On 28 May 2010, the Financial Reporting Council published the new UK Corporate Governance Code, concluding an extensive consultation process. Now is a good time for remuneration committees to undertake a review of the remuneration strategies and ensure that they stand up to scrutiny when reporting under the Code.
On 28 May 2010, the Financial Reporting Council (FRC) published the new UK Corporate Governance Code (the Code), concluding an extensive consultation process (see News brief “Corporate governance: room for improvement (www.practicallaw.com/0-501-3083)”).
Although it will be late 2011 before we see companies reporting under the Code, the Code will apply to reporting periods beginning on or after 29 June 2010.
The Code is not ground-breaking in terms of the changes it makes in the areas of remuneration and incentives, but it does contain some important underlying shifts. Now is a good time for remuneration committees to undertake a review of the remuneration strategies and ensure that they stand up to scrutiny when reporting under the Code.
The main principles in relation to remuneration in the Code reflect existing good practice, and should not come as a shock (D.1 and D.2, the Code). Schedule A to the Code (the design of performance-related pay for executive directors) also restates many of the principles under which companies should already be operating. However, there are a number of changes to the detail of the Code in this area:
Non-executive directors’ remuneration. There has always been a prohibition on non-executive directors (NEDs) receiving options, as these were seen to jeopardise their independence. This prohibition has been widened to include “other performance-related elements” of remuneration (D.1.3, the Code).
Clawback. As expected, the Code addresses the subject of clawing back payments made to executives. Companies are now required to consider the use of provisions that permit the company to reclaim variable components in exceptional circumstances of misstatement or misconduct (Schedule A, the Code).
Clawback can take different forms. It is not often a requirement to obtain repayment of remuneration which has actually been received; that results in practical difficulties, not least that it is highly unlikely that any tax or National Insurance contribution already paid can be recovered from HM Revenue & Customs when payments are subsequently clawed back from an individual. Instead, the most common form of clawback is deferral of the delivery of cash or share incentives which have been "earned", while the company retains discretion to reduce or remove the award during the deferral period.
Risk policies. Schedule A to the Code also now specifically states that remuneration and incentives should be compatible with risk policies and systems. This codifies existing good practice. Remuneration committees which do not continually assess whether incentives drive bad as well as good behaviour should certainly now do so, preferably in conjunction with their audit/risk committee.
Performance-related pay. A careful balance needs to be struck between the Code requirement (main principle, D.1, the Code) that a "significant" proportion of a director’s remuneration package be dependent on individual/corporate performance and the view articulated by the Financial Services Authority that salary should be a sufficient proportion of total remuneration to allow bonuses in particular to be "fully flexible" (paragraph 19.3.17, Remuneration Code, Senior Management Arrangements, Systems and Controls (SYSC), FSA Handbook). The concern is that where bonus-linked elements of the overall pay package form the overwhelming majority of the package, companies will find it difficult not to pay at least a portion of that element.
The supporting principle to D.1 of the Code (the level and components of remuneration) is amended to require performance-related elements of executive directors' remuneration to promote the long-term success of the company. This is appropriate in terms of driving good behaviour when setting performance targets and structuring cash and share incentives generally. Such an approach was already implicit in setting a responsible remuneration policy, and many companies already approach remuneration in this way.
Pay disclosure. Remuneration committees are exhorted to: "Be sensitive to pay and employment conditions elsewhere in the group" (supporting principle to D.1, the Code). Directors’ remuneration packages are very visible to both shareholders and employees through the detailed disclosure requirements for annual report and accounts (in the Large and Medium-sized Companies and Groups (Accounts and Reports) Regulations 2008 (SI 2008/0410)).
Remuneration reports have to be put to shareholders (section 439, Companies Act 2006). Although the vote is only advisory, a mere threat by shareholders to vote against the remuneration report is enough for most companies to consider changing their policies.
The issue most hotly fought over in the consultation was board re-election requirements. Sir David Walker had worried that annual elections might be "accountability in too short a time frame" and did not recommend them in his review of corporate governance in the UK banking industry, although he has subsequently stated publicly that he now regards annual re-election as a good thing (see News brief “Walker Review: banks on best behaviour (www.practicallaw.com/1-501-3087)”). The GC100 (the association of general counsel and company secretaries of the FTSE 100) and The Hundred Group of Finance Directors were opposed.
Sir David is the winner, with the Code now requiring annual re-election of directors, but with a sop for smaller companies (the requirement relates only to the FTSE 350) and a reminder that the regime functions on a "comply or explain" basis (B.7.1, the Code).
The concern remains that this provision will lead to short-termism, which is ironic when in general the Code has been amended to emphasise long-term success as a goal. Perhaps this emphasises the need to focus on the long term in remuneration structures to combat the spectre of annual re-election as a driver of short-termism. The FRC emphasises that, in the nine-year period it reviewed, only 19 directors on the FTSE All Share lost a re-appointment vote. It will be interesting to see whether that statistic changes under the new regime.
The Code shifts the emphasis when selecting board members. The main principle on effectiveness has changed from requiring an appropriate balance of executive directors and NEDs, to requiring "the appropriate balance of skills, experience, independence and knowledge" (B.1, the Code). The Code provision requiring at least half the board to comprise independent NEDs remains, but now independence is not enough: a NED must have sufficient industry or other knowledge to challenge the executive directors (main principle and supporting principle, A.4, the Code).
There is also an increased emphasis on boardroom diversity, with revised supporting principles requiring boardroom recruitment to be conducted with "due regard for the benefits of diversity on the board, including gender" (B.2, the Code).
FTSE 350 companies will now need to have externally facilitated board reviews every three years (B.6.2, the Code). There has been much scepticism over this proposal, not least because an industry will need to be created around it and that industry is not currently established. Sir David is evangelical about the input he received from behavioural psychologists in particular, so potentially this requirement could, in the long term, assist in policing corporate culture.
Louise Whitewright is a partner in the executive compensation, employee benefits and share incentives department, and Nicola Evans is a partner in the corporate department, of Hogan Lovells International LLP.