Further regulation of executive pay proposed

The Department for Business, Energy and Industrial Strategy (BEIS) has published a package of proposals for the reform of corporate governance, primarily directed at listed companies. Out of the wide range of options for reform mooted in its green paper on this topic last November, the changes now proposed fall at the lower end of the spectrum, with many of the more onerous suggestions having been dropped or watered down. This was largely expected given the Government's lack of a parliamentary majority following the recent election.

In the area of executive pay, BEIS will take forward a number of proposals for reform. It also plans to make changes to strengthen the voice of employees, customers and suppliers which may well have an indirect impact on executive pay. Although the majority of the reforms apply to quoted companies, some are targeted at both public and private companies. In the future, large privately-held businesses may also find themselves being held more to account on executive pay and other matters under plans to develop a voluntary corporate governance code for such businesses.

The proposed reforms will involve new secondary legislation and changes to the UK Corporate Governance Code (the Code) as well as action by a number of other bodies. Where Code changes are involved, the Financial Reporting Council (FRC), which is responsible for the Code, will need to consult on how, if at all, those changes are implemented. The reforms are due to take effect by June 2018 so as to apply to company reporting years commencing on or after that date.

The key proposed changes which will impact on the setting and disclosure of executive pay are set out in the following box and more detail is given below.

• Companies receiving 20 per cent or more opposition to executive pay resolutions to be named on a public register
• CEO/average UK workforce pay ratios to be disclosed annually
• More detail on the possible outcomes under LTIPs to be disclosed in remuneration policies
• A minimum five year holding period for share-based remuneration to be introduced into the Code
• Greater disclosure of how directors have taken various stakeholders' interests into account 
• One of three employee engagement measures to be adopted (but it will not be compulsory to have an employee on the board) 

Response to the green paper

Ongoing concern over the level of executive pay and whether it is closely enough linked to performance was at the heart of the proposals put forward in the green paper last November. The response to the consultation in this area seems to have been substantial with a range of views expressed. While many considered that the 2013 reforms, including a binding vote on the directors' remuneration policy in quoted companies, were sufficient, the majority believed that shareholders need greater powers to hold companies to account on executive pay. In particular, there was general agreement among respondents that remuneration committees could do more to engage with both shareholders and the workforce generally in setting executive remuneration policies. Concerns were also expressed about whether long-term incentive plans (LTIPs) are effective in linking pay to performance.

Following an analysis of the responses, the Government has decided to implement the following pay reforms:

Dissent on executive pay resolutions

The FRC will be invited to revise the Code to set out the steps which companies should take when they encounter significant shareholder opposition to executive pay resolutions (expected to be 20 per cent or more of the votes). For example, companies might have to respond publicly within a certain time period or put the existing or revised remuneration policy to a shareholder vote at the next AGM. The exact requirements will depend on the outcome of the consultation exercise which the FRC will need to conduct before making any changes to the Code.

In addition, the Investment Association (IA) will be asked to maintain a public register of listed companies encountering shareholder opposition of 20 per cent. or more to executive pay (and other) resolutions, together with a record of what those companies say they are doing to address concerns. This naming and shaming exercise is clearly meant to spur companies on to greater engagement with shareholders in order to ensure support for remuneration policies and practices. However, information on shareholder dissent is already in the public domain so drawing it together on a public register may make little practical difference.  

The role of the remuneration committee

The Government will also ask the FRC to consult on amending the Code and its supporting guidance to put more responsibility on remuneration committees for demonstrating how pay and incentives align across the company and to explain to the workforce each year how decisions on executive pay reflect wider pay policy. The FRC will also be asked to consult on a Code change requiring the chair of the remuneration committee to have served on a remuneration committee for at least 12 months unless a clear and valid explanation can be given as to why this is not appropriate or possible.

Pay ratio disclosure

While recognising that the disclosure of pay ratios across companies in different sectors or with different workforce profiles may not always offer valid comparisons, nevertheless the Government has decided to press ahead with change in this area. New secondary legislation will require quoted companies to report annually in their remuneration report the ratio of CEO pay to the average pay of their UK workforce. An accompanying narrative should explain changes to that ratio from year to year and how the ratio relates to pay and conditions across the wider workforce. Although the comparison would only be obligatory in relation to UK employees, multi-national companies may voluntarily publish a broader ratio as well, covering all employees in their group. 

Whilst the detail has yet to be finalised, the Government's current thinking is that the ratio should be calculated on the basis of the CEO's total annual remuneration (as set out on the "single figure table" in the directors' remuneration report) relative to the average total remuneration of the company's UK workforce.

The ability to provide a supplementary narrative will be important for those companies who wish to explain considerations not reflected in the bare figures.

LTIPs

The Government is not convinced, unlike the BEIS Select Committee, that LTIPs should be abolished, although it agrees that other remuneration structures should be considered. To ensure shareholders have a greater understanding of LTIPs, new secondary legislation will require quoted companies to provide a clearer explanation in their remuneration policies of the range of potential outcomes from complex, share-based incentive schemes. The FRC will also be asked to consider adding new principles or detailed guidance on share-based remuneration to the Code.

Holding periods

Most institutional investors now expect the combined vesting and holding period for share-based remuneration to be at least five years rather than the three years which has historically been the case. Many quoted companies have already fallen into line with these expectations. However, the Government will invite the FRC to amend the Code to increase the existing three year minimum period to five years.

Share buybacks

 Although not part of the current proposals for reform, the Government plans to commission an examination of the use of share buybacks to ensure they cannot be used artificially to hit performance targets and inflate executive pay.

Measures ruled out

BEIS mentions in its response to the green paper consultation a number of measures which have been specifically ruled out. One of these was a possible obligation for listed companies to establish a Shareholder Committee to oversee executive pay and other matters. This has been rejected as being hard to implement practically and also on the basis that it could undermine the UK's unitary board system. Further regulation of the disclosure of directors' bonus targets has also been ruled out on the grounds that companies have already responded to institutional investor pressure in this area and that regulatory intervention is not needed, at least at present.

Greater engagement with stakeholders

Company directors are required by section 172 of the Companies Act 2006 to act in the way most likely to promote the success of the company for the benefit of its members as a whole. In doing so, they must (among other things) have regard to the interests of the company's employees and the need to foster the company's business relationships with suppliers, customers and others. However, there have been concerns that not enough attention is paid to these obligations and that the way in which the interests of stakeholders are taken into account needs to be strengthened. Listening to employees and other stakeholders is of course relevant to decisions on executive pay as well as other matters.

BEIS has decided to introduce new secondary legislation requiring all companies of a significant size (both public and private) to explain how their directors comply with the requirements of section 172. What is meant by "of a significant size" will be put out to consultation but the Government's initial view is that the threshold should be companies with 1,000 employees.

This legislation will be supplemented by a new Code principle for listed companies designed to establish the importance of strengthening the voice of employees and other stakeholders. The FRC is expected to consult with business to produce guidance on how best to comply with this new principle.

BEIS believes that something more specific is needed on top of this general principle in order to give employees in particular a greater voice. Various options for how this could be achieved were proposed in the green paper and respondents seem to have been split with no one course of action receiving overwhelming support; all had their pros and cons. BEIS proposes, therefore, to ask the FRC to introduce a new Code provision requiring premium listed companies to adopt, on a "comply or explain" basis, one of three employee engagement mechanisms: a designated non-executive director, a formal employee advisory council or a director from the workforce. Appointing an employee to the board will not therefore be compulsory.

To give companies more support in this area, ICSA and the IA will also be asked to develop joint guidance on the practical ways in which companies can engage with their employees and other stakeholders at board level. Also the GC100 group has been asked to prepare and publish new advice and guidance on the practical boardroom interpretation of the directors' duty in section 172.

Corporate governance in privately-owned businesses

There was considerable support among respondents to the green paper for a corporate governance framework to be extended to large, privately-owned businesses and the Government has decided to push this forward. The FRC will be asked to work with a number of other bodies to develop a set of corporate governance principles for large private companies. The new principles will be voluntary so private companies who already comply with existing codes may continue to do so if they consider that more appropriate.

The Government will also introduce secondary legislation to require all companies of significant size to disclose their corporate governance arrangements in their directors' report and on their website, including whether they follow any formal code. The meaning of "significant size" has not yet been decided but is likely to mean companies with more than 2,000 employees unless they are subject to an existing corporate governance reporting requirement. The Government is also considering extending a similar requirement to LLPs of equivalent scale.

Enforcement

Responses to the green paper raised concerns that the FRC does not have sufficient powers to undertake its functions effectively and indeed the FRC has itself asked for greater powers. The Government will look at this but, in the meantime, proposes to ask the FRC, the FCA and the Insolvency Service to agree letters of understanding between them by the end of the year to ensure they use their existing powers effectively to sanction directors and ensure the integrity of corporate governance reporting.

Further information

For more information about the proposals for corporate governance reform, please speak to your usual Ashurst contact or to David Baxter whose contact details are given below.