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Putting a lid on the LTIP jar

07 November 2017 by Charlotte Fleck

Putting a lid on the LTIP jar - Read more

Government inaction will not halt criticism and reform of long-term incentive plans

It is easy to see why some coverage has suggested the government backed down from meaningful reform on executive pay.

Previous sweeping proposals for the abolition of long-term incentive plans (LTIPs), binding annual votes on executive pay, and mandatory worker-directors have been rejected in favour of tentative calls for more guidance and increased transparency.

However, the August green paper on corporate governance reform and the assorted responses contain much that boards should be aware of.

If nothing else, continued controversy and change seem likely, with many areas to be kept under review and greater amounts of guidance, secondary legislation and changes to the UK Corporate Governance Code to follow.

The concerns raised in the paper regarding LTIPs reflect those that have been brought up repeatedly over recent years. Some allege LTIPs fail to adequately align executive pay with long-term performance, that targets set are too narrow and too complexly, and that they encourage executives to hit bonus targets rather than increase long-term value.

There is a case for LTIPs, partly because no plausible alternative suitable for adoption on a broad scale has been proposed. LTIPs are starting to look like the worst form of incentive – apart from all the others.

Fixed salary and cash bonuses are part of every executive’s reward structure, but lack the long-term nature and inherent alignments with shareholder interests of share-based awards.

Market value share options reward executives who achieve growth in share price but, as the green paper comments, can reward poor performance unless subject to appropriate targets.

A market value threshold also means awards need to be granted over more shares to deliver the same value if targets are achieved – and if the share price rises substantially there can be a multiplicative effect and windfall gains.

Room to improve

In this context, a measured approach seems sensible. One concrete recommendation by the green paper is a move to a five-year holding period for share awards (including both vesting and the post-vesting holding period), which could be a pragmatic and easily-adopted way to increase awards’ longevity.

As a counterpoint, this is already the approach taken by a number of companies. Incremental positive change has much to be said for it, but if the package of guidance and recommendations suggested by the report fails to sufficiently change things, the paper leaves the possibility open for more dramatic reforms.

It is also interesting to note the green paper’s comparison to the seven-year deferral period now required for variable pay in the banking sector. If successful, elements of financial services’ stricter pay regulation could be copied elsewhere.

Uncertainty is, by definition, difficult to plan for. It is tempting to move towards more discretion in share plans, allowing maximum flexibility. However, this can have its own pitfalls.

Even a discretion stated in plan documents to be absolute will still be subject to an implied reasonableness term as to how it is exercised, and the less specific that rules are about the circumstances in which an executive will or will not receive value, the more scope there is for dispute.

As with the Investment Association’s report on executive pay last year (to which the green paper refers with approval), the government encourages more diversity in reward structures. How this will feed into practice is hard to say.

In our experience, companies tend to report some investor resistance to moving away from the familiar templates – but the context of repeated complaints about the shortcomings of the standard LTIP model suggests this needs to change.

As so often, investors could equally respond by pointing to the need for meaningful consultation by companies and the importance of clearly explaining the reasoning for and expected impact of changes.

An old hope

If the government’s recommendations have a theme, it may be the hope that sufficient transparency will lead to better practice.

The impact on remuneration should be seen in the context of the reforms as a whole, including the proposals requiring boards to explain how they have taken into account their duty to consider the interests of stakeholders other than shareholders. It is impossible to legislate good decision-making, but the hope appears to be that requiring better explanation and disclosure is a starting point.

Expanding on existing requirements for directors’ remuneration reports and policies, new secondary legislation will require pay policies to more clearly set out the impact of share price growth, and the range of potential outcomes, for long-term share-based incentive arrangements.

At the time of writing this has not been published, and so it remains to be seen how far this will elaborate on the information already available – maximum and minimum pay figures, for example, must already be included.

The step which has been making headlines is the requirement to disclose the ratio of executive pay to that of average UK workers. How pay will be determined for this purpose has not yet been clarified.

Gender pay gap reporting uses the straightforward metric of the value subject to income tax, but in the context of long-term, variable share-based awards this can be misleading in any given year. However this is determined, companies need to prepare to provide narrative to go with the figures.

Remuneration committees should also consider the level of executive pay in the context of the whole workforce. Companies should think about the information committees will need to take meaningful account of this, and how it is to be presented.

Complex excess

Too much information can be no more helpful than too little. For both remuneration committees and investors, being presented with a lot of data to digest can obscure the key features.

A common concern is inappropriate and overly-complex performance conditions, and better explanation of the targets and outcomes used would presumably allow shareholders to scrutinise and challenge them more easily.

Overcomplicated performance conditions both make it hard for shareholders to do this and could reduce the actual incentive effect of awards. Executives themselves need a clear understanding of what they are being asked to work towards.

For large companies operating globally, sometimes targets and disclosure must be complex.

One proposal the government rejected was a simple red-yellow-green rating system to indicate companies’ overall compliance with the code, over fears it would push companies towards ‘tick-box’ compliance and undermine flexibility. ‘Simple’ measures of pay and performance can also mislead.

Performance targets are often commercially sensitive and may not be disclosed until after the fact, if at all. The Investment Association continues to press for better disclosure here. The key information will again be that presented to the remuneration committee.

New guidance from ICSA and the Investment Association on listening to stakeholders reminds boards to ensure they are getting the information they need rather than passively allowing managers to select it.

This should also be seen in the context of concerns that LTIPs can be too narrowly-focused, for example, on ‘earnings per share’ rather than long-term, sustainable growth in the company’s value. 

Some suggest performance conditions should be tied not just to the obvious financial metrics but to everything from return on capital investments, to social benefit and environmental impact. This clearly poses problems in terms of complexity and of deciding how best to measure such impacts.

Tipping the balance

Striking the right balance between regulation and flexibility is hard. For now, the government’s proposals give companies the space to continue working to improve, but if meaningful change is not seen then future interventions will likely be more direct.

There is however no substitute for real, good-faith engagement between companies, investors and other stakeholders.

Firms should also think carefully about the ongoing problem of how to gather and present the right information for decision-making, and how to measure and evaluate those decisions after.

Charlotte Fleck is an assistant solicitor at Pett Franklin

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