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Shares are not the only option

If there’s one element of the annual reports and accounts that’s universally read, it’s the section on directors’ pay. While the serious stuff of finance is often left to magazines such as this one, you can guarantee a board that enjoys a whopping pay rise will earn populist media attention and headlines containing the words ‘fat’ and ‘cat’.

Yet, despite all the tabloid fuss over what directors pocket, there has been little sensible discussion or guidance as to how companies should deal with directors’ pay. That is until now. A report has emerged from the International Corporate Governance Network (ICGN) which FDs would do well to read.

If you don’t have much faith in your powers of persuasion you could always ask Alastair Ross Goobey to come and explain. Not only does he chair Hermes Focus Funds, but he also chairs the ICGN and was instrumental in putting the report together.

The ICGN’s thinking was to come up with a set of guidelines which were acceptable to company managements and institutional investors. Despite all the fuss over pay, in Ross Goobey’s opinion, company directors have not been under particularly intense or intelligent scrutiny from those that matter – institutional investors.

Adopting the ICGN’s report might reveal more to shareholders and the world at large about how directors are remunerated, but more importantly it would also start to explain why they are so rewarded.

Ross Goobey’s point is that investors are demanding transparency. It’s important to make a distinction between transparency and disclosure.

This applies not only to directors’ pay but to any element of financial reporting.

A key element of transparency is explaining the possible outcomes of the remuneration structures in terms of reward. In governance terms this would fall to the remuneration committee, but in reality the FD’s team would do the number crunching. The ICGN makes it clear that it expects quoted companies to have performed a Monte Carlo simulation to see what the sums might be in extreme cases, and what the probability is of the outcomes coming within reasonable range. If a company hasn’t checked how its system may work out in practice it could be embarrassed when a remuneration structure delivers a reward to an executive that bears no relationship to the company’s health.

Companies can incur shareholder’s wrath over pay in two fundamental ways: first, they can decide or be persuaded that they need to put their people in the top pay quartile. This creates a game of leapfrog where directors’ salaries leap over each other in an endless bid to keep in some self-imposed position in the pay league. This game is great for pay consultants and the directors themselves but is not amusing for shareholders.

Secondly, shareholders wince over the apparent lack of correlation between performance and reward. The villain is often the share option. In a bull market the share option rewards directors for being directors. Conversely, of course, you may have done a brilliant job as FD in 2002, but if your bonus was in share options the chances are your hard work will go unrecompensed.

The answer, according to the ICGN, is not to ban share options as some suggest, but not to make them the only long-term incentive. Their simplicity is outweighed by their all-or-nothing nature and so should be supplemented by long-term cash or real share bonus schemes. Where options are part of the deal they should not be issued in huge trenches but over several years.

The other occasion which sparks genuine shareholder fury and tabloid comment is when directors sacked for their poor performance leave with a substantial pay-off. Companies often pay the director a lump sum of more than the contractual amount and without any attempt to negotiate down the contractually due sum. In essence shareholders are paying twice for the failure of directors to do their job: once as they calculate the hit they have sustained as a result of the slide in the share price and secondly in the cost of getting rid of them.

The reason why directors’ pay attracts so much more attention is simple: it’s unique because it’s the only issue where the interests of the board and the interest of the shareholders diverge. No code of practice will resolve the conflict of interest, but a governance regime properly explained in the report and accounts may persuade shareholders that they are not being taken for mugs.

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