Remuneration of directors and senior executives

Question 1

Why is remuneration an important CG issue? (6)

Answer 1

1. Companies need to attract and retain talented executives = Remuneration helps to achieve this
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 = difficult
4. Excessive remuneration for only moderate performance results in the company being run for the benefit of management rather than shareholders
5. directors should not be rewarded for failure
6. High levels of executive pay undermine public trust in large businesses

Question 2

What does the governance framework on directors’ remuneration include?

What do the Listing Rules require UK companies with a premium listing to do in relation to the governance framework on directors’ remuneration? (Shareholder approval)

Answer 2

= a mixture of statutory provisions, listing rule requirements and code requirements

LR = require UK companies with a premium listing to obtain shareholder approval for most long-term incentive schemes in which the directors may participate

Question 3

What are the statutory provisions under the CA2006 on the governance framework on directors’ remuneration? (3)

Answer 3

1. all companies are required to make certain disclosures regarding directors’ remuneration in their annual reports and accounts
2. quoted companies cannot make remuneration payments to directors unless they are in accordance with a directors’ remuneration policy approved by shareholders
3. does not require quoted companies to establish a RC but, if there is one, requires various details about the committee to be disclosed in the directors’ remuneration report

Question 4

What does the UK CG Code require/do in relation to the governance framework on directors’ remuneration? (2)

Answer 4

1. requires listed companies to establish a RC of INEDs to set the pay and benefits of the chair, executive directors and senior managers
2. restricts the length of service contracts and the level of compensation that is awarded on termination = seek to prevent directors from being rewarded for failure

Question 5

Are ED employees?

Are they paid directors’ fees?

How about NEDs?

Answer 5

• EDs are appointed as director AND appointed under a service contract to perform executive management functions

Under the contract EDs typically forego the payment of directors’ fees and are paid a salary instead.

• NEDs do not have a service contract = are simply paid directors’ fees which are determined by the board

Question 6

What are the 5 components of a remuneration package for a director or senior executive?

Answer 6

1. basic salary;
2. payments into a pension scheme
3. an annual bonus, usually linked to the annual financial performance of the company;
4. long-term incentives = share options or share awards
5. other benefits and perks = a company car

Question 7

What are the 2 elements that remuneration can be divided into?

What are the further 2 elements of the second one?

Answer 7

• The fixed element = the remuneration received by the director regardless of performance e.g. their salary and pension contributions

• The variable element = performance-related incentives e.g. cash bonuses, share options

• The variable elements of pay can be divided into:
1. short-term incentives = cash bonuses based on annual performance targets

2. Long-term incentives = share options may be awarded each year, but are typically linked to performance over a longer period of 3+ years

Question 8

What are short-term performance-based incentives?

What are the 6 different ways to measure financial performance?

Answer 8

= reward executives if actual performance during a review period reaches or exceeds certain predetermined targets = usually linked to the financial year

1. earnings per share
2. annual profit before interest and taxation (PBIT);
3. total shareholder return (TSR)
4. earnings before interest, taxation, depreciation and amortisation (EBITDA);
5. return on capital employed (ROCE);
6. other KPIs e.g. net income

Question 9

What are long-term incentive share options?

What is the exercise price and what do the Listing Rules say about this?

Will the executive get a benefit if the share price remains below the exercise price?

Answer 9

= Each option gives the holder a right to buy a new share in the company at a fixed price on or after a specified date in the future, provided that they are still in their job at that time

• Exercise price = the purchase price for the new shares under the option
• Listing Rules = the exercise price for options given to directors must not be less than the current market price

With share options, the executive gets no benefit if the share price remains below the exercise price

Question 10

What are long-term incentive share grants?

When does the director receive the shares and acquire ownership over them?

Will the executive get a benefit if the share price remains below the exercise price?

Answer 10

= directors given existing shares in the company (provided that they are still in their job) after a specified period of time, typically 3 years

= Not at the time of grant, only when the shares vest = will be conditional on the achievement of certain performance targets during that time

With share grant schemes = the executive benefits even if the share price falls, because the shares still have some value

Question 11

What are the 6 practical problems with devising a satisfactory remuneration scheme that links rewards with performance?

Answer 11

1. Selecting the right performance measures
2. Setting the thresholds at which rewards are paid = challenging but not unobtainable and disincentivizing
3. Deciding whether to place a cap on any rewards and determining the level
4. Ensuring targets for short-term incentives promote the long-term success of the company
5. Ensuring targets used for incentive schemes do not promote bad behaviour
6. Designing a scheme that will be satisfactory to shareholders

Question 12

Companies often use comparative pay data to decide the level of remuneration for directors and senior executives.

What is the problem with this method of determining directors’ pay?

What does the FRC Guidance on Board Effectiveness say?

Answer 12

= every company in the comparator group decides that that they want to pay average or above average salaries, pay will begin to spiral out of control

• FRC Guidance on Board Effectiveness = ‘It is important to avoid designing pay structures based solely on benchmarking, or the advice of remuneration consultants, as there is a risk this could encourage an upward ratcheting effect on executive pay’

Question 13

An excessive use of options can result in a serious misalignment of interest between shareholders an directors.

What are the 4 drawbacks of share option schemes?

Answer 13

1. Option holders do not benefit from dividend pay-outs. EDs may have interest in keeping dividends low
2. Share prices are volatile = Option holders may be unjustly benefit in a bull market and be inadequately rewarded in a bear market (both disincentivizing performance)
3. EDs may prefer a long-term incentive scheme involving the grant of shares, since the shares will always have some value once they have vested
4. IFRS2 Share-based Payment requires companies to recognise the award of share options as an expense, chargeable against the company’s profits = may discourage some companies from using options as an incentive.

Question 14

What does the UK CG Code say on directors being involved in setting their own remuneration?

Answer 14

No director should be involved in deciding their own remuneration:
Principle Q = a formal and transparent procedure for developing policy on executive remuneration and determining director and senior management remuneration should be established’.

In practice this means setting up a RC

Question 15

What does the UK CG Code say on levels of remuneration?
Specifically:

Directors should exercise what? (2)

RC should review and take into account what when setting ED remuneration?

Levels of remuneration for the chair and all NEDs should reflect what?

Remuneration for NEDs should not include what?

What should pension contributions for EDs be?

Answer 15

• Principle R = Directors should exercise independent judgement and discretion when authorising remuneration outcomes, taking account of company and individual performance, and wider circumstances

• Provision 33 = RC should review and take into account workforce remuneration and the alignment of incentives and rewards with culture

• Provision 34 = Levels of remuneration for the chair and all NEDs should reflect the time commitment and responsibilities of the role.

Remuneration for all NEDs should not include share options or other performance-related elements.

• Provision 38 = only basic salary should be pensionable

Question 16

What does principle P of the UK CG Code say on performance related remuneration?
Specifically:

What remuneration should be aligned to and linked to?

What is this intended to do?

Answer 16

• Principle P = requires executive remuneration to be ‘aligned to company purpose and values’ and to be ‘clearly linked to the successful delivery of the company’s long-term strategy’

intended to ensure that directors’ remuneration is more closely aligned with the interests of shareholders

Question 17

What does Provision 36 UK CG Code say on performance related remuneration? (3)

Answer 17

• Provision 36 states that:
1. Remuneration schemes should promote long-term shareholdings by EDs that support alignment with long-term shareholder interests

2. Share awards granted for this purpose should be released for sale on a phased basis and holding period of 5+ years
3. RC should develop a formal policy for post-employment shareholding requirements

Question 18

What does Provision 37 UK CG Code say on performance related remuneration? (2)

Answer 18

• Provision 37 states that:
1. Remuneration schemes and policies should enable the use of discretion to override formulaic outcomes

2. They should 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

Question 19

What does Provision 40 UK CG Code say on performance related remuneration? /
What are the 6 factors RC should address when determining EDs remuneration policy and practices?

Answer 19

• Provision 40 = RC should address the following when determining executive director remuneration policy and practices:
1. Clarity
2. Simplicity
3. Risk
4. Predictability
5. Proportionality
6. Alignment to culture

Question 20

What does the UK CG Code say on the membership of the remuneration committee? (3)

Answer 20

Provision 32:
1. should consist exclusively of INEDs and should comprise at least 3 or, in the case of smaller companies, 2 such directors
2. company chair is permitted to serve on the RC if they were considered independent on appointment as chair (although they are not allowed to chair the committee)
3. the chair of the RC must have served on a RC for at least 12 months before their appointment as chair of the committee

Question 21

What are the duties of the remuneration committee according to the UK CG Code? (2)

What does FRC Guidance on Board Effectiveness require the committee’s terms or reference to do?

Answer 21

Provision 33 states that the RC should have delegated responsibility for:
1. determining the policy for ED remuneration; and
2. setting remuneration for the chair, EDs and senior management

• para 63 = the committee’s terms of reference should be made available on the company’s website and should explain its role and the authority delegated to it by the board

Question 22

Who will lead the consultation process with shareholders on remuneration?

How will the company conduct these consultations?

How often must shareholders approve the remuneration policy?

What does the CA2006 require?

Answer 22

RC chair is expected to lead the process of consulting shareholders on matters within the committee’s remit.

company will normally conduct them through shareholder representative bodies, such as the Investment Association

At least every 3 years

CA2006 = requires the overall directors’ remuneration policy to be approved by the board before it is put to shareholders

Question 23

What does the UK CG Code say on remuneration consultants? (3)

Why does this Provision require these things?

Answer 23

Provision 35:
1. where remuneration consultants are appointed, this should be the responsibility of the RC

2. The remuneration consultants should be identified in the annual report alongside a statement about any connection they have with the company or individual directors
3. . RC should exercise independent judgement when evaluating the advice of external 3rd parties and when receiving views from EDs and senior management

= reflects concern about potential conflicts of interest remuneration consultants may have which may compromise their objectivity

Question 24

What are the 6 fundamental principles that consultants should apply when giving remuneration advice to listed companies?

Who suggested these?

What should a person do if they believe this Code has been breached?

Answer 24

1. Transparency
2. Integrity
3. Objectivity
4. Competence
5. Due care
6. Confidentiality

Remuneration Consultants Group (RCG) ‘Voluntary Code of Conduct in Relation to Executive Remuneration Consulting in the UK’?

• Where any person believes that a consultant has breached the RCG Code, they should report this to the member firm concerned

Question 25

What are the 2 things the annual remuneration report of a quoted company is required to include under the statutory disclosure regime?

What do DTRs require the corporate governance statement to describe in relation to committees?

Answer 25

1. Details regarding the membership of the remuneration committee and any advisers.
2. A statement by the RC chair summarising the major decisions and changes made in relation to directors’ remuneration during the year

• DTR 7.2.7 requires a listed company’s corporate governance statement to describe how each committee of the board operates.

Question 26

What does the UK CG Code require the remuneration committee report within the annual report to include? (4)

Answer 26

Provision 41 = there should be a description of the work of the RC in the annual report, including:

1. an explanation of the strategic rationale for EDs’ remuneration policies and performance metrics
2. reasons why the remuneration is appropriate
3. Shareholder engagement and the impact this has had on remuneration policy
4. Workforce engagement to explain how executive remuneration aligns with wider company pay policy

Question 27

What does the Wates Corporate Governance Principles for Large Private Companies say on remuneration?

Answer 27

Principle 5 = A board should promote executive remuneration structures aligned to the long-term sustainable success of a company taking into account pay and conditions elsewhere in the company

Question 28

Name 4 non-binding guidance under Principle 5 the Wates Corporate Governance Principles for Large Private Companies on remuneration

Answer 28

1. Remuneration for directors and senior managers should be aligned with performance and the achievement of company purpose, values and strategy.
2. Board should establish clear remuneration policies = enable effective accountability to shareholders.
3. Boards should consider the benefits of remuneration policy transparency = build trust with wider stakeholders.
4. Establishment of a committee allows boards to delegate responsibility for designing remuneration policies and structures for directors and senior management.

Question 29

Which companies are required to produce a Directors’ Remuneration Report?

What 2 things must the report include?

Who must the Directors’ Remuneration Report be approved by?

Answer 29

• S.420 CA2006 = quoted companies are required to make detailed disclosures regarding directors’ remuneration in a separate section of the annual report and accounts known as the directors’ remuneration report

• Report must include:
1. the company’s policy on directors’ remuneration policy; and

2. the annual remuneration report (=implementation report) containing information on how the remuneration policy was implemented during the year

• S.422 CA2006 = The report of a quoted or traded (not including AIM companies) company must be approved by the board and signed on its behalf by a director or secretary

Question 30

When is the directors’ remuneration policy of a quoted or traded (not including AIM companies) company required to form part of its directors’ remuneration report?

How often must the remuneration policy be approved?

What happens if the remuneration policy isn’t approved?

Where must the remuneration policy be made available?

Answer 30

= if the company intends to move a resolution to approve a new policy or renew the existing policy at the next accounts meeting.

• The directors must invite shareholders to approve their policy at least once every 3 years whether or not it has been revised

• S.226A and 226B CA2006 = A quoted or traded (not including AIM companies) 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

• The directors’ remuneration policy must be made available on the company’s website

Question 31

Which regulation sets out the content requirements for the Directors’ remuneration policy?

What must the remuneration policy include? (2)

Answer 31

Large and Medium-sized Companies and Groups (Accounts and Reports) Regulations 2008

• Must include:
1. A table describing each component of the remuneration package that may be offered to directors under the policy

2. A statement on whether and, if so, how shareholders’ views expressed to the company were taken into account in formulating the directors’ remuneration policy

Question 32

What is the purpose of the annual remuneration report (implementation report)?

How often must the remuneration report be approved?

Why is this advisory vote important?

Answer 32

= to disclose to shareholders how the board has implemented the directors’ remuneration policy during the financial year

• S.439 CA2006 = 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

entitlement to remuneration is made conditional on this resolution being passed

Question 33

Which regulation sets out the content requirements for the annual remuneration report (implementation report)?

What must the annual remuneration report (implementation report) include? (5)

Answer 33

Large and Medium-sized Companies and Groups (Accounts and Reports) Regulations 2008

• It must contain:
1. Total pension entitlements for each director
2. Scheme interests awarded during the financial year
3. Payments made to past directors
4. Payments for loss of office
5. Director’s shareholdings and share interests in the company

Question 34

What does the CA2006 say on the length of director’s service contracts?

What does the UK CG Code say on the length of director’s service contracts?

What does the UK CG Code say the RC should do in relation to compensation for director’s appointments and departures? (2)

Answer 34

• s.188 CA2006 = directors’ service contracts must not exceed 2 years duration without shareholder approval

• Provision 39 = states that:
1. Notice or contract periods should be 1 year or less

2. RC should ensure compensation commitments in directors’ terms of appointment do not reward poor performance
3. RC should be robust in reducing compensation to reflect departing directors’ obligations to mitigate loss

Question 35

What does the UK CG Code say remuneration schemes and policies should do? (2)

Why does it say this?

What are the 2 methods on how this can be done?

Answer 35

• Provision 37 = remuneration schemes and policies should:
1. enable the use of discretion to override formulaic outcomes
2. include provisions that 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.

= intended to allow RC to make certain adjustments to performance-related pay in certain circumstances e.g. where there is an unjustified outcome

1. Malus provisions
2. Clawback provisions

Question 36

What is a malus provision?

What is a clawback provision?

What does The Investment Association’s Principles of Remuneration sate in relation to these provisions? (2)

Where must these provisions be disclosed?

Answer 36

malus’ provisions = allow the company in special circumstances to forfeit all or part of a bonus or long-term incentive award before it has been paid

‘clawback’ provisions = allow the company to recover sums already paid

1. circumstances in which performance adjustment and clawback can be implemented need to be agreed and documented before awards are made
2. the current market standard triggers for malus and clawback are gross misconduct or misstatement of results

• The directors’ remuneration policy of a quoted company is required to disclose whether incentive schemes include malus and clawback provisions
• If these provisions are ever invoked, details should be provided in the annual remuneration report (implementation report)

Question 37

What are the Listing Rule requirements for shareholder approval regarding long-term incentive schemes?

What are the 2 exceptions?

Answer 37

= require all share options and long-term incentive schemes established by a UK company with a premium listing to be approved by an ordinary resolution of the shareholders unless the scheme falls within 1 of the exceptions:
1. schemes offered to all employees; and
2. schemes for individual directors established specifically to facilitate the recruitment of those concerned

Question 38

What are the Listing Rule requirements for prohibition on discounted share options regarding long-term incentive schemes?

Answer 38

= options or other rights over shares may not be granted to directors or employees without shareholders’ approval if the exercise price would be less than the market value of the shares

Question 39

Are NEDs employees of the company?

What remuneration do they receive?

Where are there terms of appointment set out?

What happens if they are removed from office?

Answer 39

•No = no service contract

• receive a fee for their services as an officer of the company, not a salary

• terms of their appointment are set out in a simple letter of appointment

• If they are removed there is no breach of contract and no compensation will usually be payable

Question 40

What is the procedure for setting NED fees?

Would it be appropriate for the remuneration committee to be involved in the process?

Who sets the remuneration of the chair if they are a NED?

What happens if a NE chair sits on the RC?

Answer 40

• Provision 34 = remuneration of NEDs should be determined in accordance with the articles or, alternatively, by the board.

• No because this this would mean that some of the NEDs were involved in setting their own remuneration.

• Provision 33 = the remuneration of the chair, whether executive or non-executive, should be determined by the RC

• A non-executive chair who serves on the RC would need to recuse themselves when the committee is deciding their own remuneration (Principle Q)

Question 41

What does the UK CG Code say on the levels of NED’s (and the chair’s) fees?

Answer 41

Provision 34 = levels of remuneration for the chair and all NEDs should reflect the time commitment and responsibilities of the role.

Question 42

What does the UK CG Code say on NED’s involvement in performance-related schemes?

Why is it inappropriate for NEDs to participate in performance-related schemes? (3)

Answer 42

Provision 34 = their remuneration should not include share options or other performance-related elements

1. this would involve a conflict of interest for those serving on the RC who are responsible for designing these performance schemes
2. it would have the effect of aligning the interests of the NEDs more closely with those of the EDs (rather than the shareholders) and make them more liable to allow the company to take bigger risks; and
3. the company’s performance is not as reliant on the things that NEDs do

Question 43

What are 3 pieces of guidance on remuneration other than UK CG Code and FRC Guidance?

Answer 43

1. Investment Association’s Principles of Remuneration
2. PLSA Stewardship and Voting Guidelines
3. PRA/FCA Remuneration Codes of Practice

Question 44

Name 3 suggestions in the Investment Association’s Principles of Remuneration.

Why are they influential?

Answer 44

1. Remuneration structures should be designed to reward sustainable long-term business performance
2. Structures should include clawback and malus provisions
3. Executives should build up a high level of personal shareholding to ensure alignment of interests with shareholders.

= the recommendations represent the views of institutional investors in the UK, who still hold a significant stake in most listed companies

Question 45

According to the PLSA Stewardship and Voting Guidelines, what does good company behaviour look like? (3)

How should investors consider voting?

Answer 45

• What Does Good Company Behaviour Look Like?
1. Remuneration structures should cascade down to all employees

2. RC should design rewards that drive long-term success
3. Companies and shareholders should have regular discussions on strategy and long- term performance

• How Investors Should Consider Voting:
Shareholders should view the separate resolutions for the remuneration policy and remuneration report independently