FRC consultation on changes to the remuneration section of the Combined Code

In addition to general recommendations on board governance (including consulting on whether the whole board – or, alternatively, just the chairman – should be required to submit to annual re-election), greater shareholder involvement and a change in name to the “UK Corporate Governance Code”, the FRC has made various remuneration proposals. However, they are not dramatic.

This is mainly because the headline remuneration proposals in the Walker Report (where our law-now on these changes can be accessed here) are to be implemented either through specific legislation in the Financial Services Bill currently going through Parliament (if that legislation survives the General Election) or through specific changes to the FSA’s remuneration code for larger financial services companies. This means that the Combined Code did not in the end actually need to implement any Walker remuneration proposals. However, that did not mean that the FRC could not voluntarily recommend that some of them be implemented for all listed companies, but in the event the FRC chose only to take a few of the remuneration recommendations from the Walker Report, which many companies will welcome.

Ahead of the looming annual report and AGM season for many companies, the FRC’s proposed changes to the Combined Code as they affect remuneration are summarised below. Walker recommendations not adopted by the FRC are also discussed for comparison, alongside the probably more important recent Association of British Insurers (ABI) letter to chairmen of remuneration committees (which can be accessed here) which contains a useful update of the ABI’s current position.

Final comments on the proposals are sought by the FRC by 5th March 2010, with the intention that the amended and newly named code will apply to all companies with 30th June 2010 or later year-ends.

Nicholas Stretch will be speaking at a Quoted Companies Alliance sponsored breakfast event on 26th February to discuss these and other relevant changes and developments.

Relevant considerations for remuneration committees and those drafting remuneration reports are as follows:

Changes to the Combined Code proposed by the FRC

There will be a new Supporting Principle that performance-related remuneration should be aligned to the long-term success of the company (with the implication being that short-term success should not be over-emphasised at the expense of the long-term).

This was a goal previously included as a Code Provision and going forward there will inevitably be pressure for more discussion on this subject at remuneration committee level and more disclosure on this in remuneration reports, although very few companies will not have been taking this into account already as this had to be considered in any event.

Action: Companies should therefore consider whether, and, if so, how they will now re-address this issue going forward and how they should disclose it. The change from Code Provision to Supporting Principle is intended to elicit a more discussive response from companies on how they are reaching this goal rather than seeking a brief acknowledgment of compliance.

Non-executive directors should not normally receive any form of performance-linked award.

The Combined Code currently only mentions options, meaning that, for example, LTIP awards to non-executive directors would not technically be in breach of the Combined Code, although they would certainly offend against its spirit. While this change puts the basic position beyond doubt, the Combined Code does still, however, mention that performance-related remuneration can exceptionally be awarded on certain conditions, although ABI guidelines are more emphatically against the award of any performance based incentives to non-executive directors.

Performance conditions should include non-financial targets which support a proper assessment of risk. Payout should also be risk-adjusted.

What underlies this change to refer to non-financial conditions is the perception over the last few years that obsessive attention to financial targets has allowed other risks to creep in unchecked. Targeting financial (often short term) performance should therefore be balanced by other measures. It is notable that a reference to total shareholder return being a suitable performance measure has now been dropped from the Combined Code, which reflects total shareholder return or “TSR” having been much maligned in the remuneration code produced by the FSA for larger financial services companies and in the Walker Report. However, despite this criticism, we do not expect to see TSR becoming significantly less popular among companies as a whole because of this, nor any significantly different performance measures being used outside the financial services sector than has previously been the case.

Action: Remuneration committees should therefore ask themselves whether they still have the appropriate balance of measures.

Clawback in the event of mis-statement and misconduct should be considered.

Clawback is still in the very early stages of being considered as a legal concept in the UK and the debate here is not helped by complicated employment questions of proportionality, unfavourable tax treatment, and the detail which needs to be considered in each case. Most companies will still feel that they can achieve the same objective by deferring payment or vesting until after a point when it can reasonably be expected assumptions will no longer prove unfounded. However, it is difficult to argue against clawback as a concept or aspiration, and including it in any arrangements will at least prevent remuneration committee embarrassment if bonus assumptions prove to be wrong or misplaced.

Action: Remuneration committees should consider whether to insert appropriate terms as standard in future awards or contracts (amending existing awards or contracts may be problematic), also whether to amend employee share plan rules, and whether to publicise this to shareholders.

Walker recommendations not being adopted by the FRC

The FRC has decided not to recommend changes to the remuneration committee’s terms of reference.

The Walker Report proposed that the remuneration committees of relevant financial companies should assume responsibility for firmwide remuneration policy, as well as the detail of all “high-end” employee remuneration, which may well turn out to be a larger number of employees than first thought. It recommended this because it felt that remuneration arrangements were inherently important for an appropriate appreciation and reinforcement of risk both by the company and employees. However, the FRC does not think that remuneration committees generally need to take on this role outside the financial services sector and is content to see the Combined Code continue to apply just to the packages of executive directors and senior management immediately below the board level. This chimes with the ABI’s much stronger views. The ABI is adamantly against remuneration committees taking on this role.

Remuneration committees of non-financial services companies will therefore be grateful that they have been spared the role that their equivalents in financial service companies are going to be required to take on. Companies should also be relieved that the FRC has not implemented the European Commission’s recommendation that at least one of the members of the remuneration committee should have “knowledge of and experience in the field of the remuneration policy”, which would seem to have required every board to contain an HR specialist.

No additional disclosure requirements are to be required for below Board level employees.

Walker recommended disclosure of the relevant number of employees of relevant financial services companies with remuneration in bands above £1 million. This is to be implemented by legislation (although it should be noted from ministerial statements that the Government wants disclosure to begin at a lower threshold and in narrower bands). The FRC clearly has no appetite for this, with shareholder interest also being reasonably low despite intense media and Government interest.

The FRC does not seek greater deferral of bonuses/vesting of share awards.

The Walker Report and the FSA’s own remuneration code for larger financial services companies both talk about at least two thirds of annual bonuses being paid out more than one year after being earned and at least half of all variable compensation being paid out as a long-term incentive with full payout only being received after five years. The FRC has declined to go into any such level of detail on this, meaning that the majority of annual bonuses can continue to be paid out in full at the end of the year, and long-term remuneration will be received after three years. The ABI, however, gives some support for this trend to postpone receipt of shares further, but it is fairly muted.

There is no express requirement to build up a minimum shareholding in a company.

Walker recommends that this should comprise at least one year’s remuneration (not just salary). However, since the ABI in any event promotes this level of shareholding, and there is pretty much universal acceptance of it, its absence from the Combined Code may have minimal impact.

Remuneration Committee chairman re-election if the remuneration report is voted down.

The Walker Report recommends that if the remuneration report attracts less than 75% support, the remuneration committee chairman should automatically stand for re-election next year. The FRC has decided not to adopt this proposal. Instead, it poses the larger question of whether the whole board or chairman should retire annually or this issue should not yet be regulated. One reason that the Walker recommendation would not be welcome is that it gives rise to potential confusion for investors over whether they should vote against the remuneration report (which would be non-binding) or vote against the remuneration committee chairman re-election resolution (which would be binding and, if the vote were lost, that individual would have to cease to be a director).

No additional disclosure on possible pension enhancement is proposed.

Following Sir Fred Goodwin’s departure from RBS and the later disclosure that a discretionary enhancement to his pension was possible and was given, the Walker Report has proposed that the existence of such a possibility is disclosed and examples of any application of discretionary exercise in the previous year given in the remuneration report. Of all the Walker Report remuneration candidates for inclusion in the Combined Code so as to apply to listed companies generally, this seemed a prime candidate, but oddly this is not included in the list of proposed amendments to the Combined Code, although it is arguable whether legislation governing remuneration reports requires this disclosure (and the disclosure of any policy in this area) in any event.

Action: Nonetheless, in light of the furore which followed the disclosure of Sir Fred Goodwin’s arrangements, remuneration committees of companies operating final salary schemes should probably consider their policy in this area so as to report on it, even though disclosure is not strictly required.

While supporting the code of practice for remuneration consultants the FRC has not brought the proposed code of practice within the formal Combined Code framework.

As part of a general campaign to make remuneration arrangements more robust, remuneration consultants have been put under some pressure to adopt a code of practice on such matters such as conflicts of interest, good practice and transparency. The remuneration consultancy industry has suffered much criticism, particularly from the ABI. While the remuneration consultants code as written does no more than emphasise the boundaries and processes which most respectable companies and advisers would already be observing, the adoption of a code by the industry and its blessing by Walker and the FRC may in years to come mark a watershed. This is because, now that there is a remuneration consultants code, it would only be a small further step to bring more remuneration processes within the ambit of that code or even within the formal scope of the Combined Code and this could, if remuneration continues to be a big issue, provide a future battleground and opportunity for further public regulation of pay.

Action: Remuneration consultants are drawing their clients’ attention to the code (whether companies are in or outside the financial services sector) and terms of engagement are being altered accordingly, although, as stated above, in practice very little will change for most companies and advisers. The ABI has, however, suggested that the annual remuneration report should include the level and nature of fees charged, which would be a significant change if followed.

The Remuneration Consultants Group, and its code of practice, can be accessed here.

ABI letter to remuneration committee chairmen

Although the ABI sent this letter to certain chairman of FTSE 350 remuneration committees in December 2009, it is only recently that it has given this letter publicity.

http://www.abi.org.uk/

Key points are:

Communication.

Remuneration committees should regularly communicate with key shareholders in case of difficulty or significant exercise of discretion. This seems like a plea to speak to shareholders rather than rely on advisers (and not disclose the issue).

Tax efficient plans.

The ABI is concerned that companies’ interests (principally, corporation tax relief and flexibility on the timing of expenditure to acquire or issue relevant shares) are being sacrificed for employees’ interests in some arrangements, which may even cause the company reputational damage if the scheme is too complicated or aggressive. We do not think that this is necessarily directed at joint share interest plans, which the market now understands, but at some even more complicated growth arrangements which have been put to shareholders.

Scaling back grants in response to share price falls.

Where there have been significant share price falls, it may not be acceptable to continue granting at the same salary multiples as before.

Bonus payments should not be made where there as been an “exceptional negative event”.

Companies may agree with this in principle, but where the event was outside the control of executives, this may be hard medicine to deliver. Most bonus schemes for directors should include a discretionary override to allow this to happen, however.

Financial underpins should be objective.

Many plans which use relative share price performance or TSR as a measure also have a financial underpin to ensure that there has also been good underlying corporate financial performance. The ABI stresses this should not be assessed relative to other companies – it should be an absolute test.

Retention awards rarely work.

The ABI says its experience is that retention awards rarely achieve the desired effect, and so should not be implemented. Companies may have different experience or expectations, however – and even the ABI accepts that they may be appropriate when a new team is brought in to turn around a company.