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A consultation document by the Department of Trade and Industry

Comments from ACCA
September 2003

Executive Summary

ACCA is pleased to comment on the consultation document Rewards for Failure: Directors� Remuneration � Contracts for Performance and Severance published in June 2003 by the Department of Trade and Industry (DTI).

ACCA believes that firm but practical solutions are required to address what has become a serious obstacle to the process of restoring trust in capital markets. It is necessary to address the issue of rewards for failure at several levels, involving all the significant stakeholders. Any satisfactory solution, therefore, requires that:

• shareholders be more effectively involved in decisions over pay
  
  
• remuneration disclosures are made on a timely and fully transparent basis
  
  and
  
  
• board members themselves display greater sensitivity to the relative balance of their pay and that of others in their company.
  

ACCA recognises that, in the post-Enron environment, board members may be exposed to greater personal liability and are rightly being subject to greater institutional oversight. Greater transparency over employment contracts at their inception should ensure that, in future, exit payments can clearly be related to contractual undertakings which, at the time they were entered into, were judged appropriate by all concerned.

Shareholders will be more effectively involved when they have appropriate information about the terms and conditions of directors� pay and performance, and when companies themselves introduce new, voluntary mechanisms, which allow shareholders to communicate with companies on such issues. Greater shareholder involvement, supported by broader non-executive director representation on remuneration committees, should, in turn, lead to greater sensitivity on the part of board members.

ACCA expects that the Higgs recommendations in respect of non-executive directors will lead to a greater sensitivity on the part of all board members in respect of remuneration issues generally. Nonetheless, the introduction of a standard measure tracking the relationship of board pay to average employee pay and return on capital employed would help to ensure that boards remain sensitive to the issue of compensation.

With the exception of this last point, ACCA strongly prefers a voluntary approach, which empowers shareholders, to one involving the introduction of new legislation.

General Comments

1. We present our general comments under two headings: discussion and proposed solutions.

   DISCUSSION

2. We are concerned that the questions raised in the consultation document fail to address the root of the problem, which is the lack of an effective restraint mechanism for directors� pay. We note that excessive directors� pay or rewards for failure have not been seen as a problem for companies outside the FTSE 350. Although the numbers of directors receiving excessive rewards for failure is small, however, such payments reflect an inappropriate culture at the top of an organisation. This can have a strong influence on the rest of the organisation and on society as a whole. Rewards for failure are therefore a symptom of a public interest problem.

   �Rewards for failure� in the wider context

3. We note that the purpose of this consultation is to seek views on "whether, and if so how, further measures are required to enable shareholders to ensure that compensation reflects performance when directors� contracts are terminated". It should always be borne in mind, however, that �rewards for failure� can arise when directors receive more payment than can be justified, both (1) when they leave an employment and (2) when they remain in their employment. Apart from termination payments themselves, termination is often the time at which existing contractual obligations such as vesting of share options and deferred bonuses crystallise. The problem of �rewards for failure� must therefore be considered as part of the wider subject of directors� remuneration. If directors� original terms and conditions are seen to be fair and reasonable, then any problem issues on termination should be dealt with automatically and satisfactorily.

   The lack of effective mechanisms for determining pay

4. As noted above, there is no effective mechanism for ensuring restraint in directors� pay, either during or after employment. As evidence, we cite US research, which highlights that in 1970 the average chief executive officer (CEO) was paid approximately 25 times more than the average worker. 30 years later this multiple had risen to 600. In the UK the average multiple for the FTSE 100 CEOs is nearer 80, but the trend is for multiples to increase. It was reported that last year UK directors� pay went up 7 times more than the increase in average earnings.
   
   
5. While a �market rate� for directors� pay may be said to exist, it is nevertheless difficult to justify existing levels of pay objectively. Market forces, in the usual sense of the term, have not applied because, unlike true markets, there has been no effective restraining influence. The alleged need to receive the �market rate� for the job has led to what has become, from the perspective of executives, a virtuous circle of ever increasing reward, unrelated to the economic performance of the company or the risks they take.
   
   
6. Previous attempts to address instances of excessive pay have met with little success. The requirement to disclose pay in the annual report has arguably served to increase demands for more pay, since no director wants to earn less than the average. Remuneration committees have generally not succeeded in ensuring restraint in spiralling executive pay. It is possible that remuneration committees do not have the right composition. They tend to comprise people who are themselves executive directors of other companies. Such a group is perhaps unlikely to be effective in keeping pay in line with company performance and other pay levels in the organisation.
   
   
7. Although few would argue that directors should not be well rewarded for adding value for shareholders, research suggests that in most companies, directors� pay bears little or no relation to company performance. It is important for regulators and others not to be too prescriptive when defining individual and company performance in what will often be complex situations. For example, an apparent �reward for failure� may arise if a successful executive in a successful company is tempted away to rescue a troubled company on the understanding that some compensation will be provided if the rescue is unsuccessful. Such a payment could be classified as �rewarding failure� but, in the absence of provision for such a payment, the company might be unable to attract the best people to effect the necessary turn-around.
   
   
8. The requirement for shareholders to vote on the remuneration report has had a beneficial impact because boards are unwilling to risk a negative vote. We are doubtful, however, that on its own this requirement to vote will do more than curb the worst excesses.

   PROPOSED SOLUTIONS

   Disclosure of remuneration policy and trends

9. Many of the issues could be dealt with by development and disclosure of a clear honest remuneration policy and reporting in line with it through the proposed mandatory Operating and Financial Review Statement. The new Combined Code omits the requirements for reporting the remuneration policy because this is now a legal requirement. However, the remuneration policy should drive remuneration arrangements and lack of adequate reference to the policy means that the Combined Code is less of a �self-contained stand-alone� document than it was before.

   Empowering shareholders

10. As institutional shareholders hold their investments on behalf of others, and the managers of these bodies are themselves well remunerated, they may lack sufficient incentive to curb all but the worst excesses. ACCA strongly recommends that government efforts should be focused on ensuring that individual shareholders have a voice and that institutional investors are genuinely accountable to the people whose money they look after.
    
11. Shareholders, institutional and individual, need to be well informed on a timely basis about pay and exit packages. In addition, directors should be required to demonstrate to shareholders that their pay is reasonable in relation to their own performance, company performance and employee pay. ACCA would like a standard measure used to track the relationship of board pay to average employee pay and return on capital employed, this would help to ensure that boards remain sensitive to the issue of compensation. Apart from this, we would not seek to prescribe how directors demonstrate that pay is reasonable, but transparency is essential. Transparency is best achieved by providing information based on appropriate benchmarking and supplying trends over time. We recognise, however, that it can be difficult to identify the best criteria for assessing performance and determining remuneration.

    Directors� employment contracts

12. It is important to get employment contracts right in the first instance. Companies should take reasonable steps to ensure that shareholders are satisfied with proposed pay and conditions. It seems generally accepted that directors� pay should be linked, in some way, with company performance. Unfortunately, incentive schemes can sometimes have unintended consequences and reward action which does not always lead to long-term added value for the company.
    
    
13. Transparency is essential and the Operating and Financial Review (OFR) will provide more opportunity for boards to explain how they evaluate both corporate and individual performance. The company remuneration policy, which is voted upon by shareholders, should describe the links between directors� individual performance and their pay.
    
    
14. Clearly, ensuring that shareholders are satisfied with proposed pay and conditions requires:
    
    
    • that shareholders have the information they need to make an informed evaluation
      
      
    • a means for shareholders to communicate their views
      
      and
      
      
    • a forum where dialogue can take place.
      
      
    Timing of disclosure
    
    
15. Normally the full extent of a severance payment will not be publicly known until the publication of the annual report for the year the payment was made. Details of payments should be disclosed earlier. The Listing Rules should be amended to require disclosure of severance settlements as soon as they are agreed or when a first payment is made � whichever is sooner.
    
    Enhancing communication
    
    
16. At present, only large (normally institutional) shareholders communicate with the representatives of a company board. The new Combined Code enhances this opportunity. Unfortunately, other shareholders have no means to communicate with the board, other than through the company general meeting. Individual shareholders often hold their shares through a nominee and lack even the opportunity to attend an AGM. It is unfortunate that the new Combined Code does nothing to improve the rights of smaller shareholders.

    Recommendations for government

17. There are several ways the government could explore ways of empowering smaller shareholders.
    
    
    • Encouraging companies to establish a web-based discussion forum for shareholders and requiring companies to respond to issues raised. Such a forum could allow shareholders to vote on issues proposed by them.
      
      
    • Counting and disclosing non-institutional shareholders� votes on pay policy separately. This would encourage such shareholders to vote.
      
      
    • Ensuring that remuneration committees are more representative of society. The Higgs report discusses ways of ensuring that non-executive directors come from more diverse backgrounds. This should encourage more realistic pay levels.
      
      
    • Including an employee representative on the remuneration committee.
      
      
18. Improving communication between shareholders and companies and empowering smaller shareholders on matters relating to directors� pay should help to ensure that board remuneration policies are subject to less criticism in the future.

    Answers to Specific Questions

    Q1. Views are sought on whether, and if so how, best practice on compensation and severance could be further extended to limit the total amount paid by:

    a) restricting notice periods (and therefore severance) to less than 1 year;

    b) capping the level of liquidated damages.

19. As indicated in our general comments, we consider that the solution lies with enabling shareholders and ensuring greater sensitivity and ethical awareness, rather than via legislation. Restricting notice periods may help. In the absence of other constraints, however, directors may choose to compensate for a reduction of notice period by demanding other means of payment. This could also apply to capping liquidated damages, where directors may insist on, and obtain , a level of damages set at a very high figure in order to receive the �market rate�.
    
    
20. It may be harder to ensure ethical behaviour and it is perhaps unfortunate that the Financial Reporting Council (FRC) did not make ethics a more explicit part of the new Combined Code. In a large organisation, the ethics of its staff reflects the ethics of society at large. Academics, however, have suggested that CEOs tend to have a different set of ethical values. Boards should be encouraged to review their, and their company�s, ethical performance and report on their procedure for doing this in a way similar to the way companies report on their review of internal control. Such a practice, particularly if it involves staff across an organisation, should encourage convergence of ethical values and practice between directors, staff and society.
    
    
21. A recent study by the Institute of Business Ethics concluded that there is strong evidence to indicate that larger UK companies with established codes of ethics (an indicator of a company operating ethically) out-perform (in terms of financial and other indicators) companies who say that they do not have a code.

    Q2. Views are sought on whether, and if so how, best practice could be further extended to encourage the operation of phased payments in order to restrict the level of any severance or compensation payment.

22. This suggestion does not address the root of the problem. Phased payments are only likely to discourage executives from finding another job until they have received their money.
    
    
23. Companies hiring a director before the end of a phased payment period will probably compensate him/her for any lost severance payment. Shareholders with a wide portfolio of shares are unlikely therefore to be spared the expense of funding the payment.

    Q3. Views are sought on how improvements in best practice might be most effectively promulgated (eg. Institutional shareholder guidance, Combined Code amendments).

24. It is time to consider more radical solutions as existing measures have not worked. We stated above several ideas that should be considered.
    
    
    • Encouraging companies to establish a web-based discussion forum for shareholders and requiring companies to respond to issues raised. Such a forum could allow shareholders to vote on issues proposed by them.
      
      
    • Counting and disclosing non-institutional shareholders� votes on pay policy separately. This would encourage such shareholders to vote.
      
      
    • Ensuring that remuneration committees are more representative of society. The Higgs report discusses ways of ensuring that non-executive directors come from more diverse backgrounds. This should encourage more realistic pay levels.
      
      
    • Including an employee representative on the remuneration committee.
      
      
25. None of these measures would require legislation.

    Q4. Views are sought on other best practice options which would have the effect of limiting severance payments in cases where a company has performed poorly.

26. We prefer that directors be awarded shares rather than share options. We suggest that, if share options are granted, a deferment mechanism is built in such that directors have to hold their shares, or cannot benefit from the exercise of their options, until a qualifying period has elapsed after they have left the company.
    
    
27. Severance payments are sometimes payments for silence. Such payments run counter to the need for transparency and should not be made.
    
    
28. It is conceivable that an executive has performed well but the company as a whole performs badly. The new Combined Code contains the principle that boards should evaluate themselves. Methods of evaluation will emerge that should enable better linkage between pay and long-term performance. The OFR will provide an opportunity for boards to demonstrate satisfactory linkage between company performance, their performance and their pay.

    Q5. Would it be possible, and if so in what ways, to legislate for contracts to include provisions which require the board to take into account underperformance in determining severance payments and which would avoid the potential for litigation?

29. Boards should take underperformance into account but, as indicated in our general comments, we do not believe that legislation would be the best approach. The new Combined Code requirement for board appraisal and the Company Law Review recommendations for enhanced disclosure in the OFR on performance should enhance transparency. These, in conjunction with a remuneration and severance policy and employment contracts which link pay to long-term performance, will help to ensure that underperformance is appropriately taken into account.

    Q6. Should companies legislation provide that the statutory period for a director�s contract would be limited to one year duration, or three years on first appointment, as recommended by the Company Law Review?

30. We believe that pressure from more empowered shareholders would mean that such legislation would be unnecessary. Nevertheless, we support this proposed amendment to legislation.

    Q7. Should companies legislation provide for the prohibition of rolling contracts having a notice or contract period in excess of the period permitted by section 319, as recommended by the Company Law Review?

31. Yes, this is also an area where legislation could be amended. Alternatively such a provision could be added to the Combined Code.

    Q8. Should companies legislation provide for the prohibition of covenants which provide for more compensation than would be available under a one year or three year term contract, as appropriate?

32. This does not address the heart of this issue. In any case, rather than legislation, it would be preferable to include this in the Combined Code. Such covenants if they exist should be disclosed to shareholders.

    Q9. Do you wish to make any comments on the costs and benefits of the proposals as set out in the Regulatory Impact Assessment?

33. We prefer option 2, which is the development of best practice guidelines. Ideally such guidelines should be part of or annexed to the new Combined Code.

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