UK: Executive Pay And Corporate Governance In The UK

Enterprise - April 2010

Following the global financial crisis, the level and structure of executive pay has become a hotly debated issue in the UK and internationally. Many commentators blame the crisis on lax regulation, procyclicality in the capital holdings of significant banks and on excessive risk taking. It is argued that excessive bonuses paid annually led to a culture of short term risk taking among high influence employees of certain financial institutions. This in turn had negative implications on each institution's regulatory capital at a time when capital levels should have been rising. By the time the true result of many transactions appeared, bonuses had already been paid on the perceived profits made. It is in this context of moral hazard and regulatory failings that the current UK regulatory framework has been strengthened.

The regulatory framework

The current framework for regulating executive pay is largely set out in the Combined Code on Corporate Governance (the Code), which sets out general principles of best practice for certain companies listed on the London Stock Exchange. The Code's two main principles state that the level of remuneration should be sufficient to attract and motivate the right calibre of people, but should not be higher than necessary, and that the procedure and the process of fixing remuneration should be formal and transparent.

The Companies Act 2006 (the Act) also requires every quoted company to send a copy of its remuneration report to certain parties, including every shareholder. In addition, the Listing Rules and The Large and Medium-sized Companies and Groups (Accounts and Reports) Regulations 2008 (the Regulations) state what a directors' remuneration report must contain and the form it must take. Directors are liable for fines in the event that the Regulations are breached. A vote by the members must also take place each year approving the directors' remuneration report. The vote gives shareholders the chance to examine the remuneration of executives, although a director's contractual rights are not affected.

A further example of attempts at solving problems in this area is Sir David Walker's review of corporate governance in UK banks and other financial institutions (the Walker Review), to which Norton Rose contributed. The Walker Review recommended that short term bonuses should be paid in thirds over three years, long-term incentives should constitute at least half of the variable remuneration offered and half of these long-term incentives should vest after three years, with the remainder after five years. The Financial Services Authority (the FSA) has implemented many of these suggestions in a new code of practice on remuneration which came into force at the beginning of 2010 (the Remuneration Code). The Remuneration Code sets out eight principles aimed at ensuring that the practices of companies are consistent with those of good risk management and sustainability. One principle states that the calculation of bonus pools should be profit-based rather than revenue-based, which has attracted criticism in the past. The FSA also states that a bonus pool calculation should include an adjustment for current and future risk, and take into account the cost of capital employed and liquidity required. The aim of this is to encourage bonuses based on long term success and avoid the repercussions of risky behaviour based on meeting short term goals. The FSA has also made clear that bonuses which are guaranteed for more than one year are likely to breach the principle aimed at allowing companies to have a fully flexible bonus policy.

The Financial Reporting Council (FRC) has also sought to update the Combined Code, taking into account many of the recommendations made in the Walker Review and addressing the problems that many feel contributed to the financial crisis. A new supporting principle states that performance-related elements of executive remuneration should be aligned with the long-term interests of the company and the interests of shareholders. Like the Walker Review, the FRC proposes to introduce measures for reclaiming variable components of remuneration in certain circumstances. However, the FRC does not set out any specific details in relation to how this will be done or to which payments it will apply.

A level playing field?

Whilst there is agreement that steps need to be taken in this area, there is concern that the extensive regulation that continues to be put in place will actually have a negative impact on the UK economy. Angela Knight, chief executive of the British Bankers Association, voiced the concern that UK companies may be put at a competitive disadvantage: "whilst these changes are made in the UK, and importantly the UK banks have been working with the FSA for some time to get their pay structures right, the UK must remain a competitive banking industry, and other countries must also make the changes too." The chief executive of the FSA, Hector Sants, states in relation to the latest reforms to the Remuneration Code "whilst there is general international agreement on the need for supervisory action on remuneration policies and practices, we will be the first major financial regulator to take this step". Although this is viewed by Sants as a positive move, unless the rest of the world takes the same steps then there will not be a level international playing field and large companies and individuals may relocate away from the UK to avoid the more stringent regulations.

The outlook

It is unclear whether the new regulations will end the debate over executive pay. The Remuneration Code does seek to address many of the important issues, such as the timescale over which bonuses are paid. A change in company practice to reward structures based on long term success may lead to fewer risks being taken and a more stable economy. The claw back of bonuses could also ensure that decisions based on short term success are reduced. However, the Remuneration Code currently only applies to 26 financial institutions. Its scope will need to be widened if it is to affect the whole industry. Another concern is the effectiveness of shareholder votes on remuneration policies. Although there has been a rise in recent years of shareholders voting against remuneration policies, the effect of this has been questioned due to the fact that the shareholder vote is only advisory. Further, the introduction of the "super-tax" on banker bonuses of more than Ł25,000 does not appear to be achieving its objective. The Chancellor of the Exchequer, Alistair Darling, introduced this tax with the aim of deterring banks from paying large bonuses and instead encouraging them to use profits to build up their capital base. However, it appears that this has not worked, with many banks recently announcing large bonus pools. It appears that banks are willing to pay the tax in order to be able to keep rewards high for their staff. Therefore, whilst bringing in much greater revenue for the Government, the 50% tax does not appear to be changing the practices of financial institutions. There has also been an increase in tax planning, with tax specialists now advising on ways of mitigating the effects of the new tax.

It is not yet clear whether the financial crisis and the regulation that has been put in place will change the current culture in executive pay. However, it would be naive to think that the recent measures will end the debate.

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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