The new code enhances the use of discretion on pay

Charlotte Fleck discusses the remuneration committee's power to take action on excessive or misaligned pay being strengthened by the new UK Corporate Governance Code.

Coins representing remuneration

Another year, another round of shareholder dissent on executive remuneration. Headlines have been made by companies such as Royal Mail, Unilever, Persimmon and Playtech for paying executives large sums without justifying them by reference to the value created by those executives.

So what happened? How can companies make sure their own executive pay aligns with performance – and make sure unhappy shareholders do not leave them in the headlines next year? The newly revised UK Corporate Governance Code has an important part to play here and, as well as addressing some of the scandals of recent years, clearly has in mind wider initiatives.

You can read Peter Swabey’s breakdown of the new code, 'Sharper governance with the new UK code', while we explore some of the developments around remuneration.

Consider the workforce

With the results in for the first round of gender pay gap reporting, the next set of ratios to be produced will be the disparity between CEO pay and that of the wider workforce. As with gender pay, it is likely that publication of the difference will lead to pressure on companies to narrow the gap and negative publicity for the worst offenders.

“The new code goes further by requiring the board not only to consider other stakeholders, but to engage with the workforce”

Likewise, companies will be required to report on their compliance with the directors’ duties in section 172 of the Companies Act 2006. These include not just the basic duty to shareholders, but also the requirement to ‘have regard’ to factors including the interests of employees, impact on the community and the environment and the desirability of maintaining a reputation for high standards of business conduct.

This will become a statutory requirement from 2019 onwards, but the new code goes further. For example, by requiring the board not only to consider other stakeholders, but to engage with the workforce via methods such as the appointment of a director from the workforce, a worker advisory panel, or a designated non-executive to represent the interests of workers.

Mindful discretion

The linkages here are not difficult to see. If workers are poorly paid, executives will need to justify their own remuneration packages, as well as the potential effect on how the company’s governance and conduct are perceived by investors.

As well as setting executive pay decisions in context, a key change is also to increase the use of discretion by the remuneration committee, with the guidance accompanying the code suggesting committees should be in a position to use their discretion to override formulaic outcomes and be ‘mindful’ of potential reputational damage.

This makes a great deal of sense. If companies find that the conditions for payments to executives have been met, despite the circumstances being such that no one would really expect bonus or LTIP payouts to be triggered – for example, when an increased share price has very little to do with an executive’s performance (as was the case at Persimmon) or a proper examination of the company’s finances would reveal it to be on the brink of insolvency (such as Carillion) – how else can a sensible outcome be managed?

There is also scope for some performance conditions to be more carefully thought out in the first place. For example, the government is consulting on the use of share buybacks to artificially increase total shareholder return without improving the underlying performance of the company – undoubtedly not the intended outcome, but still a predictable response to financial incentives.

Back to reality

But even the most carefully considered performance criteria can still fail to match up to the reality of a changing world.

The chair of Persimmon resigned for his failure to cap payouts under their incentive scheme, but caps can act as a disincentive once reached, and back in 2012, one can see why the possibility of the company performing too well might not have struck the remuneration committee as much of a concern.

Giving remuneration committees the power to make changes when the unexpected happens is the obvious way to make sure remuneration keeps step with real performance and prevent embarrassment.

“Even the most carefully considered performance criteria can still fail to match up to the reality of a changing world”

It is equally obvious this cannot be sufficient on its own, however.

A repeated theme in changes to governance and reporting is the need to engage with stakeholders – and yet this year’s news stories show what can only be described as continued ‘own goals’ from companies.

At Royal Mail, 70% of shareholders voted against its remuneration report with significant termination payments to a departing chief executive; at Playtech, the award of 1.5 million shares to its chief executive was rejected. These votes will not have come out of nowhere, so the question is how remuneration committees end up so out of step with shareholder opinion.

There is an important role here for good governance in establishing processes for engagement with stakeholders – investors, workers and others – and ensuring boards and committees have the information they need. Decisions made in isolation can look very different in their proper context.
Furthermore, even the best and most thoughtful use of discretion to reduce inappropriate payments to executives can carry problems.

Reasonable use

The code does not require discretion to be used ‘reasonably’, but the FRC’s feedback statement to the consultation makes clear this is because it considers it already implicit in the framework within which committees operate.

The meaning of ‘reasonable’ use of discretion requires some background. The limits on the use of contractual discretion are imported from public law and give two ways in which the exercise of a discretion can be challenged: firstly, based on whether the decision-maker took all relevant factors into account; and secondly, based on whether, having done so, its decision was so unreasonable that no reasonable person could have made it.

It is to be hoped that very few remuneration committees will find their decisions challenged under the latter test. But taking all relevant factors into account is a more difficult process.

As a lawyer, this also brings me to the Daniels v Lloyds Bank case from earlier this year. This came out of the aftermath of the financial crisis and concerned the decision by the board of Lloyds to refuse payments to former executives based on their involvement in the decision by Lloyds to acquire HBOS. In court, however, Mr Daniels succeeded in requiring payment to be made, as the specific performance conditions attaching to the awards had still been achieved.

One might expect that the facts of this case could never arise today, with the widespread adoption of malus and clawback conditions, but that might not be the case. The standard malus and clawback conditions in most share plans relate to gross misconduct and misstatement of financial results – neither of which obviously apply here.

Guidance accompanying the new code suggests extending these to include serious reputational damage and corporate failure. The former might have applied in the Daniels case, but whether the actions of an executive damaged the reputation of a company seems like fertile ground for dispute, given the fraught context in which such decisions will have to be made.

Consider all factors

There will not always be a perfect answer and too much scope for discretion also leads to uncertainty, reducing the incentive effect of awards.

Reading between the lines, the outcome of the Daniels case was almost inevitable, based on the contractual terms of the award made – but one suspects the board might have made a decision to withhold payment knowing it would be challenged, rather than be seen to willingly reward failure.

Still, there is plenty companies can do to prevent themselves being in a similar position. It might seem obvious to a board or remuneration committee that an award should not be paid – but they should still make a considered decision and take all factors into account. Process and documentation are easy wins.

If committees are guided to engage with stakeholders, presented with the information they need on all the factors they should take into account, and their consideration of those factors carefully recorded, not only will their decisions be less open to litigation but companies may also find their relationships with stakeholders improving and remuneration not a negative headline, but a real contribution to success.

Charlotte Fleck is an associate at Pett, Franklin & Co

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