15 May 2018 by Peter Swabey
Recent changes to executive pay regulation need more time to have an effect
On 22 March, the Business, Energy and Industrial Strategy Committee launched an inquiry ‘into aspects of pay in the private sector’.
Titled ‘Corporate governance: Delivering on fair pay’, the inquiry was broken into two parts – a review of ‘compliance by business with reporting requirements on the gender pay gap and to consider what steps they are taking to address the gap’, and a review of ‘the implementation of the prime minister’s undertaking to crack down on excessive executive pay’.
The committee asked for feedback in two tranches – that on the gender pay gap by 10 April and that on executive pay by 8 May. Some of the salient points of our response on the gender pay gap were covered in my column on page 57 of the April issue of Governance and Compliance.
“It is too early to assess the impact of changes that have been made in the past year”
With regards to the issues raised by the committee’s inquiry into executive pay, the committee stated that it will ‘look at progress in simplifying the structure of executive pay and pay reporting, and the role of remuneration committees, institutional investors and shareholders in curbing excessive pay.
This will follow up the report on corporate governance prepared by the previous BEIS Committee in April 2017, which made a range of recommendations on corporate governance and executive pay.’
The committee is focused on progress in the last year on this issue and, once again, we were of the view that it is too early to assess the impact of changes that have been made in the past year. That said, many of the recommendations made by the committee have been carried forward.
The government indicated in its response to the green paper on corporate governance, published in August 2017, that it will ‘introduce secondary legislation to require quoted companies to … Report annually the ratio of CEO pay to the average pay of their UK workforce, along with a narrative explaining changes to that ratio from year to year and setting the ratio in the context of pay and conditions across the wider workforce’
The Financial Reporting Council (FRC) is currently consulting on proposed revisions to the UK Corporate Governance Code, which address the committee’s recommendations that companies ensure that bonuses are genuinely stretching and aligned ‘with broader corporate responsibilities and company objectives’.
The proposed Principle P states: ‘A formal and transparent procedure for determining director and senior management remuneration should be established. Performance-related elements should be clear, stretching, rigorously applied and aligned to the successful delivery of the strategy.’
Provision 32 of the revised code requires that: ‘Before appointment as chair of the remuneration committee, the appointee should have served on a remuneration committee for at least 12 months.’
The recommendation that ‘the chair of a remuneration committee be expected to resign if their proposals do not receive the backing of 75% of voting shareholders’ has not been carried forward – although, of course, the chair of the remuneration committee, in common with all directors, is subject to annual election by shareholders, which renders this recommendation redundant.
The FRC has not proposed to amend the code to ‘establish deferred stock rather than LTIPs as best practice in terms of incentivising long-term decision making’, as suggested by the committee.
However, it has proposed a number of requirements focused on simplicity, clarity and predictability of remuneration structures and that ‘in normal circumstances, shares granted or other forms of long-term incentives should be subject to a vesting and holding period of at least five years. Longer periods, including post-employment periods, may be appropriate.’
As we noted, however, in our response to the green paper, ‘we are not convinced that holding periods are generally perceived to be a problem: the concern appears generally to be about the quantum of awards, which is, in many cases driven by a tendency to discount the value of potential future payments, sometimes referred to as “jam tomorrow”.’
“This link between shareholder gain and executive remuneration is important to many shareholders”
One of the challenges of doing away with LTIPs is that they were introduced in an attempt to align executive pay outcomes with the shareholder experience and are popular with many shareholders.
As we went on to say in our green paper response: ‘Using restricted shares would give more certainty and predictability – and would create a long-term interest. However it is our experience that most shareholders currently prefer awards to be based on performance conditions.
‘It is accepted that increases in share price are not necessarily linked to company performance, but shareholders are aware that they also reap the benefit of this increase in share price. It is this link between shareholder gain – in terms of earnings per share and/or total shareholder return – and executive remuneration that is important to many shareholders.
‘The challenge with this type of remuneration is twofold: because their value is linked to share price, the quantum of awards can be high in the event of a substantial increase in share price.
‘However, because the realisation of the award is, at the time of its being set, in the distant future and not guaranteed, the value of such awards tends to be heavily discounted by executives, with the result that they can be higher.’
Finally, the committee recommended that the FRC introduce a code requirement ‘for a binding vote on executive pay awards the following year in the event of there being a vote against such a vote of over 25% of votes cast.’
This has also not been carried forward, rather, the FRC has included a provision to require a company that receives more than 20% of votes against any resolution to explain ‘what actions it intends to take to consult shareholders in order to understand the reasons behind the result’ and update on how that feedback is being taken into account.
The committee also asked about improvements in the reporting of executive pay over the last year and: ‘What steps have been taken by remuneration committees and institutional investors to combat excessive executive pay in the last 12 months?’
The problem here, in both cases, is the shortness of the timescale. We have seen some improvements in the reporting of executive pay, particularly in terms of explaining the potential outcomes with greater clarity, but it is only now, in late April, that 31 December year-end companies’ reports are being published and it is too early to conduct a full review of these.
Similarly, both remuneration committees and institutional investors are tied by the remuneration policy that shareholders have approved and relatively few companies have presented a new policy to investors that was prepared after the previous committee report.
That said, we have been encouraged this year to see more companies taking policies based on restricted shares to their shareholders. The use of restricted shares can also facilitate these opportunities being offered to all employees, rather than a small number of executives.
Wider all-employee share ownership should be encouraged and companies should consider whether performance-based incentives and other employee benefits should not be offered on an equal basis to all employees.
The final question from the committee was what further measures should be considered. Remuneration policies were first put to the shareholder vote at 2014 annual general meetings and again in 2017. Very few companies received negative votes against their policies in 2017, which suggests that the system is working.
Firms respond to investor requirements and, for the vast majority of well-governed companies, it is our experience that this works well, with remuneration reports being approved on an annual basis by overwhelming majorities of shareholders.
Where there is shareholder dissent, this is not always for the same reasons and can, sometimes, be for conflicting ones.
“The most effective policy intervention would be one that addressed specific areas of abuse”
We remain of the view, as explained in our response to the green paper, that ‘we do not believe that shareholders need stronger powers over executive pay at this time. Executive pay in UK companies has never been more regulated, but only a small minority of companies received objections to their remuneration policy from shareholders in 2016.
‘The evidence is that, since the 2013 changes were introduced, three-quarters of companies have received votes of 97% or more in favour of the remuneration policy and that executive pay has reduced over these three years.
‘In our view the most effective policy intervention would therefore be one that addressed specific areas of abuse rather than the market as a whole. It would be sensible to evaluate the impact of the 2013 regulations before considering further changes to shareholder powers.’
The changes introduced in 2013 have been through only one full cycle of reporting and so cannot be said to be fully established or, yet, to have been fully effective or otherwise.
Overall, then, our message on executive pay – as it was on the gender pay gap – is that it is still too soon to say whether or not the recent changes have been effective, or for changes that are in the process of development to have been introduced.
Although the committee’s focus on these important issues is helpful, not least because it keeps them firmly in the government’s mind, both the issue of the gender pay gap and of executive remuneration merit detailed thought and a more considered programme of government action.
On executive pay, in particular, before meaningful action can be taken over the fact that executive pay is sometimes excessive, it is essential first to be clear about the ill that we are seeking to cure, because not all of those who talk about ‘high pay’ are coming at the question from the same viewpoint.
As we have repeatedly stressed, is it the issue that pay is disassociated from performance; that there is income inequality in our society; or that some people are simply paid too much?
Whichever it is, and I believe it is a combination of these factors, the case has not been made for what appears to be an exclusive focus on executives in public companies.
For good reason, their pay is visible to all, but the same cannot be said of the income of those in equivalent positions in private companies, professional firms or private equity and other investment firms, to say nothing of entertainment or sports stars, or those who receive income from inherited investment.
We are not permitted to publish our submission in full until the committee has done so. Following their publication, both submissions will be available on the ICSA website.