In January 2012, in our briefing “Executive Remuneration: The Government’s proposals”, we reported on the Government’s proposals for greater transparency and more shareholder involvement in the area of executive pay. The Government has now published a consultation paper setting out its proposals in more detail. These proposals will impact on all UK incorporated quoted companies as it is intended that they will apply to the remuneration of all directors of such companies, with their principal impact being on executive directors.
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Annual binding vote on future remuneration policy
The Government proposes that shareholders of UK incorporated quoted companies should have a binding vote on the company’s future remuneration policy which will replace the current advisory vote on the directors’ remuneration report. At the start of the year, in one section of the directors’ remuneration report, companies will have to set out the proposed pay policy for the year ahead, including potential payouts and the performance measures to be used. Any proposed changes to the remuneration policy will be contingent on the resolution being passed and companies will have to act within the scope of the remuneration policy agreed by shareholders at the start of the year. If the binding vote on the company’s future pay policy is not passed at the AGM, the company will have either to operate within the last pay policy approved by shareholders or call a further general meeting to vote on a revised remuneration policy, as circulated to shareholders in advance of that further general meeting. Such a meeting will have to be held within 90 days of the AGM at which the original resolution was voted down.
The Government is considering the level of support that should be required to pass the annual binding vote on the future remuneration policy. It considers that a threshold of between 50 per cent and 75 per cent may be appropriate to ensure that a single shareholder with 25 per cent or more of the total voting rights in a company could not, alone, reject a special resolution.
The Government anticipates that most shareholders will want to allow the company’s remuneration policy to permit the remuneration committee some discretion and flexibility. However, so that shareholders can see that their views have been taken on board, the Government proposes that companies will need to report on how shareholders voted on all pay resolutions in the previous year, how shareholder votes have subsequently been sought and how the company has responded and adapted its remuneration policy accordingly.
The Government hopes that a binding vote on future remuneration policy will encourage better quality engagement between companies and shareholders at an early stage in the devising of the remuneration policy. It suggests that if the binding vote is not passed and the company decides to continue with its previous year’s remuneration policy which shareholders are unhappy with, possibly because they no longer deem it fit for purpose, shareholders will need to express their dissatisfaction when voting on the re-election of directors, for example. However, if the binding vote is not passed it may be difficult for the company to resort to its previous remuneration policy as much common policy is likely to run through the remuneration policy year on year. As a result, a “no vote” is likely to leave the company not really knowing what is and is not acceptable to its shareholders with respect to, for example, the detailed operation of its long-term incentive schemes (LTIPs).
In future, no director’s service contract will be able to guarantee that a director has the right to participate in a particular type of remuneration scheme, or to specify the level of remuneration that the director could receive in particular circumstances, as this will depend on shareholders agreeing the remuneration policy, and so the scope of potential rewards, on an annual basis. As a result, some existing service contracts and other arrangements may need to be amended to ensure that provisions relating to variable remuneration do not conflict with the ability of shareholders to approve the company’s remuneration policy annually. Companies are likely to have until 1 October 2013 to amend any service contracts and other arrangements to accommodate this.
Companies will need to avoid entering into any new arrangements with respect to remuneration which could give an individual director legal entitlements which may subsequently come into conflict with the remuneration policy agreed with shareholders. If a company does agree a contractual term which is inconsistent with the remuneration policy approved by shareholders, then the directors who entered into or authorised the contract will be liable to account to the company for any loss, and the director who receives any payment will have to hold it on trust for the company.
The proposals may have an impact on recruitment since companies that recruit a director during the course of the year will have to offer that individual a remuneration package consistent with the remuneration policy that has already been approved by shareholders. Companies will have more freedom to negotiate a pay deal with a new director if their approved remuneration policy permits such flexibility. However, they will be unlikely to offer generous sign on bonuses or offer inflated packages, which may assist in slowing down any pay ratcheting.
The Listing Rules already set out requirements with regard to shareholder approval of LTIPs. The Government envisages that the proposed forward looking policy statement in the annual directors’ remuneration report will explain how the company proposes to use its discretion to determine the actual performance criteria, targets and potential levels of award for individual directors in the year ahead within the broad framework for LTIPs which shareholders have already approved or have been asked to approve. The outcome of the binding vote on the proposed remuneration policy will have no direct impact on the shareholder vote approving a new LTIP, or on the status of an LTIP that has already been approved by shareholders, but it will give shareholders an opportunity to approve the details of how such schemes will operate in practice for directors for the year ahead.
From the point of view of the company, although shareholders are likely to have previously approved the parameters of the LTIP arrangements, the remuneration committee has always been able to exercise its discretion each year with respect to details such as levels of grant and performance criteria without the need for shareholder approval. The proposals will effectively give shareholders the right in future to approve or vote down these key details and companies are likely to find this loss of flexibility and control difficult to manage. In addition, timing issues are likely to arise in terms of the granting of awards. Companies generally make their annual LTIP grants after the preliminary announcement of their results, so normally in advance of the AGM. Presumably in future, if the proposals are implemented, all grants to directors will have to be conditional and revoked if shareholders do not approve the company’s remuneration policy. An alternative will be for companies to change the time at which they grant awards but this may cause transitional and other difficulties.
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Advisory vote on how remuneration policy has been implemented
So that shareholders of UK incorporated quoted companies continue to have a say in actual payments made to directors, the Government proposes maintaining the annual advisory vote on the section of the directors’ remuneration report which explains how the remuneration policy has been implemented in the previous financial year, including actual awards made. Within that section of the remuneration report, companies will have to clearly quantify and justify awards made to directors.
The advisory vote would be a special resolution and if it is not passed the company would have to make an announcement to the market within 30 days setting out:
- the number and proportion of votes for and against and abstentions;
- the main issues raised by shareholders (which materially affected the outcome); and
- how the company proposes to work with shareholders to address these issues.
The Government intends this advisory vote to be an opportunity for shareholders to indicate whether they are content with how the previously approved remuneration policy has been implemented, particularly where the remuneration committee has exercised discretion. As a result, it expects to see high levels of support for the advisory vote where a company and its shareholders have agreed a robust remuneration policy, with clear links to performance, and the company’s remuneration committee has built trust among shareholders.
While an individual director’s pay will not be contingent on the outcome of the advisory vote, its result will be a clear indication to the board as to whether or not shareholders are happy with how remuneration has been managed by the company. Once again, the Government comments that if shareholders are routinely dissatisfied with how the remuneration policy is applied and how the remuneration committee has exercised its discretion, then shareholders will continue to have the opportunity to vote against the re-election of directors.
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Binding vote on exit payments
Although best practice on corporate governance has sought to address the issue of large exit payments to departing directors, currently there is ability for companies to have a fair amount of latitude in this area without requiring shareholder approval. The Government therefore proposes that shareholders be given a binding vote on any exit payment to be paid to a director of a UK incorporated quoted company which exceeds the equivalent of one year’s base salary. This will apply where a director’s contract has been terminated early and without due notice either by the company or by the director. Approval will be required of the entire exit package (to the extent the threshold of one year’s salary is exceeded) including payments made under the service contract and other arrangements. These will include benefits and performance related awards such as an in-year bonus, a deferred bonus where vesting is subject to further performance testing or ongoing service, and unvested LTIPs and share options.
Shareholder approval will be required by way of an ordinary resolution passed at a general meeting and if that ordinary resolution is not passed, the company will only be able to pay an award to the director which does not exceed the basic limit. The Government believes that approval should be sought on a case by case basis after the director’s contract has been terminated and has decided not to follow the Australian approach which permits companies to secure advance approval to award compensation above the level of one year’s base salary.
The new proposals will capture arrangements with those directors who, on leaving their role as a director, retain a link with the company for anti-competition or other purposes. As a result, directors serving out notice on “garden leave”, those who have been paid under ongoing non-competition covenants, and those who are no longer directors but remain employed in some other capacity will come within the new regime, as will directors whose contracts have been terminated as a result of a change in control.
The Government hopes these proposals will give shareholders a real say on payments for failure and should reduce drawn out negotiations between companies and departing directors. However, in practice, the proposals are likely to make termination negotiations with directors very difficult to manage and, with LTIP awards, the proposals effectively eliminate the possibility of automatically treating any director as a “good leaver”. If a company does decide to seek permission from shareholders to pay a particular individual above the limit of one year’s salary, then there is likely to be a delay before such a payment can be made, particularly if the company decides to wait until the next AGM. The Government points out that the benefit of this is that it will enable the company’s performance over the course of the year to be confirmed and, where relevant, it will enable any performance-related pay to be calculated and pro-rated accordingly, but, as mentioned, this is likely to add to the difficulties over termination negotiations.
Statutory compensation for unfair dismissal, redundancy or discrimination claims (whether determined by an Employment Tribunal or agreed bona fide on termination between the company and the director) will be excluded and unaffected by the proposals. Companies will also be expected to continue to undertake to reduce payment in lieu of notice if a departing director secures other employment within the notice period.
As a result of the proposals, all contracts and other arrangements entered into after the date when the new legislation comes into effect will not be able to provide for any contractual entitlement to an exit payment beyond one year’s base salary and will need to make it clear that any exit payment in excess of one year’s base salary is subject to shareholder approval. Companies will need to amend existing contracts and other arrangements to acknowledge that they are subject to a binding shareholder vote before the new legislation comes into effect. If companies do decide to buy directors out of their existing contractual rights in order to renew them in line with the new legislation, then the Government will expect any such payments to be clearly disclosed in the directors’ remuneration report when reporting on payments made in the previous year.
Under the proposed new regime, it will also not be possible to provide directors with contractualised rights to pension enhancements in the event of early termination of their contract since any payment upon early termination (above one year’s base salary) will be subject to the shareholders’ binding vote and this will include pension top-ups.
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The Government has requested comments on the consultation paper by 27 April 2012 and it will then confirm the exact measures it proposes to take forward in primary legislation later this year. At the same time, it plans to issue new draft regulations on the content of directors’ remuneration reports to take account of these proposals. The Government hopes that the new legislation will come into force in spring 2013, with the provisions taking effect for reporting years ending after 1 October 2013 and for directors whose contracts are terminated after that date.
The Government will also work with the UK Listing Authority to review any necessary changes to the Listing Rules in light of these proposals so as to ensure that UK incorporated quoted companies are not subject to conflicting legal requirements.
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The proposals, if implemented, will require UK incorporated quoted companies to engage to a far greater extent than is often currently the case with their shareholders in relation to the content of their remuneration policy and the extent of the flexibility to be given to the company’s remuneration committee. From a practical perspective, a lot of resource is going to be needed to "manage" the outcome of the shareholder vote. Any company wanting to change its remuneration policy in any significant way, such as through the introduction of new performance criteria or increased grant levels, is going to need to conduct a prior consultation exercise with its investors. Companies are also going to need to review the content of existing service contracts and other arrangements with their directors in order to determine whether any amendments will be needed if the proposals are implemented. If the Government’s proposed implementation timetable remains on track, then next year companies will also need to bear in mind the new provisions when recruiting new directors.
It is not entirely clear how the proposals, if implemented, will work in practice, particularly in relation to the limit on exit payments to departing directors. The current flexibility afforded to remuneration committees does enable them, in many cases, to settle a dispute with a departing director quickly and in a manner which best protects the interests of the company and its shareholders. Where there are concerns about the enforceability of restrictive covenants and/or the protection of confidential information, the ability of a company to reach a swift settlement with a director can be critical in limiting possible damage to the company and its business. In addition, by limiting exit payments that can be agreed without shareholder approval to the equivalent of one year’s base salary, there are concerns that some directors may view the taking on of the role of an executive director, with all its associated obligations and potential liabilities, as far less appealing going forward.
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