UK: Corporate Governance - ABI Launches New Guidelines On Executive Remuneration

Last Updated: 5 February 2003

For many years, the Association of British Insurers (ABI) has published guidelines on share-based incentive schemes. In recent years the ABI has moved towards supporting annual grant policies (coupled with a relaxation of the historic "four times salary" individual limit on option grants), requiring tougher performance conditions for options, requiring resistance to retesting performance conditions and seeking greater disclosure of costs to shareholders. In essence, the ABI support the concept of higher pay for higher performance.

The ABI has now issued new guidelines on executive remuneration which are wider than the earlier guidelines on share-based incentive schemes.

The guidelines incorporate the best practice statement on contracts and severance pay which the ABI and the NAPF published jointly in December 2002, together with two new sections, on the basic principles of remuneration and on the structure of pay packages. The existing guidelines on share-based incentive schemes are also incorporated, with minor modifications reflecting market practice over the past year. The guidelines will be relevant for boards and remuneration committees preparing their Directors’ Remuneration Reports and determining their remuneration policy. In particular, the guidelines will have increasing importance in light of the new statutory vote on the remuneration report introduced by the Directors’ Remuneration Report Regulations 2002 (for further information see the separate Herbert Smith briefings dated August 2002 and December 2002).

The Guidelines can be accessed from the ABI website

Executive remuneration principles

There are 12 principles in all, covering basic guidelines about structuring remuneration; dialogue with shareholders concerning remuneration; and what should go in the remuneration report. An important principle is that remuneration committees should maintain a constructive and timely dialogue with their major institutional shareholders and the ABI about remuneration policies, including issues relating to share incentive schemes.

Another principle is that the Board should demonstrate that performance based remuneration arrangements are clearly aligned with business strategy and objectives. The ABI favours simplicity: "Simple structures assist with motivation and enhance the prospect of successful communication with shareholders". Remuneration committees should seek to ensure that remuneration reflects market requirements. They should take business size, complexity and geographical location into account when appropriate.

Remuneration committees should also have regard to pay and conditions elsewhere in the company. They should pay particular attention to arrangements for senior executives who are not board directors but have a significant influence over the company’s ability to meet its strategic bjectives. The guidelines suggest that appropriate disclosure of their remuneration may be best achieved by disclosing the number of executives with specified levels of remuneration on a banded basis. (Note that care will need to be taken not to breach data protection laws if individuals could be identified from the information disclosed.)

When preparing their remuneration report, the remuneration committee should makesure that it sets out the principles which have been followed and describes the approach used when putting into place the different components of total remuneration.

Several of the principles relate to relationships with shareholders. Contemplated changes to remuneration policy and practice should be discussed with shareholders in advance, and any proposed departure from the stated remuneration policy should be subject to prior approval by shareholders. All new share based incentive schemes should be subject to approval by shareholders by means of a separate and binding resolution whether or not they are dilutive. If the rules of the share based incentive scheme, or the basis on which the scheme is approved by shareholders, permit some degree of latitude on the amounts to be granted or the performance criteria, any changes should be detailed in the remuneration report. Any substantive changes in the operation of schemes which have previously been approved should be subject to prior shareholder approval. Where there is performance-linked enhancement or matching arrangements in respect of shares awarded under deferred bonus arrangements, there should be a separate shareholder vote. Boards should review regularly the potential liabilities associated with all elements of remuneration and make appropriate disclosure to shareholders. There should be transparency on all matters relating to the remuneration of present and past directors and where appropriate other senior executives. Shareholders’ attention should be drawn to any special arrangements and significant changes since the previous remuneration report.

Guidelines for the structure of remuneration

These more detailed guidelines are aimed at helping remuneration committees to devise remuneration packages which achieve an appropriate balance between fixed and variable pay and between long and short-termincentives. The guidelines suggest that a policy of setting salary levels below the comparator group median can be helpful because it provides more scope for increasing the amount of variable performance based pay and incentive scheme participation. On the other hand, if the company wants to pay salaries at above the median level, it is required to justify this.

Annual bonuses are permissible but should be related to performance.

All performance targets should be disclosed in the remuneration report. If there are commercial confidentiality concerns which prevent disclosure of specific short term targets, that is acceptable provided the basic parameters adopted in the financial year are reported on.

Transaction bonuses will not be supported by shareholders. Material payments which may be regarded as ex-gratia in nature require prior shareholder approval.

There should be informative disclosure of the value accruing to pension schemes or other superannuation arrangements, which should include the costs to the company, the extent to which liabilities are funded and aggregate outstanding unfunded liabilities. Remuneration committees should scrutinise all other benefits, including benefits in kind and other financial arrangements.

Best practice statement on executive contracts and severance

This is a response to growing criticism in the media and elsewhere of executive directors receiving large payments on departure from the company. The main thrust of the statement is that remuneration committees must focus very carefully at the outset – that is, when the service contract is first entered into – on the potential cost of termination. Remuneration and nomination committees should work together during the appointment process to design service contracts which do not commit companies to payment for failure.

Bonuses should depend on achieving clear performance objectives and boards may wish to provide that they cease to be payable, at least in part, to departing executives.

In terms of contract length, the guidelines state that the one year period provided for under the Combined Code should not be seen as a floor, and remuneration committees should be prepared where appropriate to consider shorter periods. Only in exceptional circumstances, such as where a new chief executive is being recruited to a troubled company, will a longer notice period applying during an initial period possibly be appropriate.

The statement suggests a number of ways of reducing the compensation companies will be obliged to pay on termination:

• The statement supports the inclusion of a clause providing for phased payments, where the company continues to pay the departing executive on the usual basis for the outstanding term of the contractor, if earlier, until the executive finds new employment.

• The liquidated damages approach, where the parties agree upfront how much the director will receive on severance as a lump sum, is not generally supported by the shareholder institutions.

• If the contract is simply to include a notice period, damages for which would then be subject to the director’s duty to mitigate his loss, shareholders will expect reassurance that the board has taken steps to ensure he does so to the fullest extent possible.

• The statement suggests that if a director is dismissed following the use of a disciplinary procedure, the contract could provide for termination on a shorter notice period than otherwise.

• A further suggestion is that contracts permit dismissal without notice in cases of serious financial failure – such as a very significant fall of the share price relative to the sector.

• Finally, the statement suggests some companies may decide to provide for cash compensation on termination to be paid by reference to shares, with the amount of the shares set at the outset of the employment, thereby tying the compensation to the company’s fortunes.

For further information on the best practice statement on executive contracts, please see our separate Employment Briefing dated January 2003.

The statement notes that pension enhancements often represent a large element of severance pay and involve heavy cost to shareholders. The board should state the full economic cost of any pension enhancement as early as possible. They must justify their choice to shareholders and demonstrate that the route they have chosen involves the least overall cost to the company. They should distinguish between the amount that is a contractual entitlement and the amount of any discretionary enhancement agreed as part of the severance package. Shareholders are likely to question the latter if they are doubtful of its merits.

© Herbert Smith 2003

The content of this article does not constitute legal advice and should not be relied on as such. Specific advice should be sought about your specific circumstances.

For more information on this or other Herbert Smith publications, please email us.

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