Risk & Economy » Regulation » Pay should be linked to success

While most quoted companies operate one or more share incentive schemes for
senior managers or the wider workforce, institutional shareholders are keen to
ensure that their shareholdings are not excessively diluted as a result.

The Quoted Companies Alliance, which represents the interests of
London-listed companies outside the FTSE-350, recently issued a booklet
containing a summary of the Association of British Insurers guidelines on share
schemes and executive remuneration. We note some of the key provisions here.

However, the QCA says that, while it agrees with the ABI principles, they are
only guidelines, which some QCA members may find difficult to comply with. At
the same time, the QCA says that institutional investors accept that it may not
always be desirable to require smaller companies to comply fully with these
guidelines and that they may support alternative practices if they are consulted
in advance.

Executive remuneration
The ABI guidelines make clear that remuneration committees should be properly
constituted, independent with regard to thought and scrutiny, and with
appropriate powers. They should maintain a dialogue with institutional

Remuneration committees must guard against the possibility of unjustified
windfall gains for executives and, in particular, ensure that any variable or
share-based remuneration has a “robust performance measure”. The guidelines
suggest that the remuneration committee and the audit committee work together to
evaluate performance criteria.

While it’s appropriate to look at pay levels throughout the company in
determining executive remuneration, companies should be wary of looking at
external comparisons “which have the effect of increasing remuneration without
any corresponding increase in performance”.

All new share plans should be put to a shareholder vote, and if remuneration
committees decide to make any exceptional award over and above the policies
already disclosed, then they should disclose the details and the reasons for
doing so.

Share incentive plans
The guidelines make the point that shareholders expect all incentive plans to
follow the spirit of these guidelines and that they are generally supportive of
schemes that link pay and performance and which align the interests of
executives with those of shareholders.

Phased grants are “strongly encouraged” as are sliding scales in relation to
the achievement of targets against a benchmark.

But shareholders are concerned about the threat of dilution. The guidelines
say that the overall dilution limit under all schemes should not be more than
10% in ten years with a further limit of 5% in ten years for discretionary

The vesting of options or other share-based awards should be conditional on
meeting demanding and stretching financial performance targets over a period of
time. These targets should be:
• Related to overall corporate performance;
• Measured against a peer group or other benchmark;
• Disclosed and transparent.

Higher rewards should require more demanding performance. Performance
conditions should be measured over a period of three or more years.

There should be no automatic waiver of performance conditions on a change of
control, nor on the early termination of employment.

The underlying financial performance of the company should be a key
determinant of the extent to which share-based awards vest. The performance
criteria should reflect a robust measure over any shorter period.

When share awards vest on a change of control, they should be
time-apportioned, bearing in mind the duration of the vesting period that has

When shareholder approval is sought for a share incentive scheme, the cost
should be disclosed, including the potential value of the awards by reference to
face value of the shares expressed as a multiple of salary. The expected value
and the maximum dilution should also be disclosed.

Phasing of awards and option grants on an annual basis helps to reduce
exposure to volatility and cyclical factors, reducing potential exposure to
‘underwater’ options.

Options should not be granted at a discount and the price at which shares are
awarded should not be less than the mid-market price immediately before the

ABI-NAPF best practice
The ABI and the National Association of Pension Funds issued a statement on best
practice relating to contracts and severance, which says it is unacceptable that
failure or under-performance can result in large payments for departing
executives. Companies should have policies that prevent them from being required
to make “unmerited payments”.

Objectives for executives should be clear and made public whenever possible.
“The more transparent they are the easier it is to determine whether executives
have failed.” Bonuses should be cut or eliminated when performance is poor.

Service contracts should be for a year or less – the one-year limit should
not be seen as a ‘floor’, though, exceptionally, a longer contract maybe
required where, for example, a chief executive is being recruited to a troubled

Boards could use the statutory disciplinary procedures implied in the
Employment Act 2002. Contracts should state that, in the event of dismissal as a
result of disciplinary procedure, a shorter notice period than the one in the
contract will apply.

Companies should consider a safeguard for extreme cases, such as no
compensation in the event of dismissal for financial failure such as a
substantial fall in the share price.

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