LLM CORPORATE GOVERNANCE AND LAW/GRAD ICSA

Effectiveness of shareholder voting on Executive pay: UK perspective

Legal Dissertation U16187 -11B
Randhir Mehrotara UP639100
4/2/2013

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Contents Abstract Introduction Chapter 1 Chapter 2 Chapter 3 Conclusion Bibliography 2 3 5 12 39 50 54

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Abstract This study attempts to demonstrate how the Advisory vote on Pay hasnt met the challenges put forward before it - namely to match performance to pay for the senior management teams. The new development of the Binding vote is a reactive attempt to curb excessive remuneration. The main positives are the transparency in remuneration with clarity in narrative reporting. Whether such legislative muzzles are required remains to be seen. It is expected, the Binding vote will, over time, set best standards for benchmarking pay practises among peers and increase the engagement with shareholders.

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Introduction The nature of the problem FTSE100 chief executives were last year awarded average total remuneration of 4.8m, a rise of 12 percent, which in the context of stagnating earnings for the vast majority of the populace, might seem exorbitant, as it is over 200 times average total pay in the private sector of just under 24,000 (figures from the Office for National Statistics).1 According to a study conducted by the consultancies Manifest and MM&K, main problems with pay are in the largest companies, where directors' remuneration - while large in itself - is a small proportion of total costs.2 Basic pay for the bosses of the UK's biggest companies rose 2.5 percent. It was the variable elements of pay - so-called long term incentive awards and deferred bonuses - that soared. Over the past two decades, Companies have struggled with addressing the principalagent problem and improving the link between pay and performance. This led to a significant change in the structure of remuneration where most companies now pay a much larger proportion of remuneration in the form of variable and deferred pay. Most directors pay packages contain the following elements:3 Base Salary: usually determined through benchmarking, based on general industry salary surveys supplemented by detailed analyses of selected industry or market peers. Annual Bonus/Incentive Plans: Typically bonuses pay out an award based on the performance of the company over no more than one year, usually the previous financial year. The payments may be made in cash or shares or a combination. Deferred Bonus Plans: annual bonus plans which incorporate an element of deferral.

1 2

http://www.guardian.co.uk/business/interactive/2012/may/09/shareholder-rebellions http://www.bbc.co.uk/news/business-18407587 3 http://www.bis.gov.uk/assets/biscore/business-law/docs/e/11-1287-executive-remuneration-discussionpaper.pdf

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Long-Term Incentive Plans (LTIPs): LTIPs typically involve the granting of shares to directors after a three year period upon the achievement of performance criteria, and must include some qualifying conditions with respect to service or performance that cannot be fulfilled within a single financial year. Share Option Plans: Share option plans are contracts giving directors the right to buy shares at a pre-specified price for a pre-specified period of time, which usually starts three years after the agreement of the plan and ends no later than ten years after it. Share option plans are non-tradable and are often forfeited if the executive leaves the firm before they become exercisable. Retirement Plans: Top executives routinely participate in supplementary retirement plans in addition to the company-wide pension plan. Argument for High Compensation/ Retaining talent This problem is predominantly the prevalent boardroom culture and the mindset of directors. Those who sit in the boardroom tend to have spent their working lives in a corporate environment dominated by the idea that the only way to attract and retain top executive talent is to pay the going global rate for the job. Similarly, the Remuneration consultants, advising the Remuneration committees in navigating the intricacies of increasingly complex executive compensation packages, rely on benchmarking compensation packages of senior executives with those of their global peers. Lastly, the independence of these remuneration consultants has been called into question as remuneration consultants have consistently been hired by the firms in different capacities. This has created an upward-only ratcheting system for corporate remuneration and made boards too insulated from what's going on in the rest of the UK economy. The rising executive compensation packages may also be seen as the manifestation of globalisation, as most FTSE 100 companies generate most of their revenue outside the UK. While the economies of UK, United States and Continental Europe are posting weak results, Asia is still booming and is the revenue driver for most multinationals. With the London Stock Exchange becoming the listing destination of choice for global
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commodities companies at a time when the world is experiencing perhaps the greatest commodities and energy boom in history, it's perhaps not surprising that the pay of those who run the likes of Xstrata, Rio Tinto.4 Recognizing the issue of shareholder voting on Executive Compensation is a complex one, this study considered the inputs of major stakeholders in the consultative process such as Association of British Insurers (ABI), Investment Management Association (IMA), Public Interest Research Centre (Pirc), Proxy voting firms Manifest and ISS/GlassLewis along with consulting firms Deloitte, PWC. Viewpoints of additional stakeholders such as FRC,CBI, TUC, IoD, IDS, ShareSoc and the main professional accounting and governance bodies such as ICAS/ ICAEW / CIMA / ACCA and ICSA were also considered. With greater media attention bringing the issue of linking Executive Pay to Performance into the forefront, it leads to the asking of two primary questions: 1. Is there a need for a Binding vote? 2. Are current proposals a step in the right direction? This study will attempt to determine how effective shareholder voting on Executive Pay has been in matching Pay to Performance Objectives: What is the shareholder vote on Executive Compensation? Trace the development of the Advisory Vote and Reporting Requirements Examine the workings and effectiveness of the current system Explain the new proposals and what effects they may have Conclude whether the proposed changes are required

http://www.bbc.co.uk/news/business-13594215

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Chapter 1 Evolution This chapter aims to provide a summary of the evolution of company law reporting requirements on directors remuneration. Oversight of corporate governance issues is a responsibility placed on investors in the UK. A good example of how the UK government encourages increased stakeholder involvement is by reviewing the Directors Remuneration Report Regulations 20025 (later incorporated into the Companies Act 2006)6 but it might be prudent to first examine the development of shareholder voting on remuneration. The earliest reference of directors compensation reporting requirements can be found in Section 148 of the 1929 Companies (Consolidation Act) which required companies to provide details of directors compensation to shareholders on demand. Developments under Section 196 of the Companies Act 1948 required a companys accounts to show: sum of directors' payments(salaries, bonus payments) ; sum of past and current directors' pensions; and sum of any compensation to past and current directors for loss of office.

The development which laid the groundwork for shareholder voting on directors remuneration was under the Companies Act 1948, Table A, where it is stated that: The remuneration of the directors shall from time to time be determined by the company in general meeting.7 Section 6 of the Companies Act 1967 required the accounts to show the payments of the chairman, and in respect of the directors, in bands of 2.500, the numbers whose payments fell within those bands.
5 6

Directors Remuneration Report Regulations 2002 Companies Act 2006 7 Companies Act 1948, Table A

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Companies Act 19858 consolidated and further reformed company legislation. The provisions on directors pay were set out in Schedule 5 paragraph 22 and 25 with provisions for the chairman at paragraph 24. The bands for directors pay were up rated to commence at 5,000, and bands of 5,000. The 1985 Act was amended shortly afterwards by the Companies Act 19899, and the provisions on directors pay were moved to Schedule 6 (as given effect by section 232 of that Act). In 2002, the Directors Remuneration Report Regulations 2002 revised section 232 and provided that provisions of Schedule 6 on disclosure would only apply to companies that were not quoted companies. For quoted companies, section 234B was inserted into the 1985 Act which gave effect to a Schedule 7A which required quoted companies to produce a directors remuneration report for each financial year.10 The schedule set out the details of the report. The regulations also provided for a new section 241A of the Companies Act 1985 which gave the members the right to an advisory vote on the remuneration report. The latest consolidation and reform of company legislation was the Companies Act 2006. The provisions for all companies other than quoted companies now appear in section 412. The provisions on quoted companies can be located in section 420,421,422 and 439. The details of the remuneration report, formerly in Schedule 7A, are now set out in the Large and Medium-sized Companies and Groups (Accounts and Reports) Regulations 2008 Schedule 8. Excessive remuneration in the UK- historical perspective In the early 1990s, issues such as large golden handshakes, the structure of share option schemes and pay increases disproportionate to the inflation, company

8 9

Companies Act 1985 Companies Act 1989 10 BIS Discussion Paper: Executive Remuneration

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performance and average worker salaries caused the then Prime Minister to appeal to directors for pay restraint. In 1999, the Department of Trade and Industry (DTI) - currently the Department for Business, Innovation and Skills (BIS) appointed PricewaterhouseCoopers to prepare a report on listed companies regarding adherence to best practice framework on directors remuneration set out in the Greenbury Code of Best Practice and the Combined Code. It was discovered only 2.6 percent of the 270 firms monitored by PwC chose to put forward the remuneration report for shareholder approval at the annual general meeting something which the Greenbury Report 1995 had greatly encouraged. As a result of the PwC report, the Government announced a consultation in July 1999 on measures for creating an effective and more focused way in which shareholders could influence directors pay. However, as the Government perhaps assuming the issue of excessive pay would solve itself, wasted all of 2000 without announcing the outcome of its July 1999 consultation. With growing frustration among share holders over the slowness of the Government, in the absence of any initiative from the DTI, various investor groups independently took matters into their own hands. By building on the push provided by the consultative process, various ideas for improving shareholder oversight of the remuneration setting process in additions to proposals to improve reporting were put forward. Taking the lead, in early 2001, PIRC wrote to all 800 companies within the All Share Index asking them to put forward a voluntary resolution seeking endorsement for remuneration reports and notified them that PIRC would be advising clients to vote against senior members of remuneration committees where no such resolution was forthcoming. In a similar fashion, a group of investment managers, co-ordinated by Hermes, wrote to companies with a similar request, suggesting also that they might propose a shareholder resolution on the matter at recalcitrant companies. Approximately 10 percent of FTSE100 companies complied.11

11

www.rpmi.co.uk/uploads/pdf/Say_on_Pay_report.pdf

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Finally, the Directors Remuneration Report Regulations (DRRR) came into force on 1 August 2002 and applied to companies' financial years ending on or after 31 December 2002. The DRRR set out the need for incorporating the remuneration report within the reporting documents of a company, and also introduced a mandatory annual vote for shareholders on the remuneration report for listed companies, in advisory form. Listed companies are required to put their remuneration report to shareholders in general meeting as a separate resolution. Taking a hands off approach, the Government has typically refrained from getting involved in setting regulation in the matter relying instead on the Comply or Explain format unless a proven necessity arose. In its response to the Trade and Industry Select Committees 16th Report of Session 2002-03, on Rewards for Failure, the Government stated that it recognised best practice was the preferred option and that legislation was considered an inappropriate route which would create unnecessary complexity and uncertainty as well as significant regulatory burden, there are consequences should the voluntary approach fail: the Government will be monitoring the position closely and, if need be, will not hesitate to take the appropriate action.12 Here, it is important to understand not only the political and social context but also the concerns raised by the practises of prominent companies in the period in question that led up to the implementation of the remuneration report vote requirements as a response for the need for a vehicle to allow shareholders a stronger voice on remuneration concerns. Here are some key examples: At the turn of the millennium, British Airways angered shareholders by paying their departing chief executive Robert Ayling compensation approximately 400 percent of base salary. The Board of Directors, reacting to the controversy, put the remuneration policy to a shareholder vote at the companys next AGM.

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SAY ON PAY: SIX YEARS ON - LESSONS FROM THE UK EXPERIENCE

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In 2001, a 2.5m payout to directors at Royal Bank of Scotland, following the NatWest takeover, provoked a 17percent vote against the chairman of the remuneration committee, Sir Angus Grossart. At Schroders, the board tabled a resolution seeking approval for a payment of 5 million to the departing chairman and ex-chief executive, Sir Win Bischoff. This was deemed as a reflection of his outstanding contribution during the groups development and success over a 16-year period. The resolution met with significant opposition by the shareholders (40 percent voting against) who questioned whether such a discretionary payment was justified given previously paid out salary, bonus and incentives schemes had already rewarded him for company growth under Sir Wins guidance.13 In 2001, Billitons merger with BHP was overshadowed by concerns about the automatic vesting of share options with no connection to whether performance targets had been met, on the completion of the merger. This met with massive opposition by shareholders. During 2002, 30 percent of companies put their remuneration reports or policies for shareholder approval, up from 8 percent in 2001 and 3 percent in 2000. Larger companies took point with 44 percent of FTSE100 companies bringing forward a resolution, compared to 17 percent of Small Cap companies.14 The year 2002 marked the time in the UK where two companies were forced to withdraw or amend their proposed share option schemes due to the level of opposition. The first was Prudential which, despite a prior consultation process, attracted 41 percent opposition for an overly complex scheme for chief executive, Jonathan Bloomer, awarding him between 3m and 6m (estimates varied) and around 90 percent of his salary for median performance. Given Prudentials role as a reputed institutional investor, the issue became one of setting best practises and benchmark of acceptability for other companies.15 In the face of opposition from various fund managers, Prudential withdrew the share scheme.

13 14

SAY ON PAY: SIX YEARS ON - LESSONS FROM THE UK EXPERIENCE ibid 15 ibid

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Selfridges amended its share scheme proposals in response to forum campaign waged against it by institutional investors against its weak performance targets. The amendment clarified the maximum award limit and introduced a 5 percent dilution limit without amending the target. The resolution was passed with substantial 25 percent dissenting vote. The company subsequently committed itself to reviewing the scheme. Whilst share schemes attracted dissenting votes, major controversies also emanated from other remuneration issues such as substantial increases in basic pay at BP, Barclays and Schroders. GlaxoSmithKline plc (GSK) Whilst not the only company to have its remuneration report resolution defeated, GSK was the first company to have its remuneration report defeated by its shareholders and this served to raise the profile of the remuneration report resolution and the debate about executive pay in general. It was consequence of the happenings at GSK in 2003 that the remuneration report resolution became firmly established as a key aspect of the UK governance timeframe. The concerns at GSK related to the golden parachute provision within the pay arrangements for then chief executive, JP Garnier, with respect to the two-year contract provisions that GSK had agreed with him, and the US pay characteristics of the pay structure, such as a lack of performance linkage. There was 51 percent opposition to GSKs remuneration report vote. The total dissent of 61 percent (10 percent abstained) made the GSK vote the highest opposition to a remuneration report at a UK company since the advisory pay vote was introduced. In response to this vote result, and the concern expressed by a majority of the shareholders who voted, the company announced a fundamental review of all aspects of its remuneration policy and practices by Deloitte & Touche. Subsequently, GSK overhauled its remuneration plan for 2004 after extensive consultation with shareholders and their pay consultants.

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Chapter 2 Over the last decade, it has been observed that directors pay in the UKs largest listed companies has quadrupled with no clear link to company performance.16 The MM&K and Manifest Executive Director Total Remuneration Survey 201117 demonstrated poor correlation between remuneration, performance and shareholder value. The survey found that while the median FTSE 100 CEO remuneration was up 32 percent in 2010 from 2009, the FTSE 100 index only rose by 9 percent over the same period. What was identified was a shift from longer-term incentives (typically over three years) to annual bonuses, mirroring the approach that caused so many problems in the banking sector. The current regulatory system Since 2002, under the current system which was introduced under The Directors Remuneration Report Regulations 200218, shareholders in the UK have been entitled to an advisory vote on the directors remuneration report which was designed to empower shareholders and give them an effective and more focused way in which to influence directors pay. The objective was to encourage shareholders to become more e ngaged in corporate governance and to develop relationships with the companies they invest in.19 The pay of the top executives in UK listed company is decided by the company's remuneration committee which is made up of non-executive directors. The NEDs in the remuneration committee are guided in determining the compensation packages by remuneration consultants in trying to find the right balance between executive pay and performance.

16

Average total remuneration of FTSE100 CEOs has risen from an average of 1m to 4.2m for the period 19982010. Data from Manifest/ MM&K, The Executive Director Total Remuneration Survey 2011, May 2011, available at: http://blog.manifest.co.uk
17 18 19

The Directors Remuneration Report Regulations 2002 PIRC and Railpen Investments, Say on Pay: Six Years on: Lessons from the UK Experience, September 2009. Available at: http://www.pirc.co.uk/sites/default/files/documents/SayonPay.pdf

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Development of the Current system Prior to the new Regulations coming into effect, disclosure of directors remuneration was based on a mixture of provisions in the UKLA Listing Rules20 (paragraph 12.43A), the Combined Code21 and Schedule 6 Companies Act 198522. The Directors Remuneration Report Regulations 2002 (which amended the Companies Act 1985) put the disclosure of directors remuneration onto a statutory footing by requiring all UK companies listed in the UK, stock exchanges of any other EU state as well as major US stock exchanges to: include a detailed report on directors remuneration in the annual report; and put a resolution on the report to shareholders at each annual general meeting.

Directors Remuneration Report Regulations 200223 Prior to the Directors Remuneration Report Regulations 200224, The UKLA Listing Rules25 already required a lot of detail about directors remuneration to be included in an annual remuneration report. What the Regulations did was put these matters on a new statutory footing, add new procedures that needed to be followed, add to the level of disclosure in relation to pay policy and requirement to put the report to the annual, nonbinding Advisory vote.

Under Section 234B of the Companies Act 198526, requirement for listed companies to prepare a directors remuneration report became a statutory requirement, rather than only a Listing Rules27 requirement. Failure to comply became a criminal offence making all directors liable to a fine.

20 21

UKLA Listing Rules Combined Code 22 Companies Act 1985 23 Directors Remuneration Report Regulations 2002 24 ibid 24 ibid 25 UKLA Listing Rules 26 Companies Act 1985 27 UKLA Listing Rules

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Requirement to have the Directors Remuneration report approved by the board and signed on its behalf by a director/company secretary with filing requirements with the Registrar of Companies at Companies House making it an offence to circulate, publish or file the report, if it has not been properly signed, with all circulated copies stating the name of the person who signed it.

Requirement of a copy of the report must be sent to every shareholder of the company, every holder of the companys debentures and every person who is entitled to receive notice of general meetings.

Under Section 241A of the Companies Act 1985,28 Listed companies were now required to put the directors remuneration report to a shareholder vote. This was the first instance of the Government heeding the prolonged and vociferous campaign launched by institutional investors and other corporate governance activists. Previously, the Combined Code29 only required a company to consider whether the remuneration report should be voted on.

A Schedule 7A to the Companies Act 198530 set out the detailed information to be included in the remuneration report. This was building on the information that had been required in remuneration reports under the requirements of the Listing Rules31 from years past. The UK Listing Authority amended the Listing Rules32 so that they did duplicate the requirements found in Companies Act 198533

28 29 30 31

Companies Act 1985

Companies Act 1985 Listing Rules? 32 Listing Rules 33 Companies Act 1985

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Contents of the remuneration report The detail of what was needed into the remuneration report was set out in Parts 2 and 3 of the Schedule 7A34. Part 2 of Schedule 7A35 set out disclosure requirements on policy and performance: The names of members of the remuneration committee, the names of any persons who materially assisted the remuneration committee on matters relating to directors remuneration and, if any of those who assisted were not themselves directors of the company, information on the nature of any other services they provided during the year. A statement of the companys policy on directors remuneration for the forthcoming and subsequent financial years requiring companies to additionally disclose their policy on non-executive directors remuneration The policy statement including, for each director, a detailed explanation of the performance conditions applicable to his or her entitlements to share awards. In relation to each directors remuneration, the policy statement explained "the relative importance of those elements which are, and those which are not, related to performance. The policy statement included information on the companys policy on length of contracts with directors, and notice periods and termination payments under those contracts. Requirement for a performance graph illustrating actual shareholder return on a holding of the companys listed shares over the last five years compared with the shareholder return over the same period on a portfolio with identically matching investment details. Details of directors service contracts and/or contracts for services, and, in the case of non-executive directors, letters of appointment including date, unexpired term and notice periods; any provision for compensation on early termination; and details of any other provisions in the contract which shareholders need to know about in order to

34 35

Companies Act 1985, ibid

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estimate the liability of the company on early termination. An explanation of any "significant award" made to a former director including any compensation package for loss of office and details of what, if any, discretion was exercised to enable said director to exercise options or receive other share awards. Audited information Part 3 of the Schedule7A36 required detailed information to be set out regarding the actual amounts received in the financial year by way of salary and fees, bonuses, expenses and other non-cash benefits and any compensation for loss of office or other termination payment; information on each directors share options and interests under long term incentive schemes; and information on each directors entitlements under pension schemes. Additional requirements on excess retirement benefits, compensation for past directors and sums paid to third parties for directors services. Requirements on the auditors to report to shareholders on part 3 of the remuneration report and state whether in their opinion it has been properly prepared in accordance with the Act37. The auditors required to provide a statement giving details of any noncompliance with the Act. Summary Financial Statements For those listed companies that send out a summary financial statement, the Companies (Summary Financial Statements) Amendment Regulations 200238 set out the minimum level of disclosure required in the summary financial statement: the aggregated amount of directors remuneration, the statement of the Companys policy on directors remuneration and the performance graph. The Directors Remuneration Report Regulations 200239 came into effect by applying to financial years ending on or after 31 December 2002. This required companies with financial year ending on or after December 31, 2002 to produce a
36 37

Companies Act 1985 ibid 38 Companies(Summary Financial Statements) Amendment Regulations 2002 39 Directors Remuneration Report Regulations 2002,

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remuneration report satisfying the new requirements as part of its next annual report and put the necessary resolution to shareholders at the next Annual General Meeting. These changes placed the onus on those Non Executive Directors who were members of Remuneration committees and were tasked in setting executive compensation to have to immediately acclimatise themselves with the details of the Regulations. These additional requirements along with the rise in increased complexity of executive pay packages saw an increase of additional stake holders (pay advisors and chartered secretaries) to get into the business of thinking about how information on remuneration was to be collected, tabulated and presented in order to satisfy the new disclosure requirements. The Directors Remuneration Report Regulations 200240 were rolled over into the Companies Act 200641 under which the current regime has been: to require boards to disclose how directors pay is decided, the details of remuneration, and the criteria determining the size of payments in a Directors Remuneration Report (DRR); to give shareholders an annual advisory vote on the DRR (which covers both details of remuneration in the previous financial year and the boards remuneration policy); to require prior shareholder approval of remuneration which might either have a direct major impact on the position of shareholders or which gives rise to the most significant conflicts of interest; and to create remuneration committees made up of independent directors.

40 41

The Directors Remuneration Report Regulations 2002 Companies Act 2006

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How effective has the Advisory vote been in maintaining the link between pay and performance? An effective way to demonstrate the disconnect between pay and performance is to evaluate average executive compensation versus performance of FTSE 100 and FTSE 250 indices. Using PIRC research42 over the period 200-2008, the graphical representation allows the opportunity to study indirectly how effective the advisory vote on directors pay under the Directors Remuneration Report Regulations 2002 has been in matching pay to performance.

Figure 1: source PIRC Figure 1 provides a graphical breakdown in average executive director total remuneration and FTSE 100 Index performance with steady, marginal growth in salaries
42

Say on Pay: Six Years On Lessons from the UK

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over the 2000 -2008 timeframe with maximum growth being in LTIP. It can be also seen how the growth in Cash Bonuses was independent of the performance of FTSE 100 index. The only period of slowdown in LTIP correlates to the stock market slump of 2002.Subsequent to the market recovery in the period during the 2003- 2007, The FTSE 100 index grew at steady 40 percent as compared to 300 percent growth in LTIP and bonuses. In Figure 2, on examining a similar relationship between average executive director total remuneration and FTSE 250 (Mid Cap) Index performance, the sharp drop in LTIP in 2003 coincides with the market slowdown in the same timeframe. The 2005 crest in LTIP and bonuses (slightly ahead of a rise in the FTSE 250 index) represents a clear disconnect between pay and performance as the large gains in LTIP would relate to a depressed market timeframe of 2002-2003. Perhaps, the most bizarre instance would be 2008 when LTIP increased 150 percent year-on-year as compared to a decline in the FTSE 250 Midcap Index returning it to same levels as the 2000 Base year.

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Figure 2: source PIRC It might be inferred from both graphs is the rise in average total remuneration for executive directors was due to an increase in the use of LTIP in executive compensation replacing previous methods of compensation such as share options which became unpopular in usage (among the senior executives) as options tied compensation to share prices effectively making directors remuneration subject to the same vagaries as the share holders. As can be seen, the shift to LTIPs was the biggest driver of executive remuneration and helped in playing a huge role in the disconnect between pay and performance.

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Shareholder Spring Shareholder activism always has been an issue which grabbed headlines but its the recent rise in instances of shareholder activism in these times of falling corporate performance which has been dubbed the Shareholder Spring and is one of this years biggest business stories, as the recent public disputes over executive pay attest. In corporate boardrooms all across the UK, the term activism remains a word with negative connotations with many commentators sceptical about the value of shareholder activism, believing it to be disruptive and short-termist. Despite this, it is a term which has become an established part of the corporate landscape. As a result of some high profile shareholder activist situations, there has been an abundance of press commentary on the drive for greater shareholder involvement in setting executive pay in relation to performance. Using the United States as a comparative model, while there is no conclusive evidence about how effective/ineffectiveness of activism by institutional investors particularly pension funds and hedge funds evidence about ineffectiveness has been inconclusive. However, in the case of the UK, it has been anecdotally observed that shareholder activism is forcing senior management to ensure better and more open lines of communication particularly with their major stakeholders i.e. institutional investors which is a positive development.43 This activism can be in the form of soft power where it would be no more than the gentle suggestion of strategic direction. These suggestions do carry the implicit threat of the exercise of statutory powers, and often this is made explicit.
44

An aggressive

demonstration is in the case of some Hedge fund investors who have acquired reputations for activism and are less likely to be welcomed on a company's register by its board. TCI (The Childrens Investment Fund Management) is a good example of a UK domiciled hedge fund which is extremely aggressive in matters of investor activism. With stated aims of ensuring sound corporate governance and increased shareholder value in the companies it takes a significant stake in, TCI has overseen the overthrow of
43

http://hb.betterregulation.com/external/shareholder_activism_in_the_uk.pdf http://www.capitalinsights.info/news-articles-edition-4/driving-change.aspx

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the CEO of the German stock exchange Deutsche Borse in which it had a majority stake when he refused to give up plans to acquire the London Stock Exchange a move which was in line with the Quasi-Marris45 growth objectives of the German stock exchange but one which would have destroyed shareholder value in the short/medium term. Not one to step away from a fight, TCI has currently sued the Government of India in order to safeguard its stake in Coal India Limited. The differing ways in which institutional investors approach the issue of engaging the executive board demonstrate the level of their risk aversion and susceptibility to media glare. Shareholder engagement with companies is nothing new. However, the current difficult economic environment has brought concerns into sharper focus for investors faced with the prospect of lower returns. Many of the current issues causing shareholder dissatisfaction have been under discussion between shareholders and companies for some time, its just that they have come into prominence recently. It could be argued public relationships between the board of directors and institutional investors have not been critical enough. Large institutions have been pressuring directors to curb excessive pay, in private, for a long time, but it has only had an impact once that pressure has been made public. The last few months have seen many high-level executives forced out of public companies. In most cases, the assertive shareholders exercised their options regarding concerns they had such as executive remuneration and company performance. Sly Baileys departure from media group Trinity Mirror and Andrew Mosss resignation from Aviva46 are just some examples which exemplify the phenomenon that has been dubbed the shareholder spring. Only a handful of FTSE 100 companies Aviva, WPP, Royal Bank of Scotland, Royal Dutch Shell and GlaxoSmithKline have had remuneration reports rejected since pay was subjected to a shareholder vote a decade ago.47

46 47

http://online.wsj.com/article/SB10001424052702304765304577478172485959522.html http://www.guardian.co.uk/business/2012/sep/21/revolts-top-pay-bosses

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Sir Martin Sorrell, chief executive of advertising giant WPP, suffered the biggest revolt in recent years with 60 percent of investors voting against a 30 percent increase in his salary to 1.3m and total remuneration of 13m. At Smith & Nephew, 30 percent of investors failed to back the FTSE 100 medical devices companys remuneration report. The advisory body Pirc had recommended voting against the pay plans which included 1.4m "golden hello" for chief executive Olivier Bohuon noting a serious disconnect between the financial performance of the company which had fallen short of targets and cash bonuses nearly 100 percent of salary . In its recommendation to clients before the AGM, Pirc advised "It is unclear how a golden hello benefits shareholders"48 At Citigroup, shareholders rejected the banks plans to pay its CEO (now ex-CEO) Vikram Pandit $15m (9.4m) for a year when shares fell by 44 percent. Having lost its Say-on-Pay(SOP) vote with just 45 percent voting for, Citigroups Chairman, understanding the importance of the issue, agreed to look at a more formula-based approach for setting up senior executives pay despite the vote being non -binding. Cairn Energy became a further casualty of investor ire as remuneration was voted down by 67 percent. At UBM, shareholders dissenting vote on executive remuneration topped 46 percent. Also notable were the revolts at Cookson Group (32 percent) and Prudential (33 percent) which maintained pay pressure on companies. The shareholder spring has claimed the heads of reputed chief executives at AstraZeneca, Aviva and Trinity Mirror.

48

http://www.guardian.co.uk/business/2012/apr/12/pirc-smith-nephew-pay-plans

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ABI Company Colour Top RREV Rec.

Vote on DRR

Shareholder concern Salary Overall Performance One off Use of targets Award awards

increase quantum

WPP Aviva FTSE100 Xstrata Prudential Barclays Cairn Centamin Egypt William Hill easyJet Inmarsat UBM Exillon Energy Premier Farnell SpiraxSarco

Against 40% X Against 46% Against 63% X Against 70% X For 73%

X X X X X X X X

Against 33%

Against 37%

Against 50% X

For

56%

X X X X

FTSE250

Against 60% Against 64%

Against 65%

Against 68% X

Against 69% X

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Hansteen Afren Figure 3

Against 70% For 71%

Source Keppler Associates

Does the Advisory vote on Remuneration work? By looking at the 2012 Remuneration season to date and the data on the Shareholder Spring, research shows ABI issued red top (grave concerns) and amber tops (some concerns) guidance on the remuneration policies of 35 percent of FTSE 350 companies49 where the most common areas of concern were the amount and structure of recruitment, retention and golden handshake payments; directors compensation perceived as unwarranted by major stakeholders; deficient exposure on the connection between pay and performance. From Figure 3 above, some of the companies with the lowest approval votes on their remuneration policies were: WPP, where ABI red topped and issued a guidance against its remuneration policy , faced a situation where 60 percent of the shareholders voted against the Directors Remuneration Report due to perceived disproportionate salary increase of its CEO. In May, 54 percent of insurer Avivas shareholders voted against its DRR due to a perceived mismatch between CEO pay and performance causing CEO Andrew Moss to step down. ABI, in its guidance, had red toped (citing grave concerns) and issued a guidance against Avivas remuneration report. Xstrata, amber topped by ABI, received 36 percent of its shareholders voting against its Directors Remuneration Report due to LTIP awards of exceptional size. Barclays, where ABI amber topped and issued a guidance against its Remuneration report, faced a situation with 27 percent of its shareholders voting against its executive pay package. What makes it particularly noteworthy is almost 21 percent of

49

Keppler Associates Report

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shareholders voted against the re-election of remuneration committee chairman, Alison Carnwath. Ferri and Maber discovered increased sensitivity to CEO pay in times of poor performances with particular focus on golden handshakes.50 It was surmised that management teams proactively acted to avoid confrontations with majority stakeholders in the AGM in the face of high amount of dissent on executive pay thereby attempting to reach a mutually acceptable solution.51

Figure 4: Source IDS52 Figure 4 evaluates the annual percent change in total earnings in Year 2011 for FTSE 100 CEOs and discovered an average increase of 14 percent which was significantly lower than the 43 percent increase for the year before. The large increases can be seen in the case of mainly commodity firms which posted impressive results due to a global rise in commodity prices. The presence of ARM can be explained due to its significant growth in the mobile phone chipset manufacturing market. By referencing the companies in Figure 4 with the shareholder voting patterns on their Remuneration Reports, it was discovered that rather dissenting Advisory Voting , it was the past three to five year performance of the companies which affected CEO pay negatively.

50 51

Say on Pay Vote and CEO Compensation: Evidence from the UK http://hbswk.hbs.edu/item/6253.html Julia Hanna 52 http://www.ft.com/intl/cms/s/0/8e30409e-e86e-11e1-b724-00144feab49a.html#axzz2BgBSM78F

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Was the dissenting Advisory vote ever ignored? While the Shareholder Spring movement was successful to a very large extent in bringing the issue of excessive and disproportionate executive pay to the forefront causing a majority of the firms facing a large dissenting vote to voluntarily amend the Directors Remuneration Report to appease their major stakeholders particularly the institutional investors, there is always the instance of someone who wants to buck the trend. Using an example from 2012, William Hill was amber topped by ABI citing concerns on its Remuneration Report. Despite having narrowly avoided defeat with 49.9 percent of its shareholders voting against its executive pay report where the retention award for the CEO did not demonstrate any additional performance linkages. Here, shareholders questioned why the CEO was receiving a retention bonus of 2.1 million for just doing his job. Despite these misgivings of the shareholders and the narrow margin by which the Advisory vote on Remuneration squeaked through, the CEO was awarded his pay package. In 2012, SAB Miller faced a shareholders revolt with 22.7 percent of its shareholders rejecting the companys Directors Remuneration Report. Despite investor advisory body Pirc urging shareholders to vote against electing chief executive Graham Mackay to executive chairman, all motions at SAB Millers annual meeting were carried, with 77.3 per cent of votes cast in favour of the pay package. The primary reason for this could be that shareholders may be willing to look the other way when it comes to an instance of bad corporate governance (outgoing CEO becoming Chairman) if the rewards are there (SAB Miller had reported an 8 percent growth in revenues for the past quarter, with a strong presence and growth prospects in the emerging markets of Asia). This demonstrates that the vote on Directors Remuneration can be considered by some boards and shareholders as just as what it states it is: ADVISORY. Under the current regime, other than the reputational loss caused to the company for avoiding to take into account a large dissenting vote on Executive Pay, if the Remuneration Report passes,

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even if it squeaks through as in William Hills case, theres nothing stopping directors from ignoring the dissention-bad corporate governance be damned. Similarly, it as the SAB Miller case demonstrates, if the shareholders are happy with performance, they may be willing to look the other way when it comes to good corporate governance. Lessons Learned A consequence of the shareholder spring could be if it leads to a better acceptance of the investors who takes stakes in companies to agitate for change. In the past, these activists (typically hedge funds) have often been referred to as being short-termist, serving their own interests or in extreme cases, of being asset strippers yet a more proactive role such as undertaken by this type of investor maybe exactly what the doctor ordered for many of these firms. Under the current regime, the resolution to approve or reject the remuneration report has no legal effect the Regulations say that simply putting the remuneration report to a vote does not make any directors remuneration conditional on the outcome of that vote. Therefore, regardless if a companys shareholders do not approve the remuneration report, it has no legal effect on past or future payments to directors. Similarly, the company would not be in breach of the Act if it ignored the outcome of the vote and implemented its defeated remuneration policy anyway. In practice, few listed companies would take the risk of incurring the wrath of their institutional shareholders flouting shareholder opinion as it is likely to be treated as a vote of no confidence in the remuneration committee, if not the board. With level of dissent votes on Remuneration issues typically being 10 percent, a 20 percent dissent vote at a shareholders' meeting would be easily enough to tell the directors that there was serious dissatisfaction. The high percentages of dissenting votes in the above examples demonstrates the fact that executive pay should be aligned with long term share holder value.

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Statistically, the average level of dissent against remuneration reports in FTSE350 companies was around 5-6 percent in the four years after the introduction of the vote.53 It has been the emergence of a number of high profile cases which brought the issue of shareholder voting on the remuneration policy to the forefront. The proportion of dissenting votes reduced to around 3 percent in 2008 but the financial crisis predictably led to an increase in shareholder activism and in 2009, around one fifth of FTSE100 companies had more than 20 percent of their shareholders withhold support for their remuneration reports.54 The frequency of such significant votes against has since declined, However, this has increased dramatically in the individual cases which continue to attract a great deal of attention. A large disconnect between pay and performance may be an indicator of failure of corporate governance in the organisation in differing areas. Using Barclays as an example, it can be demonstrated how a behind -the-scenes

meeting of institutional investors of the banks with Barclays chairman Marcus Agius enforced a compromise solution by the bank whereby making concessions on the

bonuses of the chief executive Bob Diamond and finance director Chris Lucas satisfied some institutional investors like Standard Life Investments. Here, Diamond and Lucas agreed they would receive only half of their bonuses awarded for 2011 until negotiated targets for the bank had been met. In other cases, it might be surmised that the companies large percentage of their

shareholders voting against their Directors Remuneration Reports thought it would be prudent to comply with the demands of the shareholders and n egate the object of contention. The primary reason could be Reputational Risk Management as the principal negative fallout of ignoring a large dissenting vote could only alienate the crucial institutional investors, who can play an important part in a companys long term strategy.

53

PIRC and Railpen Investments, Say on Pay: Six Years on: Lessons from the UK Experience, September 2009. Available at: http://www.pirc.co.uk/sites/default/files/documents/SayonPay.pdf 54 PwC, Executive Compensation: Review of the Year, 2009. Available at: http://www.pwc.co.uk/eng/publications/executive_compensation_review_of_the_year_2009.html

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Shareholder Spring and the political class In his statement in January 2012, PM David Cameron stated says it is wrong for executive pay "to keep going up and up and up" when the companies have not been very successful. He told Andrew Marr that such awards were "frankly ripping off the shareholders". He outlined proposals promising shareholders a "clear transparency, in terms of the publication of proper pay reports and binding shareholder votes on executive pay, in an effort to deal with excessive salaries citing a "market failure", with some bosses getting huge rises despite firms not improving their performances. 55 Cameron gave his speech following the publication of Pay and performance: creating a fairer share of rewards, where the Institute for Public Policy Research(IPPR) suggested CEOs in 87 of the FTSE 100 companies took home an average of 5.1m in basic pay, bonuses, share incentives and pension contributions in 2010-11 which represented a year-on-year increase of 33 percent, while the average increase in market capitalization of the firm was 24 percent. Cronyism In his January 2012 with the Sunday Telegraph, PM David Cameron tried to create the case for coming to grips with the merry-go-round cases of remuneration committee members, sitting on each other's boards and handing out each other's pay rises." Similarly, Nick Clegg,(leader of Liberal Democrats and current deputy PM) tried to win the war for sound bytes by denouncing the current structure of remuneration committees calling it crony capitalism and closed shops of vested interests in which senior business figures appeared on various company boards, often setting each others pay. Policies under consideration include barring executive directors at FTSE

100 companies from chairing remuneration committees at other companies. Not to be left behind, Labour's Leader (Ed Miliband) and Shadow business secretary (Chuka Umunna) both took the opportunity to push for what they termed responsible capitalism pushing forth their measures to tackle high executive pay which include

55

http://www.bbc.co.uk/news/uk-16458570

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greater transparency by simplifying remuneration packages as well as forcing companies to publish a pay ratio between the highest paid executive and the company median average at the same time, placing an onus on the government to publish a league table highlighting the biggest pay gaps. In the name of accountability, Labour promoted putting an obligation on investors and pension fund managers to disclose how they vote on remuneration packages. 56 While Investigating claims of cronyism, investor advisory firm Manifest carried out a study of the annual reports of FTSE 100 for the year 2010 and did not discover any such kind of blatant cronyism in the boardroom existing. Contrary to popular misconception, the study readily demonstrates the existing provisions of the UK Corporate Governance Code have proven effective in that there are very few cross memberships of remuneration committees and the overwhelming majority of FTSE 100 remuneration committee members do not sit on any other FTSE 100 remuneration committee. Summarising: Only 52 FTSE 100 directors sit on another FTSE100 board as NED, or only 5 percent of FTSE 100 directors; Of these, just 20 sit on the remuneration committees of these other companies; Where an executive from one company sits as a non-executive on another company's board, there are zero instances of an executive from that latter company also sitting on the first company's board.
http://blog.manifest.co.uk/2012/01/5431.html

In other ways, there is no practical mechanism for executives of different companies to pay lavish amounts to each other by sitting on each other's boards, in the way that Mr Cameron or Mr. Clegg seem to believe is rife. In November 2011, newspaper headlines were screaming 50 percent rise in average pay for directors which led to further outbursts by the political parties who had vested interests. The source of this data was a study published by pay research company Incomes Data Services (IDS) stating the average pay for the directors of UK's FTSE
56

http://www.bbc.co.uk/news/uk-16454102

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100 rose 50 percent over the past year while average pay for the chief executives grew by 43 percent.57 Looking closer to the IDS data, while base salary for FTSE 100 directors averaged a modest 3.2 percent over the last year, it was the average increase in LTIPs and bonus payments by 23 percent, from 737,624 in 2010 to 906,044 in 2011 which was the reason for the increase in directors compensations. What most people failed to realise is the valuation method used by IDS, where future bonuses that were to be vested (say 2 years hence- on achievement of certain, pre-established corporate goals by the directors), was done at current market price, at the time of granting of the incentives. In an environment of economic uncertainty, share holders are increasingly apt to align executive compensation packages with a bonus structure to incite performance. For the directors, mere acquisition of the options does not mean they will necessarily have intrinsic value and will be exercised in the future (they could be worth nothing if the firm fails to reach its profitability targets- an assumption totally ignored by IDS. This was definitely the case of the banks where the current market price made it unfeasible for senior management to exercise the options which they were awarded. However, in IDSs method, they would be account for the salaries of the directors regardless of exercise option).This raised questions about IDSs methodology and motivations of the vested parties which kept highlighting the issue.58 A study to investigate boardroom pay, conducted by the High Pay Commission (set up by left-leaning pressure group Compass with backing from the Joseph Rowntree Charitable Trust) concluded the average pay of top executives at a number of FTSE 350 companies had risen by more than 4,000 percent in the last 30 years, with average bonuses for directors have risen by 187 percent since 2002, without a corresponding rise in share prices representing how the disparity between what top executives and average workers earn has been building for many years. This report by the High Pay
57

Total earnings were composed of fixed pay, salary and benefits, the value of bonuses earned during the year, both cash and deferred, plus the crystallised money value of any long term incentive plan (LTIP) awards and the nominal gains made on the exercise of any share options cashed-in during the year.
58

http://www.incomesdata.co.uk/news/press-releases/directors-pay-report-2011.pdf

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Commission was used by TUC and most of the political parties to make sure the battle for sound bytes regarding excessive Executive pay was kept well alive.59 The Shareholder Spring highlighted the case against bankers by bring the focus of good corporate governance with a call to curb bonuses and other perks to fit in with agency conflict between managers and shareholders.60 But, as demonstrated in the prominent case of Royal Bank of Scotland, another issue crops up: the agency conflict between majority and minority shareholders. Here, the well entrenched majority shareholders (the UK government) tended to act in their own interests by cashing in on the popular outrage instead of concentrating on the long term viability of RBS as a business entity or looking after the minority 17 percent nongovernment stakeholders. Mr Stephen Hester (current CEO RBS) faced a thankless task of cleaning up the giant mess he inherited at RBS, replacing Sir Fred Goodwin after Labour PM Gordon Brown announced taking up an 83 percent stake in the bank. Here, the real and credible option, of running RBS as an outpost of HM Treasury, using it to finance small and medium-sized enterprises (SME) and large capital projects, was ignored. In the present climate, this would have been highly desirable- invigorating growth and job creation in the credit crunch affected economy. Instead, the political class decided to grant commercial autonomy to the bank, 61 and accept the status quo. Now, four years later, the very same Labours Ed Miliband threatened a Commons vote denouncing Hesters 963,000 payment for failure bonus when share price halved. In the case involving Mr Hester, if payment was withheld with the focus on making remuneration transparent, predictable and deserved,62 it would have been valid despite Hesters successes in shrinking the banks balance sheet and winding down its investment banking. This was standard in case of a state-controlled entity such as RBS, where the government has a locus to intervene as an investor and there is a public right to know how bonuses for top executives are assessed. However, it seems it was more a
59 60

http://www.bbc.co.uk/news/business-14781254 http://highpaycommission.co.uk/facts-and-figures/ 61 http://www.ft.com/intl/cms/s/0/c5c22adc-4a89-11e1-a11e-00144feabdc0.html#axzz1l5JSRzHK

62

http://www.guardian.co.uk/business/blog/2012/oct/08/rbs-stephen-hester-share-price

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case of the political class acting in its own interest to cash in on popular outrage with MPs from all parties joining in the cacophony of protests, amplified by the media. Recent developments by Stakeholders In conjunction with the Investor Stewardship Working Party, The Institute of Chartered Secretaries and Administrators published a consultation paper 63 on improving engagement practices between companies and institutional investors. As part of the consultation, ICSA have spoken to company chairmen about the shortcomings they have experienced in investor engagement The Financial Reporting Council has published changes to the UK Stewardship Code64 to provide greater clarity on the meaning of stewardship and the respective responsibilities of asset owners and asset managers. Since very few signatories to the Stewardship Code have updated their policy statements since its introduction in 2010, signatories will be required to review their policy statements annually, update them as necessary and indicate the date of their last review. Finally, the Financial Reporting Council is carrying out a consultation on updating the Corporate Governance Code requiring companies to make a statement when a significant minority of shareholders vote against a pay resolution. These recent developments are a direct result of the increased focus brought about by the Shareholder Spring movement. Comparison with US The traditional US attitude towards Corporate Governance has been if an investor doesnt like something, they can sell their shares. This hands off approach led to Corporate Governance failures that plagued the American Corporate landscape by destroying shareholder value and in some cases, entire firms such as Enron, Worldcom. In other prominent examples, inability of shareholders to stop executives such as Home
63

http://www.linklaters.co.uk/Publications/Publication1005Newsletter/UK-Corporate-Update-18October2012/Pages/ICSA-looks-improve-shareholder-engagement-practices.aspx 64 http://www.linklaters.co.uk/Publications/Publication1005Newsletter/UK-Corporate-Update-4-October2012/Pages/FRC-announces-amendments-UK-Stewardship-Code.aspx

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Depots Nardelli and Pfizers McKinnell, ousted for performance failures from exercising their contractual rights to undeserved golden parachutes only added to pressure for change. In April 2007, HPs activist shareholders in a trendsetting move, aimed at loosening companies near-absolute control over the composition of their boards, put forward a proposal to nominate their own candidates to the board. Despite losing the vote, this move by HPs shareholders was hailed as a leap forward in the US Corporate Governance environment, traditionally hampered by a decentralised legal system which prevented federal intervention with state law on key corporate matters such as shareholder voting. The long bull run enjoyed by US equity markets contributed to making institutional shareholders, especially the large mutual funds and retail investors, less keen to disturb a system that has rewarded them handsomely. It was the financial sector crisis of 2008 that highlighted the need for governance reforms in the eyes of investors as well as regulators. Faced with deterioration in shareholder wealth and inability in stopping the exercise of golden parachutes by ousted CEOs, US shareholders began demanding a non-binding annual vote on executive compensation, similar to the UK. Within months, more than 60 companies found themselves on the receiving end of the campaign for a say on pay. During this period of intense scrutiny, health insurer Aflac agreed to allow shareholders to vote on executive pay from 2009 a first in the US. At least 10 of the original 60-plus targets caved in to the activists demands and granted investors the right to vote on whether to introduce the measure in the future. Barney Frank, the Democratic chair of the House of Representatives Financial Services Committee, proposed legislation on the advisory vote. The Dodd-Frank financial reforms of 2010 contained measures designed to push a regulatory-led approach to Corporate Governance, with all US listed companies now required to hold an Advisory say-on-pay vote to approve executive remuneration. Despite being a mere Advisory vote, it served to mobilise the large-scale dissatisfaction among shareholders who found a powerful tool to oppose management without having to incur major expenses. This prompted boards to wake up and pay attention or risk serious reputational damage. The best example was the public rebuke to Citigroup by its shareholders who voted to
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reject its executive compensation package at the 2012 AGM. The proxy advisory firm ISS had recommended against (then) Citigroup CEO Mr. Vikram Pandits awarded pay package, which wasnt based on the firms financial performance as its stock price had declined by 90 percent over the last five years. Rather than attempting to modify it,

Citigroup pressed ahead and faced a stunning snub by shareholders. The aftermath of this widespread dissatisfaction saw Vikram Pandit step down as CEO claiming accountability for loss of market capitalisation and shareholder wealth. Impediments to Shareholder activism It is quite unusual to have more than 50 percent of shareholders voting at all. The problem of why there isnt a great deal of activism among shareholders could be explained by the fact share ownership of UK companies has changed dramatically over the last fifty years. In the 1960s, the majority of shares in UK companies were owned by individuals, many of whom took a reasonable level of interest in the companies whose shares they owned. By the 1980s, the majority of shares were owned by UK institutional investors such as pension funds and insurance companies. For shareholder activism to be effective, institutional shareholders like pension funds and insurance companies would have to get involved but they only own around a quarter of UK shares. According to the IMAs most recent figures, pension funds and insurance companies now hold around 13 percent of UK equities each, with an additional 14 percent held by other UK institutional investors.65 ONS figures show that at the end of 2008, 41.5 per cent of UKlisted shares were owned by investors from outside the UK, and individuals held just over ten per cent, the lowest percentage since the survey started in 1963.66 Governments seeking to tackle excessive boardroom pay have repeatedly returned to the well-worn tools of UK-style corporate governance: greater transparency and disclosure, improving the accountability of managers to shareholders, strengthening the role of non-executive directors, and a largely voluntary system of policing corporate governance. While each has an important role, these tools have proved themselves to be ineffective in reining in top pay over the last 20 years.
65 66

IMA, Asset Management in the UK 2009 2010, July 2010 Available at http://www.statistics.gov.uk/cci/nugget.asp?id=107

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This suggests that shareholder activism alone encouraging shareholders to vote against remuneration reports or engage with pay and performance issues in other ways will not work now either. Shareholder activism relies on institutional shareholders, like pension funds and insurance companies, but they only own around a quarter of UK shares. Over 40 per cent of UK shares are held by foreign owners. Even UK institutional investors are increasingly holding shares over shorter periods of time, making it hard for them to have oversight of the long-term interests of companies. Most institutional shareholdings are managed by fund managers, who tend to have large remuneration packages themselves, suggesting they are not best placed to tackle excessive pay. The diminished ability of shareholders to tackle excessive boardroom pay is demonstrated by the fact that only 5.6 per cent of remuneration reports in FTSE companies were voted against by shareholders in 2010. Summation At the company's annual meeting, the shareholders get to vote on what that committee has decided, which includes all of the pay, bonuses and pension provision of the directors of the company. Since this is currently only an advisory vote, which means that the company can completely ignore it if it wants to. The current regulatory environment has not been successful in demonstrating linkage between pay and performance. Where does shareholder activism go from here? The debate on executive pay currently focuses on new legislation proposed in the Queens Speech, which introduced greater powers for shareholders under the current magic mantra say on pay. The current Advisory vote meets its goal of shareholder engagement quite effectively where it lacks is in the requirement to ensure better understanding of complex pay packages and a binding vote on executive remuneration. The popular perception is majority of the positive results obtained under the Shareholder Spring have been obtained by bringing the issue of the dissenting vote in the limelight but closer analysis shows what really worked was the traditional approach taken by institutional investors in holding closed door sessions with the senior management teams of the firms they had stakes in and ensuring good corporate
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governance guidelines were followed vis-a-vis executive pay. Rather than utilising all these conversations in secrecy, an offshoot of the recent development of increased media exposure might be setting up of informal sessions where major stake holders get together with the boards of companies and hash out their issues regarding issues of dissention. Such collaborative discussions among the major stake holders would facilitate greater transparency and restore faith in the reputations of companies adversely affected by the recent Shareholder Spring events. The foundations laid in the shareholder spring create a unique opportunity for activists to force engagement and achieve their goal. UK company legislation provides the mechanics for relatively small groups of shareholders to requisition shareholder resolutions and require companies to present such resolutions to a meeting of shareholders. Activists can now also use the media and social media to promote their agenda.

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Chapter 3 The Binding vote Background Under the CA 2006,67 quoted companies68 are required to produce a directors remuneration report69 as part of the annual reports and accounts, and to put this directors remuneration report to the companys members at the annual general meeting. At the AGM, shareholders are asked to approve the report by means of an ordinary resolution70 . This resolution is advisory in nature and the company is not required by law to take any action in response to the vote. As such, no individual directors pay is contingent on the outcome of the vote. Why the Binding vote on pay policy? The current advisory shareholder vote on the directors remuneration report was initially designed to give shareholders a way in which to influence directors pay. However, as can be seen from Figure 3 feedback from shareholders in the form of dissenting shareholder voting on executive remuneration did not stop ALL the companies from responding adequately to their concerns. There was no legally binding requirement on companies to follow the dissenting vote, even if the remuneration report had been voted down. In order to address these shortcomings, the Government has introduced a new binding vote on a companys pay policy with a two fold outlook : to empower shareholders and to encourage improved dialogue with the companies they own.

This vote will require the support of a majority of shareholders voting to pass. What exactly will be this majority figure is the focus of a recently closed consultation by the BIS. The Enterprise and Regulatory Reform Bill repeals section 439(5) of the Companies Act 2006, removing the statutory provision which currently prevents the statutory
67 68

Companies Act 2006 Quoted company, as defined in section 385 of the Companies Act 2006. 69 Section 420 Companies Act 2006 70 Companies Act 2006, Section 439

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requirement for a vote on the directors remuneration report having the effect of making a persons entitlement to remuneration contingent on the outcome of the shar eholder resolution.71 This entailed changes regarding Payments to directors of quoted companies in: Members approval of directors remuneration policy Restrictions on payments to directors Payments to directors: minor and consequential amendments Payments to directors: transitional provision72

In his June 20th 2012 statement, Dr Vince Cable, citing lessons learned from shareholder spring, announced a comprehensive package of measures altering the framework for directors remuneration under amendments to the Enterprise and Regulatory Reform Bill
73

(Bill 61 2012-13) which is currently before Parliament. The

intent behind the Governments reforms was to provide shareholders with new powers to hold companies to account, while making it easier to understand what directors are earning and how it links to company performance. The Government intends all these reforms to be enacted by October 2013. These are a far reaching package of reforms aimed at strengthening the hand of shareholders to challenge excessive pay. Under the new proposals of creating a Binding vote for Executive compensation, the aim is to create a more robust framework within which directors pay is set, agreed and implemented by:
Restoring a stronger, clearer link between pay and performance; Reducing rewards for failure; Promoting better engagement between companies and shareholders; Empowering shareholders to hold companies to account through binding votes. 74

71

Parliament.co.uk, Explanatory notes on Enterprise and Regulatory Reform Bill <http://www.publications.parliament.uk/pa/bills/cbill/2012-2013/0007/en/13007en.htm> 72 http://www.publications.parliament.uk/pa/bills/cbill/2012-2013/0061/13061.pdf 73 Enterprise and Regulatory Reform Bill 74 BIS Department for Business Innovation and Skills, Directors pay: guide to Government reforms < http://www.bis.gov.uk/assets/biscore/business-law/docs/d/12-900-directors-pay-guide-to-reforms.pdf> accessed 28 June 2012

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How this was to be achieved was by introducing the reforms to: Give shareholders binding votes on pay policy and exit payments, so they can hold companies to account and prevent rewards for failure; Boost transparency in directors remuneration reports so that what people are paid is easily understood and the link between pay and performance is clearly drawn; and Promote better engagement between companies and shareholders; and ensure that reforms have a lasting impact by empowering business and investors to maintain recent shareholder activism Changes under the Enterprise and Regulatory Reform Bill Section 439(5) of the CA 200675 states that no entitlement of a person to remuneration is made conditional on the resolution being passed by reason only of the provision made by this section. Clause 57 of the Enterprise and Regulatory Reform Bill76 will repeal section 439(5)77. This will remove the statutory provision which currently prevents the statutory requirement for a vote on the directors remuneration report having the effect of making a persons entitlement to remuneration contingent on the outcome of the shareholder resolution. The repeal of this section does not automatically have the effect of making directors remuneration contingent on the outcome of the shareholder resolution on the directors remun eration report. As such, the repeal of section 439(5)78 does not, in itself, mandate a binding vote on the directors remuneration report.79

75 76

Companies Act 2006, Section 439(5) Enterprise and Regulatory Reform Bill 2012- 13 77 Companies Act 2006, Section 439(5) 78 Companies Act 2006, Section 439(5) 79 <http://www.publications.parliament.uk/pa/bills/cbill/2012-2013/0007/en/13007en.htm>

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How would the reforms work? Under the Enterprise and Reform Bill, The Government proposed a binding vote on pay policy requiring the support of a majority of shareholders voting to pass. The policy should clearly set out how pay supports the strategic objectives of the company and include better information on how directors pay compares to the wider workforce .The binding vote will be held annually unless companies choose to leave their remuneration policy unchanged, in which case it will be compulsory at least every three years. Once a remuneration policy is approved, companies will not be able to make payments outside its scope. If a company chooses to change its pay policy, it will have to put it before shareholders for re-approval. The immediate effect will be to encourage companies to devise long-term policies thereby putting a brake on annual pay ratcheting; As part of their pay policy, companies will have to clearly explain exit payments which will also be subject to the binding vote. Companies will not be able to pay exiting directors more than shareholders have agreed. When a director leaves, the company will have to promptly publish a statement of payments the director has received. Alongside the binding vote on policy, shareholders will continue to have an annual advisory vote on how pay policy was implemented in the previous year, including actual sums paid to directors. If a company fails the advisory vote it will be required to put its overall pay policy back to shareholders in a binding vote the following year. Changes to Reporting Framework - Disclosure and Single Figure On June 27th 2012, following the announcement of the introduction of Binding vote on company pay policy, the Government published draft regulations determining what companies must disclose in pay reports. 80These will fully replace existing rules and are designed to create a robust framework within which directors pay is set, agreed and implemented. The revised regulations will:

80

http://discuss.bis.gov.uk/enterprise-bill/files/2012/06/ERR-Bill-DRR-27-June.pdf

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streamline company disclosure requirements so that reports are focussed on making the link between pay and performance crystal clear introduce a new requirement to report the total pay directors received for the year as a single figure ensure shareholder engagement is sustained over the long term.

To support the new shareholder voting regime, remuneration reports will, in future, be split into two parts: 1. Forward-looking policy report which will be subject to the binding

shareholder vote. Once approved, the company will only be able to make payments within the limits it allows. For the first time, companies will be required to set out every element of pay that a director could be entitled to and how it supports the achievement of strategic objectives, the maximum value and performance measures that will be applied. The report will also set out: Scenarios for what directors will get paid for performance that is above, on and below target information on the percentage change in profit, dividends and the overall spend on pay. Principles on which exit payments will be made, including how they will be calculated and how performance will be taken into account Information on employment contracts Factors the company has taken into account when deciding on pay policy, including employee pay levels and views.81 2. Report on how the policy was implemented subject to an annual advisory vote. This report will include details of actual payments made, set out as a single figure for the total pay directors received for the year. Companies will have to report a single figure for the total pay directors received for the year. The figure will cover all rewards received by directors, including bonuses, long term

81

http://news.bis.gov.uk/Press-Releases/Government-strengthens-reporting-framework-for-directors-pay67bef.aspx

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incentives and pension provisions. Regarding the variable elements, the single figure reflects actual pay earned rather than potential pay awarded. This includes full bonuses awarded for the reporting period; and long term incentives where the reporting year is the last financial year of the performance cycle. For the first time this will allow shareholders to make comparisons between the pay directors receive year-on-year, and between companies. The report will also include:

Information on how well companies performed against conditions and how this impacted on the overall level of pay

Total pension entitlements (for defined benefit schemes) Exit payments awarded in the reporting period Details on the potential future value of new variable awards made in year Total shareholdings of directors A comparison between company performance and the Chief Executives pay Information about who has advised the remuneration committee Details on how shareholders voted at the previous AGM and any action the company took in response.82

The amendments proposed under the Enterprise and Reform Bill 2013 offer significant strengthening of shareholder rights as they include: binding vote on future pay policy advisory vote on implementation of policy in previous year binding vote on exit payments

Binding vote on future pay policy The new voting model includes proposed changes to reporting on directors remuneration entail splitting the remuneration report into: (a) future policy (potential payouts); and (b) how policy has been implemented in the previous year and actual payouts). This involves giving share holders binding vote on future policy, enabling them

82

http://discuss.bis.gov.uk/enterprise-bill/files/2012/06/ERR-Bill-DRR-27-June.pdf

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to approve the proposed structure of executive pay, how it will be determined in line with performance and what the overall quantum could be under different scenarios. Companies will have flexibility over whether to put the policy to shareholders for annual approval, or secure approval for a longer-term pay policy (3 years maximum). In the intervening years, companies will need to report in brief on key elements of the pay policy and any changes made to it but there will be no need to put the policy to another binding vote until it expires. Companies will have to put their pay policy to a binding vote at the next AGM if: they want to make major changes to their existing pay policy; or where more than 50 percent of shareholders voted against how the policy was implemented in the previous year. Advisory vote on implementation of policy in previous year Shareholders will retain an annual advisory vote on the backwards looking section of the report. This is similar to the vote shareholders currently have but would be focused on actual payments made in the previous year (rather than being a mixture of this and future pay policy, which is the case at present). This will allow them to signal more explicitly than now whether they are content with how the previously approved policy has been implemented; particularly where the remuneration committee has used its discretion. Where a company has approved a three year pay policy, it is important that shareholders continue to have a means of expressing whether they are content with how the policy is operating each year. If a majority of voting shareholders vote against this, the company will be required to return to shareholders the following year with a revised policy (subject to the binding vote). In the event that more than a quarter of voting shareholders vote against in either the advisory vote on actual payments made that year, or the binding vote on future pay policy, companies will be required to publish a statement within 60 days disclosing: the number and proportion of votes cast for, against and withheld; the main shareholder concerns, to the extent they are known; and how the company proposes to engage with shareholders on these issues.

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Binding vote on exit payments Companies will have to seek shareholder approval for their approach to exit payments as part of the binding vote on remuneration policy. Any actual payments made to departing directors will have to be disclosed at the point a director leaves and explained in the backwards-looking section of the next remuneration report. How would this binding vote work? Under the current system, in order for a shareholder resolution on directors remuneration to be given the effect of creating a binding vote, the articles of a particular company would have to be changed to introduce a binding vote on the remuneration report which would require the approval of shareholders of that company by means of a special resolution. Some reasons in favour of a Binding vote Free- riding In his report on UK bank governance83, Sir David Walker pointed out to the Free Rider problem faced by the institutional investors who hold 41.5 per cent of UK-listed shares84 where gains generated by effective engagement are enjoyed by investors across the board rather than flowing directly to the investors who have carried out the engagement. The agency costs incurred with benefits accruing to everyone (including the free riders) reduces the incentives for institutional investors to allocate resources to engage effectively with all the companies whose shares they hold. Moreover, with an increasing need to diversify their holdings in different asset classes, with equities playing a small portion of the asset mix of increasingly risk-averse investors, institutional investors are increasingly holding shares over shorter periods of time, making it hard for them as well as reducing the incentives to have oversight of the long-term interests of companies. Additionally, most institutional shareholdings are managed by fund managers, who tend to have large remuneration packages
83 84

Walker Report Available at http://www.statistics.gov.uk/cci/nugget.asp?id=107

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themselves, suggesting they are not best placed to tackle excessive pay. The diminished ability of shareholders to tackle excessive boardroom pay is demonstrated by the fact that only 5.6 per cent of remuneration reports in FTSE companies were voted against by shareholders in 2010 and 7.3 percent in 2011. Proxy voters As of 2010, large institutional investors hold more than 41.5 percent of UK listed

shares85 with a significant portion of significant portion being overseas investors and sovereign wealth funds. With control no longer in the hands of UK-resident individual investors, this has led to a situation where proxy firms in charge of voting on shareholder proposals with approval/rejection relegated to a checkmark process. This disconnect and current environment of current term ownership of equities has led to large overseas investors rarely getting involved in corporate governance issues only paying attention when their investments are not performing as anticipated. Clarity Currently, the Directors Remuneration Report contains both sections: a forward looking policy section and a backward looking retrospective analysis of what remuneration has actually been paid during the year under review leading to shareholder confusion as to what the vote is on: the amounts that have been paid during the year under review or on changes to the intended policy for the upcoming year? With no standard format for remuneration reporting at present, the proposed vote will require all companies to be explicitly clear about their forward looking policy ensuring quantum and performance conditions (which companies have been known to change midyear affecting potential pay-out but bury in the complex wordings of the Remuneration Report) to be used during the year are disclosed -safeguarding shareholder interests.

85

Available at http://www.statistics.gov.uk/cci/nugget.asp?id=107

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Engagement The current advisory vote on the remuneration report and the binding vote on long term incentive plans does bring out a massive amount of engagement and consultation between companies and their majority stakeholders as managements are keen to not alienate their shareholders. The consultative process is constrained due to time limitations imposed by companies in soliciting feedback from shareholders and the opposing point of shareholders not always responding to the methodology used by the company. The binding vote on future policy could reinvigorate the consultation process as the issue of disconnect between pay and performance could be a glimpse into more serious governance issues at the company. Engagement on remuneration matters could lead to a greater insight into the general governance practices of the Company. Counter viewpoints In its response to the BIS Consultation on Executive Pay: Shareholder Voting Rights, ICAS expressed concerns as to whether the benefits associated with the proposed binding vote for shareholders would exceed the related risks. While supporting greater engagement of shareholders in principle, ICAS expressed concerns over the practicalities of the binding shareholder vote stating it was not convinced that it would improve the ability of shareholders to hold companies to account on pay and performance.86 Questioning the practicality and benefit of introducing the binding vote, ICAS countered that a combination of appropriate pre-existing safeguards: the advisory vote and the UK Corporate Governance Code requirement for annual re-election of directors already provide sufficient opportunity for shareholders to influence a company's executive remuneration policy.87 A binding vote on future pay could tie down senior management excessively heavy consultations on executive remuneration (comparatively a small corporate governance

86 87

http://icas.org.uk/News/Latest_News/Executive_remuneration_binding_shareholder_response/ http://icas.org.uk/News/Latest_News/Executive_remuneration_binding_shareholder_response/

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issue) at the expense of other issues vital to ensuring business continuity and shareholder value creation in the long term. Would a binding vote work in the long term? In a US study examining the efficacy of shareholder voting in effecting changes in corporate policy, it was discovered that out of the 619 management-sponsored proposals rejected by shareholders between 2001 and 2010, 30 per cent percent related to equity compensation plans.88 For the 2659 management-sponsored proposals where Institutional Shareholder Services (ISS), the leading proxy advisory firm, recommended a vote against the proposal, 1719 (65 percent) related to equity compensation plans. Although only 2 percent of equity compensation proposals failed to receive the required level of shareholder support, this is substantially larger than the 0.07 percent failure rate for elections of directors.89 This might indicate proposals on shareholder voting on executive compensation attract much higher levels of shareholder disapproval than most other company-sponsored proposals that are put to shareholder vote at the annual meeting such as director elections and auditor ratification. From this, it can be observed that shareholder voting on equity pay plans is a more likely channel than director voting for shareholders to express their sentiment about firms executive compensation policies. This could be the result of considerably greater attention on shareholder voting and executive compensation.90

88 89

Statistics based on data obtained from the ISS Voting Analytics database. CS Armstrong, ID Gow and DF Larcker, The Efficacy of Shareholder Voting: Evidence from Equity ibid

Compensation Plans (2012) SSBR Paper No. 2097.

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Chapter 4

Conclusion

The new framework under the Enterprise and Reform Bill 2013 will enable sustainment of shareholder engagement over the long term, allowing shareholders to inject greater pay discipline. Under Proposed disclosure requirements of directors pay in a single figure, Companies will be required to set out every element of pay that a director could be entitled to and how it supports long-term company strategy and performance. This will go a long ways in boosting transparency so that what people are paid is easily understood and the link between pay and performance is clearly drawn, with directors no longer be possible to mask what they are actually earning. If the pay policy isnt specific enough, shareholders will have a legally binding vote they can use to reject it. Making the vote binding could encourage more engagement with shareholders. There is plenty of anecdotal evidence that shareholder engagement has increased since the advisory votes were introduced. Phineas Glover, corporate governance analyst at The Co-operative Asset Management stated Binding votes would suddenly make this all a lot more interesting" 91 In practice, if the remuneration report were to be voted down, it would create uncertainty for the senior executives working for the major portion of the year, not knowing the details of their pay packages. Instead, a more viable option might be having a binding vote on the previous year's total pay and an advisory vote on the framework for the current year's pay, including such factors as maximum possible awards. In addition to the reputational risk faced by firms when the remuneration report is defeated, share holders, though loathe to, exercise the option of crossing over their dissent by voting down directors re-election, they sometimes do exercise these options as seen in Barclays case where the Chief of the Remuneration Committee Alison Carnwath faced an astonishing dissenting vote of 21 percent on re-election. As a consequence of the proposed changes, if the remuneration policy of a company was defeated, the question of how directors deal with the uncertainty it creates remains to be seen. Should this be seen as sufficient cause for directors to resign? With senior
91

BBC News - Q&A: Voting on executive pay

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chief executives having resigned over failure of the remuneration reports, the impact of this short term issue of linking current pay to current performance might affect how the rest of the board reacts in the long term. This might destroy long run shareholder value not to mention lead to an exodus of chief executives to the more lucrative BRIC destinations. Social effects Efforts to tackle top pay also say very little about how pay and reward could be improved for the majority of workers. IPPR (the Institute of Public Policy Research) has found that many people are unhappy about the focus of rewards on a handful of top earners and the inability of most employees to share in the success of companies. Such models of reward fail to reflect the shared contribution of staff, and the role that employees have in promoting the long-term health of their companies92. A majority of employees feel proud to work for their organisation, but many fewer feel valued in the workplace. These concerns are made more important by the spectre of stagnating living standards, flat real wages and shrinking resources for redistribution to support low and middle earners. The social implications of these findings cant be ignored. Institutional investors continue to believe that overall the UK system of corporate governance works and both the advisory vote on the Directors Remuneration Report (DRR) and binding votes on new share schemes promote a significant amount of engagement What may be needed is a shift from EPS growth as the preferred method of evaluating senior management performance to include additional KPIs such as long term growth in shareholder value. This would be facilitated with requiring Long Term Incentive Plans of the chief executives to vest after retirement ensuring they are aligned with long term shareholder value creation. However, this would require both institutional investors and senior management to avoid the current mindset of short term-ism, which reflects a quantum change in mindset, not easily or readily achieved.

92

http://www.ippr.org/publications/55/7617/getting-what-we-deserve-attitudes-to-pay-reward-and-desert

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The proposed changes will provide an avenue for greater transparency and ease of use by shareholders who dont have access to compensation analyst to traverse the myriad potholes of current day Remuneration Reports. As seen from the case of the US, with boards typically relying on equity-based compensation, shareholder votes on equity pay plans are now binding under the provisions of Dodd Frank Act.93 While a failed vote deprives boards of the ability to grant the requested shares for compensation purposes, this doesnt seem to have any effect of future equity-based compensation. Theres nothing stopping management from responding to the rejection of a proposed equity pay plan by requesting additional shares in the subsequent year. As far as shareholders are concerned, the total effect of shareholder rejection on equity-based compensation may be negligible since these shares would not significantly contribute to share dilution. Therefore, it is a natural assumption that firms whose equity-based compensation plans are rejected by shareholders in the current year are significantly more likely to request shares in the subsequent year. There was no co-relation between the levels of shareholder approval for these follow-up requests to whether the original request was approved/rejected.94 What this might effectively suggest is that even if shareholder voting had an immediate effect, it might have little or no long-term effect substantive impact on firms incentive compensation policies. Thus, recent regulatory efforts such as the Frank Dodd Act in the United States and The Enterprise and Reform Bill 2013 in the UK which are aimed at strengthening shareholder voting rights, particularly in the context of executive compensation95, may have limited effect on firms compensation policies, over the long term. The effectiveness of purely using the legislative BINDING VOTE remains to be seen however, what remains clear is ably demonstrated by the words of Sir Adrian Cadbury, author of 1992 Cadbury Report on UK Corporate Governance Say on pay promotes dialogue between investors and boards and encourages investors to engage with
93 94

Frank-Dodd Act C Armstrong, Gow, Ian D. and Larcker, David F., The Efficacy of Shareholder Voting: Evidence from Equity Compensation Plans (March 13, 2012). Stanford School of Business Research Paper No. 2097 ; Rock Center for Corporate Governance at Stanford University Working Paper No. 112. 95 ibid

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boards on a readily understandable issue, where interests may conflict. It is also a litmus test of how far boards are in touch with the expectations of their investors.

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