listed companies and that, provided they are structured properly, they should not be prohibited. This does not rule out the possibility of greater European regulation of share options in the future.

Practical Steps

Companies within the scope of the FSA Code will need to consider whether to change their share incentive arrangements. If you are not regulated but have share-based executive incentives (such as an option scheme or a long term incentive plan), now is the time for a corporate governance "health-check" in light of the current trends. You might want to review the following areas:-

  • Consider the way in which you operate your share plan. Many companies have already moved away from one-off, large awards towards annual grants. This helps to reduce the impact of "underwater" options and discourages the kind of short-term, risky behaviour that the regulators are so keen to avoid.
  • Review your performance targets before granting new awards. Are they suitably challenging without acting as an encouragement to excessive risk-taking? Earnings per share and total shareholder return are still popular measures of performance, but if you compare performance with that of a peer group, consider whether this should be accompanied by an underpin that relates to the financial results of the company alone. Is there any scope for using non-financial performance indicators that are relevant to a particular individual or department (such as "customer satisfaction")?
  • What happens to "bad leavers"? Is there scope for them to retain their awards? Any Board discretion to allow awards to vest must be exercised carefully in order to avoid accusations of rewarding failure.
  • When making awards, think about the proportion of fixed salary that this represents. Most plan rules contain an annual limit on the value of awards that can be made as a multiple of salary but consider whether it is necessary to grant up to the maximum in a particular year.
  • In our experience, most plans provide for awards to vest after three years. This is simpler than "clawing back" awards that have already vested but could result in different tax treatment for the executive. This is a complex area that we would be more than happy to discuss with you.
  • Many plans contain limits on the number of shares that can be issued under them. If your company will be subject to the FSA Code, then look at whether the requirement to award 50% of variable pay in the form of shares/share-based awards will cause these limits to be exceeded.
  • Non-executive directors are not generally eligible to participate in executive share incentive plans. If they are eligible to participate in any of your schemes, then consider carefully whether this practice should continue.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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