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Background

Report Requirements
General Disclosures
Performance Graphs
Remuneration Committees
Professional Advisors
Penalty For Failure

Options & Share Schemes
Performance Conditions
Cost of Options
Dilution Limits

Service Contracts

Directors' Remuneration Report
Disclosure Requirements

A Manifest Review

Background

From 31/12/2002, UK quoted companies will be required to operate a stricter reporting regime for disclosure of executive remuneration. The objective of the new legislations is to, ‘ensure greater transparency’, ‘improve accountability’, and, ‘strengthen links between performance and pay’.

Patricia Hewitt of the DTI wished to combat the problem of directors being ‘...lavishly rewarded for lack-lustre or even poor performances’. However, Hewitt pointed out, ‘it is not for the Government to take a view on the appropriate level of remuneration for executive directors’. Therefore, the Government focused on implementing an effective framework in which shareholders could hold directors to account on remuneration issues. The aim was not to prescribe a remuneration policy for remuneration committees to adopt.

The initial consultation work undertaken on directors’ remuneration occurred under the stewardship of Stephen Byers. After the resignation of Byers, Patricia Hewitt commissioned a new consultation exercise, which closed on 15 March 2001. The consultation exercise and analysis of responses led to the passing of The Directors' Remuneration Report Regulations 2002 on 25^th July 2002. The regulations have been given Parliamentary approval and came into force on 1^st August 2002. The regulations apply to financial years ending 31^st December 2002, therefore, the full effect of the proposals will become clear in the first quarter of 2003.

Remuneration Report Requirements

The thrust of the regulations centres on the requirement for listed companies to produce a remuneration report. The Board must approve the report and shareholders are to have the opportunity to approve the report by resolution. The regulations require listed companies to take account of Schedule 7A, which contains a list of requirements for the remuneration report. One should note that the regulations amend the Companies Act 1985 to this effect. Therefore, the changes give legal effect to the Combined Code recommendations.

The shareholders are entitled to vote on the remuneration report, under an ordinary resolution. This allows a shareholder to separate remuneration issues, e.g. grants of options, from issues that are specific to the director, e.g. independence. Shareholders have a mechanism for showing their disapproval of the remuneration policy or of the remuneration of an individual. Currently, shareholders may show disapproval by voting against the re-election of a director, however, this has the disadvantage of directors not retiring every year. The Combined Code recommends directors retire every three years. Therefore, a shareholder may be unable to show disapproval of a directors’ remuneration if the director is not being re-elected that year.

However, the regulations are limited because disapproval is all shareholders may show. The outcome of the votes on the resolution has no effect on the validity of the remuneration policy, the salary of a director, options granted, etc, unlike a resolution for the re-election of a director. Therefore, the regulations deny shareholders ‘teeth’, with which to bite at under-performing or over-remunerated directors.

Performance Graphs

Companies will have to publish a graph showing the total shareholder return (TSR) of the company and of a comparator group over a five-year period. The aim of the requirement is to enable shareholders to easily determine and assess the company’s performance. The ability to compare the company’s performance is important because above market performance deserves rewarding whereas below market performance does not.

However, the weak definition of comparator group, being ‘a broad equity market index’, limits the positive effects of this measure. The directors decide against which comparator to use to compare their performance. It will be open to directors to choose a comparator group that advantageously reflects their performance and, therefore, aides their re-appointment or justifies increases in their remuneration. Further, it is open to the board to change comparator groups, as long as they have sufficient data (5 years). However, the company must justify its reasons for selecting the comparator group, although, this is likely to be satisfied with a simple statement such as, ‘the Board considers that this group represents the market in which the Company operates’. When measuring the performance of a company against a market based target it is important for that target to be reliable, consistent across the market, accurately reflect the company’s performance and set at a high level. The recent report of WH Smiths shows their performance is consistently better than that of their comparator group. When one considers that in FTSE sectors the size and precise business of the companies may vary widely, it is important for the comparator to fairly reflect performance.

The regulations require disclosure of comparator groups against which the Company assesses its performance for options to vest or become exercisable (See Performance Conditions). However, the comparator group may be different from that in the performance graph and if the comparator group for performance criteria is different it does not have to be included within the performance graph. The advantage of the performance graph is that it allows shareholders to assess the performance of the Company, and therefore, the performance of the directors. Options are a form of performance related pay, over which institutional guidelines recommend linkage to shareholder return. Therefore, it appears illogical not to require performance criteria for options to be included in the graph. The annual report of WH Smiths plc demonstrates the point. They have included a graph showing TSR for the Company and the FTSE General Retailers Sector (the sector in which the Company operates). The graph clearly shows the Company out performing the sector. However, the Company’s executive share options require Earnings Per Share (EPS) growth over the Retail Price Index (RPI) of plus 9% over a three-year period (quite standard). Therefore, the usefulness of the graph is limited, as it relates to Company performance, but not performance related pay. The fault is not of WH Smiths, but the regulations which require the graph to show TSR, not EPS which is commonly used in options. The regulations regarding the performance graph and the lack of requirements linking remuneration to performance appears to undermine the Governments aim of strengthening, ‘links between performance and pay’.

Remuneration Committees

The consultation exercise included a proposal for all listed companies to establish remuneration committees of wholly independent non-executive directors, giving legal effect to the Combined Code. The Combined Code recommendations on remuneration committees were set to ensure that executive pay is determined impartially and without the potential for conflicts of interest. Therefore, the recommendations avoid personal greed and over rating of ones own performance.

It is most disappointing to note that the proposal did not proceed beyond consultation, i.e. a requirement was not included in the regulations. Therefore the regulations do not require independent, subjective oversight of the executive remuneration. This may seriously limit the aim of preventing so-called lavish rewards, ‘…for lack-lustre or even poor performances’. Further the executives themselves may determine their own remuneration and the contents of the remuneration report.

The response to the consultation exercise noted that the majority of companies already comply with the provisions, therefore, why make it a legal requirement? The answer to this would seem to be, if the majority of companies already comply, why not make it a legal requirement? It appears that more time has been wasted considering whether or not a measure should be included than the time it would take to include the provision. The majority of us do not steal, therefore, should legislators have bothered with the Theft Act?

A further argument advanced was that the provisions would result in greater costs to smaller listed companies. One should remember that the Combined Code recommends remuneration committees comprise solely independent non-executive directors, their fees may be as low as £6,000 per annum, and therefore, the total cost of a compliant remuneration committee could be £12,000 per annum. Further, research has shown that small companies are increasingly using non-executive directors due to the perceived benefits of an experienced objective advisor (Judge E ‘Small firms see the benefits of an in-house outsider’ Times 5 Nov 2002). There are benefits that may derive from experienced non-executives that exceed corporate governance, especially as many non-executives have business experience in leading companies.

A final argument concerned the difficulties of defining and maintaining the consistency of the term ‘independent non-executive’. A problem that is quite apparent to Manifest where, for example, the 2002 report and accounts of NetStore plc considered a director independent despite being Executive Chairman of a major shareholder and holding options in the shares of the Company. The simple answer to the problem would appear to be to follow the definitions and principles of the Combined Code and institutional guidelines. Requiring impartial external audit of compliance would only seek to strengthen the committee and therefore prevent excessive remuneration.

On consultation by the DTI, the proposal received 100% unqualified positive response from institutional investors. Therefore, a pro-active shareholder approach, which many institutions currently undertake, may form a remedy on a non-legal basis. However, the lack of far reaching requirements undermines the purpose of regulations, which should raise and maintain standards, not to maintain the status quo.

Advisors to the Committee

The regulations require the name of anyone who advised or provided services to the committee. The consultation exercise considered that this measure would reduce the potential for conflict of interest or at least increase shareholder awareness. Although, the intent on ensuring the remuneration committee is not subject to impartial advice appears thwart by the lack of a requirement preventing impartial committee members (i.e. executive directors).

The consultation document considered it important for the committee to be free to choose its advisors, therefore increasing the impartiality of the advice given. However, the regulations do not prevent non-members from choosing advisors for the remuneration committee. The regulations merely require the committee to disclose whether they or others chose the advisors. Therefore, there is the potential for executive staff, who benefit from the committees recommendations, to chose who advises the committee in relation to its recommendations. By choosing the advisors, one may argue that the executives would have a mouthpiece, with an objective, impartial and expert appearance. The lack of enforceable requirements appears to weaken the independence and impartiality of the committee, further undermining the Governments’ aim of improving accountability.

Penalty for Failure to Comply

The requirements of the regulations apply to directors of companies included on the official list, on the official list of an EEA country or those admitted to dealing on the NYSE or the NASDAQ. If a Company fails to comply with the provisions regarding the laying of the remuneration report, the contents of it or the voting upon it, all directors in office immediately prior to the laying of the report will be guilty of a finable offence. Further, the regulations introduce a finable offence for breach of the directors’ duty to disclose any relevant facts to the Company. It is pleasing to note that the regulations hold directors personally liable for default, which, one hopes, will restrict apathy. At the same time, it is obvious that the gravity of an offence under this section is not so serious to deserve a penal punishment. All the defined offences include the defence of taking all reasonable steps. It is important for ‘reasonable steps’ to be set above excuses of incompetence or lack of knowledge.

Options & Share Schemes

Performance Conditions

The remuneration report must disclose performance conditions for options to vest or become exercisable. To add ‘bite’ to this requirement the report must explain the reasons for choosing conditions and summarise methods used for assessing satisfied conditions. Further, they must describe and explain any changes made to performance conditions and explain why if there are no performance conditions. These requirements will standardise the level of disclosure of share schemes for executive directors, which currently varies widely from substantial legal summaries to a meagre paragraph. Disclosure of performance conditions for options is essential in order for shareholders to assess the incentive nature of a scheme and the benefit to the Company that will ensue.

However, explanation and disclosure is all that is required. The committees are not prevented from setting, ‘non-performance based’ or ‘pre-grant’ (i.e. already satisfied) performance requirements. As shareholders may not overrule a grant of options by utilising the advisory vote on remuneration policy, the system will not put an end to the ‘fat cat’ debate, which GlaxoSmithKline’s Jean Marie Garnier has made a prime example of in recent times. Also, the general disclosure is not subject to external audit. Once, again the Government seems to have failed in its efforts to prevent the possibility of award for poor performance.

Cost of Executive Options

However, the regulations require audited disclosure of options granted, exercised and lapsed, including exercise prices, market prices and other information relevant to profit made. The majority of companies currently disclose such facts. This should allow shareholders to assess the value that the directors receive from the grants and compare this to other remuneration received by the director and to levels of remuneration in comparable companies.

However, it is most disappointing to note that they do not require disclosure of the costs of the options to the Company. Although one may determine the benefit the director is to receive due to market and exercise price disclosures, the cost (or an estimate) of purchasing or issuing the shares to the Company is not required to be disclosed. Therefore, the cost of the total remuneration package to the Company may not be easily calculated, and compared to the Company’s profits. The Sunday Times have highlighted the importance of being able to compare profits to the total cost of directors’ remuneration. It reported that the there Directors of the European office of Greenhill & Co received aggregate remuneration of £13.5m, in a period when the turnover was £17.4m and the Company made a loss of £2.5m.

The report must disclose the total amount of;

• salary and fees paid,
• bonuses paid or receivable,
• sums paid by way of expenses,
• compensation for loss of office paid,
• the total amount of any other payments paid to or receivable by the person in connection with the termination of qualifying services and
• any other benefits (excluding options and LTIPs).

When considering the level of disclosure required above, it is strange that greater disclosure regarding the cost of options was not required. Especially as most company’s report and accounts follow this section with a simple ‘total’.

The International Accounting Standards Board highlights the lack of initiative over the disclosure of the cost of options. The Board recently published, ‘Draft on Treatment of Share-based Payments’, a consultation document, the final version of which is due to come into force in 2004. The key recommendation requires, ‘an entity to measure the fair value of the goods or services received’, which includes options. Therefore, non-governmental regulations may correct the Governments’ shortfalls relating to directors remuneration, highlighting the deficiencies in the exercise.

Dilution Limits

The consultation document asked for opinions on whether or not companies should be required to disclose the overall dilution limits of their share schemes. Disappointingly, no such requirement was included within the regulations and there was no comment on the outcome of the question in the Government’s response to the consultation. Disclosure of dilution limits would ensure shareholders are aware of the extent of the potential effect of schemes and allow them to have an approximation of the cost to the company. Further, by following institutional guidelines on dilution limits, share holdings are protected. However, if the limits exceed recommended guidelines and shareholders are not aware, one may question the accountability of the Board and question how shareholders may protect their interests. A lack of disclosure in this area undermines the other disclosure requirements for share schemes.

Service Contracts

The regulations require disclosure of details of directors’ service contracts. Details such as length of contract and time of formation are required, although, the majority of Companies disclose such details. It is apparent that the majority of companies disclose the lengths of directors’ contracts; however, many omit details regarding termination arrangements and mitigation, which must be included under the regulations. Most companies allow shareholders to inspect the contracts at the AGM, however, this is of limited benefit to proxy voters, especially institutional investors, who generally do not have time to attend the AGM of every company in whom they have invested.

The important aspects of this section are the two sections ensuring full disclosure of any benefits to the director or liabilities to the company that will accrue on early termination of the contract. This allows shareholders to show their dissatisfaction at potentially high compensation awards, i.e. by positively voting against or abstaining on the re-election of an individual director rather than lodging what is, in effect, an advisory vote against the remuneration report. Although, of course, voting against the re-election of a director may well trigger the compensation award itself!

Although this section is a powerful tool for shareholders, it is rather a case of shutting the stable door after the horse has bolted. Underperforming companies may argue that they need substantial contractual promises to attract first-rate executives. However, if those executives do not perform to expectations, the contract terms are legally enforceable and therefore company is obliged to fulfil them or risk legal action. Therefore, shareholder input is required at contract negotiation stage, but this is unlikely to welcomed by companies and would most likely be extremely difficult to implement.

As noted by the Law Society in relation to the 1999 consultation:

‘The Government’s position is that a significant contribution to improving international competitiveness would be derived by linking high awards for business leaders to performance. The paper rather assumes that only one model of paying directors (i.e. performance related pay) can achieve the international competitiveness that the Government calls for…’

The purpose of this document is not a debate on the merits of performance related pay. However, the quote makes the point that the Government has solely centred the exercise on relating performance to pay, which in the main it has failed to do. The lack of requirements for an independent remuneration committee, linking of grants and awards of options to performance and a performance graph that may be at least ‘tweaked’ by the board, undermines the basis of the regulations.

The report centres on forcing disclosure rather than ‘hard rules’. The lack independent audit over much of the disclosure undermines its benefits, especially as it would create little extra burden in the majority of cases. As a wholly independent, non-executive remuneration committee is not required, remuneration may be lacking in subjective oversight. Individual remuneration policies will therefore still require the ‘eye’ of the individual investor, a degree of expertise in reviewing true value and most certainly not an assumption that more disclosure will ever mean better disclosure.

Under the regulations auditors have increased responsibilities. They must report on the auditable part of the report and state whether in their opinion whether it has been properly prepared. Furthermore, where the regulations have not been complied with, the auditors shall include in their report a statement giving the required particulars.

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