Chapter 16 - Remuneration of directors and senior executives'

Question 1

What are the typical components of an executive director’s remuneration package?

Answer 1

The remuneration package for a director or senior executive is likely to consist of a combination of:

1. a basic salary;
2. payments into a pension scheme for the individual (or payments in lieu);

3 an annual bonus, usually linked to the annual financial performance of the company;

4. long-term incentives, usually in the form of share options or share awards (sometimes called ‘restricted stock awards’);
5. other benefits and perks, such as free medical insurance, a company car or accommodation.

Question 1

What company performance targets might be used as a basis for fixing annual bonus payments to a CEO?

Answer 1

Bonus payments may depend on the achievement of both individual targets and the performance of the company over the previous financial year.

Question 2

What are the problems with linking rewards to performance for senior executives?

Answer 2

It is difficult to design performance-related remuneration for the following reasons:

1. selecting the right performance measures;
2. setting the thresholds at which rewards are paid;
3. setting a cap on any rewards under the incentive scheme;
4. ensuring that the targets used promote the long-term success of the company;
5. ensuring that the targets used do not promote bad behaviour;
6. ensuring that executives who perform well are rewarded and preventing those that don’t from piggy-backing on the
   success of their colleagues;
7. executives may develop an expectation that they should receive annual rewards regardless of the actual performance of the company; and
8. designing a scheme that will be satisfactory to shareholders.

Question 3

What company performance targets might be used as a basis for deciding how many shares should be granted to a senior executive as a long-term incentive arrangement?

Answer 3

Most companies use total shareholder returns (TSR) or earnings per share (EPS) against a comparator group of
companies

Question 4

What are the drawbacks to using share options for long-term incentive schemes?

Answer 4

The drawbacks of using share options as a long-term incentive are:

1. Share options reward holders for increases in the share price, when this may not always relate to the executives, or indeed the company’s performance (ie ‘Bull’ market )
2. When the stock markets are in a bear run and prices are declining, share options lose value, and may even become worthless, irrespective of executives or company’s performance.
3. Option holders do not benefit from dividend payouts.
4. The market price of a company’s shares may fall below the exercise price for its share options (‘Underwater’)
5. Executive directors may prefer a long-term incentive scheme involving the grant of shares, since the shares will always have some value once they have vested.

Question 5

What does the UK Corporate Governance Code say about the general level of executive remuneration?

Answer 5

Principle P of the 2018 Code now provides:

‘Remuneration policies and practices should be designed to support strategy and promote long-term sustainable success.

Executive remuneration should be aligned to company purpose and values, and be clearly linked to the successful delivery of the company’s long-term strategy.’

Principle R of the 2018 Code states that:

‘Directors should exercise independent judgement and discretion when authorising remuneration outcomes, taking account of company and individual performance, and wider circumstances.’

Question 6

What is the main guidance in the UK Corporate Governance Code on the design of performance-related pay?

Answer 6

Code Provision 40 recommends that:

1. remuneration arrangements should be transparent and promote effective engagement with shareholders and the
   workforce;
2. remuneration structures should avoid complexity and their rationale and operation should be easy to understand;
3. remuneration arrangements should ensure reputational and other risks from excessive rewards, and behavioural
   risks that can arise from target-based incentive plans, are identified and mitigated;
4. the range of possible values of rewards to individual directors and any other limits or discretions should be identified
   and explained at the time of approving the policy;
5. the link between individual awards, the delivery of strategy and the long-term performance of the company should
   be clear. Outcomes should not reward poor performance; and
6. incentive schemes should drive behaviours consistent with company purpose, values and strategy

Question 7

What are the principal duties of the remuneration committee under the UK Code?

Answer 7

Code Provision 33 provides that the remuneration committee should have delegated responsibility for:

1. determining the policy for executive director remuneration; and
2. setting remuneration for the chair, executive directors and senior management.

It also states that the committee should ‘review workforce remuneration and related policies and the alignment of incentives and rewards with culture, taking these into account when setting the policy for executive director remuneration’.

Question 8

Describe the recommendations of the Code regarding the composition of the remuneration committee.

Answer 8

Code Provision 32 states that the remuneration committee should consist exclusively of independent non-executive
directors and should comprise
at least three or, in the case of smaller companies, two such directors.

The company chair is permitted to serve on the remuneration committee if they were considered independent on appointment as chair (although they are not allowed
to chair the committee).

The chair of the remuneration committee must have served on a remuneration committee for at least 12 months before their appointment.

Question 9

What provisions are included in the Code on remuneration consultants and why?

Answer 9

Code Provision 35 provides that:

1. Where remuneration consultants are appointed, this should be the responsibility of the remuneration committee.
2. The consultant should be identified in the annual report alongside a statement about any other connection it has with the company or individual directors.
3. Independent judgement should be exercised when evaluating the advice of external third parties and when receiving
   views from executive directors and senior management.

These provisions reflect concern about potential conflicts of interest remuneration consultants may have which may
compromise their objectivity.

Question 10

What are the two main component parts of the directors’ remuneration report?

Answer 10

The two main components of the directors’ remuneration report are:

• the directors’ remuneration policy; and
• the annual remuneration report

Question 11

What is the purpose of the annual remuneration report?

Answer 11

The purpose of the annual remuneration report is to disclose to shareholders how the board has implemented the
directors’ remuneration policy during the financial year.

Question 12

What are the principles and provisions of the UK Code with regard to severance payments for senior executives?

Answer 12

The UK Corporate Governance provides in Code Provision 39 that:

1. Notice or contract periods should be one year or less.
2. If it is necessary to offer longer periods to new directors recruited from outside the company, such periods should
   reduce to one year or less after the initial period.
3. The remuneration committee should ensure compensation commitments in directors’ terms of appointment do not
   reward poor performance.
4. They should be robust in reducing compensation to reflect departing directors’ obligations to mitigate loss.

Question 13

What are ‘malus’ and ‘clawback’ provisions and where might you find them?

Answer 13

‘Malus’ provisions allow the company, in specified circumstances, to forfeit all or part of a bonus or long-term incentive
award before it has vested and been paid (also known as ‘performance adjustment’). ‘Clawback’ provisions allow the company to recover sums already paid.

Question 14

Who should set the fees of NEDs?

Answer 14

Code provision 34 provides that the remuneration of non-executive directors should be determined in accordance with
the articles of association or, alternatively, by the board.

In practice the chair and the executive directors will take the lead on making a proposal to the board regarding the fees that should be paid to non-executives, probably after taking advice from the company’s remuneration consultants. Remember that, under the Code, the remuneration of the chair (even if
non-executive) must be determined by the remuneration committee.

Question 15

Why is it inappropriate for NEDs to participate in performance-related schemes?

Answer 15

Non-executive directors are expected to play a role in setting the risk appetite of the company.

Anyone whose remuneration is based on short- to medium-term performance has an incentive to take more risk in order to chase profits.

Shareholders expect non-executive directors to act as a moderating influence in this regard. If they were allowed to participate in performance-related schemes, their interests would be more closely aligned with those of the executive
team, rather than the interests of shareholders.

Question 16

Why might it be appropriate for some or all of NED fees to be paid in shares? What are the practical difficulties
with this proposal?

Answer 16

Some people argue that paying NEDs fees in shares would more closely align their interests with those of the shareholders, as it would force them to become shareholders themselves. However, if you want them to remain as shareholders, you would have to impose a minimum holding period.

They could, for example, be required to hold the shares until they ceased to hold office. This would potentially mean that they did not receive any remuneration for their
services until the end of their tenure.

This would be likely to give rise to recruitment and retention problems. Accordingly, non-executives would probably have to be allowed to sell at least some of their shares. However, share sales by
directors always send a negative message to the market.

Setting up a system where these become a regular occurrence is not an attractive prospect for companies.

A possible compromise might be for a minimum percentage of their fees to be paid in shares (say 20%), in which case a minimum holding period could also be applied. The minimum holding period could allow them to sell those shares after, say, three to five years. The average tenure of NEDs is around four years.

Question 17

Why are the IA Principles of Remuneration and the PLSA Policy so influential?

Answer 17

The IA Principles of Remuneration and the PLSA Policy represent the views of institutional shareholders (e.g.
investment managers and pension funds) who hold a significant stake in most listed companies.

Most companies realise that shareholders will not support remuneration policies and structures that breach the guidelines issued by the two bodies. In addition, both bodies have a significant influence on government and regulatory policy in the field
of corporate governance.

Even if the majority of companies comply with the guidance, policy makers often give those recommendations more force by adopting them as legislative or code requirements

Question 18

Give two broad examples of things covered in the IA Principles and two broad examples of things covered by
the PLSA Policy.

Answer 18

The IA Principles cover levels of pay, bonuses, pensions, long-term incentive schemes, contract terms and severance
payments. A particular focus in recent years has been on ‘malus’ and ‘clawback’ arrangements.

The PLSA Policy covers a wide range of corporate governance issues of which remuneration is only one. It focuses more
on matters that will be voted on by shareholders at the AGM.

Accordingly, it focuses on the directors’ remuneration policy and the annual remuneration report and explains the circumstances in which shareholders are most likely to vote against any resolution on those matters.

Question 19

Remuneration as a CG Issue

Answer 19

1. Companies need to attract and retain talented executives.
2. Remuneration incentives can be used to motivate executives to achieve better results for the company.
3. Those incentives need to be aligned with the interests of shareholders and promote the success of the company
4. Directors should not be rewarded for failure.
5. Directors should not be able to decide or influence their own remuneration.
6. High levels of executive pay undermine public trust in large businesses.

Question 20

Problems with linking rewards to performance

Answer 20

1. Selecting the right performance measures
2. Setting the thresholds at which rewards are paid
3. Ensuring that the targets used for short-term incentives like the annual bonus promote the long-term success of the company
4. Ensuring that the targets used for incentive schemes do not promote bad behaviour
5. Preventing the ‘legacy effect’
6. Designing a scheme that will be satisfactory to shareholders

Question 21

Remuneration consultants Issues?

Answer 21

1. May have conflicts of interest by virtue of the fact they are also engaged by the executives to advise the company on other aspects of remuneration or may have another connection with an individual director (e.g. an executive director who serves on another company’s remuneration committee).
2. There is a risk that they will make recommendations which favour the executive directors and are not necessarily in the best interests of the company.
3. May be inclined to recommend complex remuneration schemes in order to increase their fees and make it more difficult for the remuneration committee to dispense with their services in future years.
4. May put pressure on the remuneration committee to accept their advice (e.g. by failing to come up with any credible alternative).
5. Executive directors and senior management may also put pressure on the remuneration committee

Question 22

Describe why a directors’ remuneration policy must be approved by the shareholders of a UK incorporated quoted company, and in what three circumstances the company would need to put its directors’ remuneration policy to shareholders for approval at its next Annual General Meeting.

Answer 22

• The remuneration policy must be approved because the Companies Act 2006 provides that a quoted company cannot make any payments to its directors unless the payments are made in accordance with a directors’ remuneration policy which has been approved by the company’s shareholders (or the payment has been separately approved by shareholders).

The three circumstances in which the company would need to put its
directors’ remuneration policy to shareholders for approval at its next Annual General Meeting are:

• If it has been three years since the policy was last approved by shareholders.
• If the company wishes to revise the policy.
• If the directors’ remuneration report was not approved by an advisory vote of shareholders at the previous Annual General Meeting.

Question 23

Q4. Provide 4 reasons why remuneration is a CG issue? (4 marks)

Answer 23

1. Companies need to attract and retain talented executives.
2. Remuneration incentives can be used to motivate executives to achieve better results for the company.
3. Those incentives need to be aligned with the interests of shareholders and promote the success of the company
4. Directors should not be rewarded for failure.
5. Directors should not be able to decide or influence their own remuneration.
6. High levels of executive pay undermine public trust in large businesses.

Question 24

Q5. List 5 reasons that might arise when linking reward to performance (5 marks)

Answer 24

1. Selecting the right performance measures
2. Setting the thresholds at which rewards are paid
3. Deciding whether to place a cap on any rewards under the incentive and determining the level of that cap
4. Ensuring that the targets used for short-term incentives like the annual bonus promote the long-term success of the company
5. Ensuring that the targets used for incentive schemes do not promote bad behaviour
6. Preventing executives who did not perform well from piggy-backing on the success of their colleagues
7. Preventing the ‘legacy effect’
8. Executives may develop an expectation that they should receive annual rewards regardless of the actual performance of the company
9. Designing a scheme that will be satisfactory to shareholders

Question 25

Q6. Provide 3 drawbacks of using a share option scheme as part of a remuneration package (3 marks)

Answer 25

1. Share options reward holders for increases in the share price, when this may not always relate to the executives, or indeed the company’s performance (ie ‘Bull’ market )
2. When the stock markets are in a bear run and prices are declining, share options lose value, and may even become worthless, irrespective of executives or company’s performance.
3. Option holders do not benefit from dividend payouts.
4. The market price of a company’s shares may fall below the exercise price for its share options (‘Underwater’)
5. Executive directors may prefer a long-term incentive scheme involving the grant of shares, since the shares will always have some value once they have vested.

Question 26

Q7. List 3 items that should be included in the remuneration policy for a quoted company (3 marks)

Answer 26

1. A table describing each component of the remuneration package
2. A statement of the principles which would be applied by the company when agreeing the components of a remuneration package for a new director.
3. A description of any provisions contained in any director’s service contract or letter of appointment which could have an impact on remuneration payments or payments for loss of office available.
4. A bar chart which indicates the maximum and minimum amount which would be payable to each executive director under the policy in the first year and the amount that would be payable to them for on-target performance in the first year.
5. An illustration, in relation to performance measures or targets, of the maximum remuneration of each executive director
6. A statement on how pay and employment conditions of employees who are not directors was taken into account in setting the directors’ remuneration policy,

Question 27

Q8. List 3 items that should be included in the implementation report for a quoted company (3 marks)

Answer 27

1. For each director, a detailed summary of any performance conditions to which any entitlement of the director to share options
2. An explanation as to why any such performance conditions were chosen
3. A summary of the methods to be used in assessing whether any such performance conditions are met and an explanation as to why those methods were chosen
4. If any such performance condition involves any comparison with factors external to the company a summary of the factors to be used in making each such comparison
5. A description of, and an explanation for, any significant amendment proposed to be made to the terms and conditions of any entitlement of a director to share options or under a long term incentive scheme

Question 28

Q9. What are the rules relating to the remuneration policy of a quoted company? (5 marks)

Answer 28

• The annual remuneration report of a quoted company must be put to an annual vote by shareholders at the general meeting at which its report and accounts are laid (usually the AGM) (CA2006, s. 439).
• If the resolution is defeated, the directors must put the existing directors’ remuneration policy or a revised policy to a vote at the next meeting at which accounts are laid, if they have not already done so earlier (CA2006, s. 439A(2)).
• A quoted company cannot make any payments to a director unless they
  are consistent with the latest policy approved by shareholders or the payment has been specifically approved by shareholders (CA2006, ss. 226A and 226B).
• The directors must invite shareholders to approve their policy at least once every three years whether or not it has been revised and must obtain shareholder approval for any revised policy before they can make any payments under that new policy. (CA2006, s. 439A)
• If the annual advisory vote on the directors’ remuneration report is defeated, the directors must put the directors’ remuneration policy (which could be a new policy or the existing policy) to a vote either at the next meeting at which accounts are laid or an earlier meeting (CA2006, s. 439A).
• The policy that shareholders are invited to approve must be a policy that has been approved by the directors either as part of the directors’ remuneration report or separately as a revised policy (CA2006, s. 422A).

Question 29

Q10. Explain the principles of malus and clawback (3 marks)

Answer 29

• Remuneration schemes and policies should enable the use of discretion to override formulaic outcomes. They should also include provisions that would enable the company to recover and/or withhold sums or share awards and specify the circumstances in which it would be appropriate to do so.

Provision 37, UKCG code

• ‘malus’ provisions allow the company, in specified circumstances, to forfeit all or part of a bonus or long-term incentive award before it has vested and been paid (also known as ‘performance adjustment’); and
• ‘clawback’ provisions allow the company to recover sums already paid.
• the current market standard triggers for malus and clawback are gross misconduct or misstatement of results (Investment Association’s Principles, Nov 2020)