On March 14, 2012, the UK Government published a consultation paper on its proposals to give shareholders of quoted companies a greater influence over executive pay.
The Government proposes to introduce a binding shareholder vote on executive pay policy (possibly requiring a 65% or 75% super majority), a non-binding shareholder vote on the subsequent application of that pay policy and a binding shareholder vote on exit payments in excess of one year’s basic salary.
The new rules would apply to certain UK quoted companies. The new rules would apply to those companies with either a standard or a premium listing on the London Stock Exchange main market and UK incorporated companies listed on the NYSE, NASDAQ or officially listed in another EEA member state but would not apply to companies trading on AIM or the Plus Growth market. The rules would replace the existing requirement for a non-binding vote on the director’s remuneration report.
Existing Regulation of Executive Pay
Since 2003 UK company law has required that quoted companies produce a directors’ remuneration report (which forms part of their annual report and accounts) and seek an advisory vote on that remuneration report. These reports provide detailed disclosure of the pay and benefits for the financial year in question but contain limited information about the bonus and incentive targets for the following financial year.
In addition to the statutory disclosure rules, the UK Corporate Governance Code (the “Corporate GovernanceCode”) addresses directors’ pay. The Corporate Governance Code applies on a “comply or explain” basis to all companies with a premium listing in the UK (e.g. FTSE companies) but can also influence “best practice” governance in other UK listed companies (e.g. those trading on AIM). Whilst the Corporate Governance Code is highly influential, it is principle-based and does not contain substantive limitations on executive pay .
In the case of share schemes and long term incentive schemes, which typically make up a substantial proportion of executive pay, both the Corporate Governance Code and the Listing Rules require shareholders to be given a binding vote.
The Corporate Governance Code is supplemented by formal guidance issued by institutional investors, most notably the ABI Remuneration Code, which formalizes the main institutional investors’ policies on executive pay. Such guidance has become increasingly prescriptive over the years. For example, the most recent version encourages companies to include claw-back provisions where appropriate. Whilst shareholder activism has undoubtedly changed practice, there is little that shareholders can realistically do if companies choose to disregard the text or spirit of the guidance.
The FSA Remuneration Code also applies to regulated firms operating in the financial services sector.
The Government believes that the ratcheting up of executive pay is unsustainable and that the people running companies should not be “handsomely rewarded for mediocrity or failure”. They believe that this is best addressed by enhancing the rights of shareholders.
The Government’s proposals are summarized below:
- Binding Shareholder Vote on Executive Pay Policy. Shareholders would be required to approve the company’s remuneration policy for the following financial year. This would include the composition and potential pay for each director and, in the case of bonuses and incentives, what the performance criteria will be, how performance will be assessed and the payout for “on-target” and “stretch” performance. Companies have traditionally been concerned that disclosure of prospective targets could compromise their commercial interests. A footnote to the consultation paper acknowledges this concern and indicates that the Government “will work with companies and shareholders to balance this against the need for greater transparency”.If shareholders vote against the remuneration policy, then the Company will either have to hold another vote within 90 days or will have to “fall back on the last policy to be approved by shareholders”. If a company is to continue to use its existing pay policy, it is not clear how much discretion a remuneration committee would have within the context of that policy (the previous year’s targets are likely to be outdated and so to be meaningful are likely to have to be altered each year), but the Government acknowledges a risk that a company who has lost a “binding vote” might continue with an old pay policy which is equally unacceptable to shareholders. In such a case the Government envisages that shareholders would have to resort to their right not to reelect directors.The Government expects that most employment agreements will not require amendment as they do not typically contain express guarantees regarding pay rises, bonuses or long term incentives. Payments made under any contracts which violate these principles could be clawed back, and the directors who authorized them will be personally liable to account for the amounts paid.
- Super Majority. Whilst shareholders have become increasingly active in recent years, the Government is conscious that many shareholders do not vote and many choose to abstain. In addition, the shareholder base of UK quoted companies has become increasingly diverse, which is significant because it is felt that UK based institutional investors tend to be the most engaged on these issues. UK based institutional investors now hold just 25% of shares (down from 50% in 1990) in UK quoted companies. For this reason the Government is also consulting on increasing the threshold for passing shareholder resolutions to be more than the simple 50% majority required for the existing advisory vote.Currently only certain “special” resolutions require a 75% majority although the Government acknowledges that this threshold may be too high. The consultation paper notes that during 2011 no FTSE 100 company failed to secure 50% shareholder support on the advisory vote for its directors’ remuneration report, but two would have failed to do so if the threshold was 65% and five would have failed to do so if the threshold was 75%. If this aspect of the proposal goes ahead, then a threshold of between 65% and 75% appears most likely.
- Non-Binding Shareholder Vote on Application of Executive Pay Policy. The Government also proposes that shareholders should be given the right to vote on the way that the (previously approved) pay policy has been implemented. As this will not be binding, executives will not be subject to claw back arrangements but companies will face the embarrassment of having to issue a circular to shareholders to explain the issues that shareholders have raised and how the company intends to address these issues.Remuneration Committees will have to keep this in mind when they consider whether performance targets are met and exercise any discretions reserved to them under bonus or incentive arrangements.
- Binding Shareholder Vote on Exit Payments. Whilst all UK companies are subject to an obligation to obtain shareholder approval for all “payments for loss of office” (i.e. including severance payments) made to directors, there are exceptions for payments which are made in discharge of an existing legal obligation.The Government is concerned that Remuneration Committees have too much flexibility to negotiate exit payments derived from existing legal obligations and that there is no legal mechanism by which shareholders can properly influence the contractual terms at the time they are entered into.The Government proposes that quoted companies should be required to obtain shareholder approval where the total value of exit payments (including contractual entitlements and incentives) exceed one year’s basic salary. Advance approval will not be permitted and, assuming companies do not wish to hold an extraordinary general meeting solely for this purpose, directors may have to wait for the next annual general meeting before such payments can be approved.Any employment agreements which provide for more generous payments will be void to the extent they provide more generous payments which are not approved and so the new rules would affect existing employment agreements and not just those entered into in the future. The Government has indicated that this proposal will not be implemented until October 1, 2013 and acknowledges that, in the meantime, some companies may look to buy directors out of their existing contractual rights.
The proposal would not affect accrued pension rights nor the relatively small number of directors who have contractual rights to enhanced pensions in the event of the early termination of their employment.
The consultation envisages that statutory claims (e.g. for unfair dismissal and discrimination) will be unaffected by these rules.
It is questionable whether shareholders will have much appetite to exercise any new powers to regulate directors’ pay, and some shareholders may be concerned that a “no vote” may have a negative effect on share price. The Government clearly envisage that a “no vote” will be exceptional and that in practice the possibility of a “no vote” will rather be a powerful moderating influence which will encourage companies to engage with institutional shareholders.
What Should Quoted Companies Do Now?
Whilst the proposals remain subject to consultation, quoted companies should review their existing employment agreements, long term incentives plans and other arrangements with their directors to see they are sufficiently flexible to allow companies to comply with the new rules if and when they become law. Whilst changes to existing arrangements are not immediately required as a result of these proposals, pending the outcome of consultation, it would be prudent to take the proposals into consideration when entering into new arrangements.
 The Corporate Governance Code principles include: (a) the requirement for executive pay to be determined by a remuneration committee made up of independent directors; (b) the principle that a company should avoid paying more than is necessary to attract, retain and motivate directors of the quality required to run the company successfully; (c) the requirement that a significant proportion of executive directors’ remuneration should be structured so as to link rewards to corporate and individual performance; and (d) that the performance-related elements of executive directors’ remuneration should be stretching and designed to promote the long term success of the company.
 The proposals would apply to both executive and non-executive directors.