Share Incentives – Money for nothing?

Share Incentives - Money for nothing?

Directors' pay is still a sore subject, despite the intervention ofthe Greenbury Report. Simon Garrett looks at the balancing act betweencorporate rewards and shareholder value

For several years now the remuneration of company directors has been the subject of much adverse press comment. Pundits have homed in on generous severance payments, easy-to-earn bonus schemes and huge share incentives, returning repeatedly to the central question: ‘Are directors getting something for nothing?’

Much of this uproar has focused on the larger public companies – the privatised utilities in particular. But the fall-out is spreading ever wider and now all public companies, regardless of size or industry, are feeling its effects. Growing private companies too are under pressure to justify directors’ rewards to shareholders and other interested parties.

The Greenbury Committee was asked to examine these complaints of corporate greed and last year produced a report that focused the debate and offered some guidance to companies trying to get the balance right between providing proper rewards for directors and getting value for money for the company. The Stock Exchange has since incorporated substantial elements of the Greenbury report into its rules.

Past pleasures

The criticisms levelled at share incentives in the past are legion. Many commentators have described them as the rich cream floating on top of the fat cat’s large bowl of milk. They maintain that share options, for example, offer directors a ‘one-way bet’ on the company’s share price.

If the price rises, directors often stand to gain substantial amounts, even if the increase is less than spectacular or caused by a general upswing in the market rather than good corporate performance. If the price falls, directors will abandon their options and may even be given replacement options at a lower price.

Some directors have got their shares without having to meet any performance conditions at all and many others have been set very modest targets, the achievement of which has opened the door to very generous share rewards.

Observers have (quite rightly) seen these features as making a mockery of any claim that such arrangements offer directors any incentive to achieve high performance.

It has also been said that the diluting impact of these rewards on shareholder wealth has not been apparent from the company’s accounts. Share options were referred to only in the Directors’ Report and had no impact on the company’s profits or cash flow. In effect, they were funded directly by shareholders through dilution of their share value.

Companies wishing to operate share incentives now have to be sensitive to public concerns and must expect to be required to justify their schemes to shareholders, staff, customers and the world at large. This trend will grow and is already affecting the smaller public companies and other growing businesses. As part of their response to these concerns, directors (and remuneration committees in public companies) considering share incentive schemes are asking themselves and their advisers a wide range of questions.

The answers to these questions, they hope, will help them to construct share incentive schemes that work well for their companies at a cost that all parties can accept.

There are a few really key issues: which share incentive will be right for us? This is in fact two questions in one. What it usually means is what will work best for our company and (and I am sorry to say that the emphasis is most often placed here) what can we ‘sell’ to our shareholders?

Other interested parties are often ignored.

Corporate culture

There is a vast range of share incentive techniques that companies can use. What is right for each company will depend on its circumstances, and culture, and what it is looking for from the incentive scheme. It is crucial, however, that the share incentive arrangements adopted form part of a coherent remuneration policy. Greenbury and common sense require that the company’s programmes are consistent and all pull in the same direction.

In the past, some companies have been guilty of ‘impulse buying’ their share incentive arrangements, often motivated by the ‘me too’ spirit.

For some this has led to a hotchpotch of share incentive schemes, the rationale behind which the directors (or the chairman of the remuneration committee) are at a loss to explain.

What are our closest competitors doing? As well as a genuine interest in how other companies have solved the problem, this question can also reveal the assumption that following the herd will be safe. One of my clients once said (in another context) that he did not want to be the only one of his peer group to take a particular course of action, but neither did he wish to be the only one not to – he wanted to be in the majority.

Whilst it must be right that each company should not reinvent the wheel, it is dangerous to assume that a scheme adopted by your competitors will also be the best option for your own company’s success.

Slavishly following the market may not anyway protect the company from criticism. Many have found that such a policy has been viewed as a cynical way of ratcheting up directors’ rewards by ensuring that the median for the sector is steadily increased. I have also seen unfortunate chairmen of remuneration committees ambushed at their company’s AGMs by shareholders who have researched the market for themselves and who have formed a more modest view of the ‘norm’ than the committee.

Value added

What should share incentives aim to achieve? Every commentator, shareholder, institutional investor and employee agrees that share incentives should encourage directors to enhance corporate performance. When you try to discover what each means by that you find that differences soon appear.

Shareholders and institutional investors are looking for a mix of enhanced share value and dividend income (and often not the same mix), employees look for security of employment, job satisfaction, enhanced levels of pay (in its widest sense) and pension provision, and the company’s directors will have in their minds a whole range of different landmark achievements that they see ahead on the road to their vision of corporate success.

Accountants are often asked to advise on the use of traditional measures of corporate performance, for example, profit, earnings per share, return on capital employed, addition to net asset value, and so on, which will be more or less relevant as measures of corporate performance, depending on the company concerned. It is all too easy to get lost in the detail – complex models are difficult to operate, to justify to shareholders and to explain to the participants. The best of models can be open to manipulation (how many main boards have a good degree of control over their company’s earnings per share over the short to medium term?). The right balance has to be struck between an accurate measure of corporate performance for your company, simplicity of operation and transparency.

Open agendas

What will the future hold and how, for example, will such schemes be taxed? Companies considering these issues must do so in the UK political and commercial environment that applies in the second half of the 1990s.

For instance, the details of share incentives adopted by a company will now have to be disclosed in its accounts. Not only will the shape of the scheme be described but also the likely levels of rewards that individual directors will earn from it. This spirit of openness is a trend that will continue and we can expect companies’ accounts to contain more detail in the future rather than less.

The issue also has implications for corporate governance. For example, I have seen substantial support at AGMs for the suggestion that shareholders should approve directors’ entire remuneration arrangements on an annual basis. I think that, if there is a change of government, there is a significant risk that this directors’ nightmare might become a reality.

But the audience tracking directors’ share incentives is wider than just the company’s shareholders. Staff, suppliers and the world at large are sitting in judgement. That judgement is highly personal to the director concerned. It has been known to destroy the credibility of anyone perceived to have been trying to get more than his just deserts. I believe that a company’s decisions in this area will be of critical importance for each individual director and can even assume life-or-death importance for his career.

On the tax front, we have already seen changes in relation to the Inland Revenue-approved executive share option scheme. Its appeal was substantially reduced last year (although it remains a powerful tool in the employee share incentive tool box) but it seems unlikely that any UK government would prune it again.

Stakeholder shares

If there is a change of government, however, it is possible that legislation will be brought forward to encourage companies to adopt more widely based share incentives, consistent with a ‘stakeholder’ economy. Andrew Smith, shadow chief secretary to the Treasury, is on record as saying ‘All employees of firms should have opportunities to participate in share schemes on similar terms genuinely related to performance, and the tax system can encourage this’. This may mean grafting performance conditions on to the existing tax efficient share incentive arrangements. Alternatively, it may mean the adoption of new Inland Revenue-approved universal share schemes, perhaps governed by elected employee committees.

It is also possible that some of the tax consequences of selective share incentives (and in particular those now pressed into use to replace or supplement Inland Revenue-approved executive share option schemes, such as unapproved option schemes or restricted share plans) could somehow be made more onerous. Such an attack might take the form of accelerating the timing of any tax liability for the participants concerned, for example, by taxing the grant of the option rather than its exercise. It could mean restricting the company’s corporation tax relief for the scheme’s running costs perhaps by prohibiting relief for the contributions to a selective, restricted share plan.

This is a debate that’s not going to go away. Companies need to attract, retain and provide incentives for key employees and directors who are best able to generate the returns their shareholders demand. Any share incentive scheme adopted by a company for its directors and employees must focus primarily on the needs of its business and not copy the market for the sake of slavishly following the herd. If the business justification is valid, the task of explaining the scheme to employees, shareholders and the world at large will be a whole lot easier.

Simon Garrett is Managing Director of BDO Stoy Hayward Benefit Consulting Limited, the employee benefits and reward arm of BDO Stoy Hayward.

Nicholas Hood …

Wessex Water chairman Nicholas Hood announced at the AGM this month that the company will grant no more executive share options following a remuneration committee review of the Greenbury Report recommendations. He asked shareholders to approve a new long-term incentive plan to reward those executives who can significantly influence the fortunes of the business over a three-year period. The principal performance conditions are aligned with performance across the utility sector and demand a minimum two per cent increase in earnings per share over the Retail Prices Index.

George Simpson …

Defence and engineering giant GEC bows to shareholder fury over the huge share options payable to new managing director George Simpson, christened ‘the fattest cat of all’. It has tightened up the performance targets and the contract now delivers the bonus in return for growing GEC’s shareprice by 10 per cent more than the FTSE-100 Index over a period of three years instead of the previously stated six months. Simpson rakes in a total remuneration package worth up to # 1.5m a year, plus up to # 4.8m in shares and share options.

Sir Stanley Kalms …

Sir Stanley Kalms, chairman of electrical retailer Dixons, admits the company flouts the Greenbury report. He himself, not the recommended non-executive director, chairs the executive remuneration committee and the company has three such groups instead of the usual one. Dixons’ profits rose by 35 per cent last year to # 135m. Kalms collected a total pay package of # 885,000 last year, including a performance payment of # 236,000. He exercised options on almost 250,000 shares in 1995/6, making a profit of around # 157,000 and exercised another # 200,000 in May to make # 598,000.

Chief executive John Clare made a profit of # 382,000 by exercising options last year and finance director Robert Shrager # 188,000. Dixons is now launching a new long-term incentive scheme which could bring even greater rewards.


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