The Department for Business, Energy & Industrial Strategy (BEIS) issued in late November the new U.K. government green paper on corporate governance reform, seeking views on three areas in which the government wants to update the regulatory framework.
These three areas are shareholder influence on executive pay, which the paper claims has grown much faster over the last two decades than both other employees’ pay generally and corporate performance; measures that could increase the connection between boards of directors and other stakeholders; and whether listed company corporate governance codes should be extended to the largest privately-held companies.
Responses to the proposals set out in the paper should be sent via e-mail by 17 February 2017 deadline.
The largest portion of the paper is given over to suggested pay reforms, many of which were set out in the speech Prime Minister Theresa May gave on launching her bid for the premier role. The paper sets the background by outlining the pay reforms that were introduced in 2013, which gave shareholders a binding vote on pay policies (at least once every three years) and an annual advisory vote on actual pay awards.
While there has been a lot of noisy protest around pay, approval of binding and advisory resolutions stood around 90 percent for the largest companies—lower than the U.S. average, but still high—and around 95 percent for small to mid-cap companies. Moreover, the numbers of resolutions actually rejected are tiny—five advisory and a single binding.
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On the other hand, 31 companies saw opposition to pay among shareholders of greater than 15 percent. Furthermore, an average of 28 percent of shareholders did not even use their pay votes, potentially indicating that they do not care about pay. Despite this comparatively low level of concern, the current government’s populist stance apparently still makes this a subject for reform.
"This Green Paper therefore focuses on ensuring that executive pay is properly aligned to long term performance, giving greater voice to employees and consumers in the boardroom, and raising the bar for governance standards in the largest privately held companies."
Theresa May, Prime Minister
The first option would be to make all or some part of the executive pay package subject to a binding vote. Within this, the binding vote could apply to the full remuneration report or refer only to variable pay, such as the annual bonus, the long-term incentive plan (LTIP) award, possibly including any proposed increase in basic salary. The binding vote could be applied annually to all companies or only to companies that have encountered “significant shareholder opposition to the remuneration report.” Significance is postulated in a range from 20 percent to 33 percent.
GREEN PAPER QUESTIONS
Below is a catalogue of Green Paper questions
Do shareholders need stronger powers to improve their ability to hold companies to account on executive pay and performance? If so, which of the options mentioned in the Green Paper would you support?
Does more need to be done to encourage institutional and retail investors to make full use of their existing and any new voting powers on pay?
Do steps need to be taken to improve the effectiveness of remuneration committees, and their advisers, in particular to encourage them to engage more effectively with shareholder and employee views before developing pay policies?
Should a new pay ratio reporting requirement be introduced? If so, what form of reporting would be most useful? How can misleading interpretations and inappropriate comparisons (for example, between companies in different sectors) be avoided?
Should the existing, qualified requirements to disclose the performance targets that trigger annual bonus payments be strengthened? How could this be done without compromising commercial confidentiality?
How could long-term incentive plans be better aligned with the long-term interests of quoted companies and shareholders? Should holding periods be increased from a minimum of three to a minimum of five years for share options awarded to executives?
Strengthening the employee, customer and wider stakeholder voice
How can the way in which the interests of employees, customers and wider stakeholders are taken into account at board level in large U.K. companies be strengthened? Are there any existing examples of good practice that you would like to draw to our attention? Which, if any, of the options (or combination of options) described in the Green Paper would you support?
Which type of company do you think should be the focus for any steps to strengthen the stakeholder voice? Should there be an employee number or other size threshold?
How should reform be taken forward? Should a legislative, code-based or voluntary approach be used to drive change? Please explain your reasons, including any evidence on likely costs and benefits.
Corporate governance in large, privately-held businesses
What is your view of the case for strengthening the corporate governance framework for the U.K.’s largest, privately-held businesses? What do you see as the benefits for doing so? What are the risks to be considered? Are there any existing examples of good practice in privately-held businesses that you would like to draw to our attention?
If you think that the corporate governance framework should be strengthened for the largest privately-held businesses, which businesses should be in scope? Where should any size threshold be set?
If you think that strengthening is needed how should this be achieved? Should legislation be used or would a voluntary approach be preferable? How could compliance be monitored?
Should non-financial reporting requirements in the future be applied on the basis of a size threshold rather than based on the legal form of a business?
Is the current corporate governance framework in the U.K. providing the right combination of high standards and low burdens?
Such a change would mean companies would need to word director service contracts so that it was clear that pay was awarded dependent on shareholder approval. Furthermore, the consequences of a negative binding vote would have to be worked out, as is happening currently in France.
The introduction of binding votes on only those companies that have had significant opposition to pay is similar to the Australian regime. In 2011, Australia introduced a ‘two-strike’ rule; if more than 25 percent of shareholder votes are cast against the remuneration report in two consecutive years then shareholders will be asked to vote on whether the company’s directors will be required to stand for re-election.
Other options for the pay vote are:
Have stronger consequences for losing an advisory vote (need supermajority next year)
Setting an upper limit on pay and require binding shareholder approval if this is exceeded
Require existing binding vote on pay policy to be conducted more frequently (or allow shareholders to require same)
Changing the current corporate governance code to put in place more stringent requirements for companies to engage with stakeholders following a significant minority or majority negative vote
The paper also raises the issue of pay ratio reporting, asking should the pay ratio between the CEO and the median employee be published, or should it rather be the ratio be between the CEO and the executive team and the next layer of management; this latter being another Investment Association principle. Here, as the paper says, context is everything, and such a requirement would allow the company to “explain to shareholders and wider stakeholders why the ratio is appropriate given the performance of the business and rewards for the general workforce.”
The counter-arguments to the publication of a pay ratio are the same as in the United States, where the finalised SEC rule seems likely to fall fowl of a Donald Trump administration. Those counter-arguments are:
Pay ratios would represent a new and onerous reporting obligation which would add little of value in helping to set appropriate pay levels.
Simple ratios of CEO pay to the median salaries could produce misleading results which could be misunderstood or misconstrued by the press and public.
Narrower ratios at financial services companies, where salaries are generally high, compared to companies in the retail sector, where salaries are much lower, means inter-industry comparisons are confusing.
It might also have the unintended consequence of incentivising outsourcing and offshoring to exclude the lowest paid workers from the calculation.
Encouragement to comply with extra disclosure advice on annual bonus performance measures has already begun to have effect. In 2014, only 36 percent of companies made full disclosure of threshold, target and maximum performance targets, says the paper, but in the 2016 annual general meeting season, 64 percent of companies have disclosed the full range, some in retrospect, and 95 percent have disclosed at least one performance target. The paper asks if non-legislative pressure on companies should be increased or whether retrospective disclosure should be made a reporting requirement.
As with the recent Executive Remuneration Working Group advice and the just published Investment Association pay principles, the paper has little to offer on LTIP reform other than the use of restricted shares and no vesting for stock options less than five years. Are there any other suggestions, it rather desperately asks.
Given the large portion of shareholders not voting on pay, one reform offered is mandatory disclosure of fund votes and the extent to which proxy advisors were used. Other options include:
establishing a committee of senior shareholders to advise on remuneration and strategy
consider ways to facilitate individual retail shareholders to exercise their rights
From the corporate side, there are more potential changes, such as:
requiring remuneration committees to engage with shareholders and employees prior to a pay vote
requiring any remuneration committee chairman to have sat on the committee for 12 months prior to becoming chairman, in line with recent Investment Association principles
But the proposed reforms are not just limited to the interests of the board and shareholders, but take account of a company’s responsibilities to “employees, customers, suppliers, and wider society.” Improving the diversity of boardrooms “so that their composition better reflects the demographics of employees and customers” is a part of these changes.
Its first proposal on stakeholder issues is to create stakeholder advisory panels “to hear directly from their key stakeholders and amplify voices with different backgrounds and perspectives to those more commonly found in the boardroom.” These panels could operate in a number of ways, including:
Directors could seek the views of the stakeholder advisory panel on particular board issues
Advisory panel members could be invited to board meetings to offer views when relevant
Stakeholder advisory panels could initiate discussions on topics that they feel are important
They could also be consulted on remuneration
The make-up of each panel would be different and would reflect the make-up of each company’s stakeholder group.
Alternatives to stakeholder panels are suggested, such as creating a specific board committee to consult with stakeholders and be their representatives. Or, and here the worker or customer representative board member idea briefly raises its head, to appoint individual stakeholder representatives to the board. However, in contrast to the clear notice that worker directors were coming in May’s inaugural speech, the green paper very specifically says that this will not be part of any mandatory legislation.
The paper also suggests strengthening reporting requirements in the strategic report so boards provide information on “how often, and by which mechanism, company boards are giving consideration to different stakeholder interests. This would involve a clear articulation of their progress to date on specific stakeholder issues, and their objectives for the coming year.”
Corporate governance in large private businesses
There are 2,500 private companies and 90 LLPs with more than 1,000 employees, and it is a growing sector of the economy in the United Kingdom, says the paper. Different governance standards must apply here, though, since governance typically protects owners who are far removed from management, while private companies often see ownership and management in tandem.
There is more at stake in governance, however, than ownership, the paper states. There must be protection of other stakeholders, including employees, customers, supply chains, and pension fund beneficiaries. Some private companies and partnerships voluntarily sign up for codes such as the Institute of Directors (IoD) private business governance code or the Financial Reporting Councils’ (FRC) audit governance code.
However, the paper also proposes formulating a formal private company corporate governance code to be extended to all private companies of a certain size. It suggests that either the FRC or IoD could come up with a more appropriate formal code for private companies with the same breadth as the existing public company governance code.
"One of the strengths of our system of corporate governance has been the use of non-legislative standards adopted by business itself."
Greg Clark, Secretary of State for Business, Energy and Industrial Strategy
Recent reporting requirements have been applied to all businesses above a certain size, irrespective of whether they were public or private. These include:
businesses operating in the United Kingdom and with a turnover of £36m (U.S.$45.25) or more are required to disclose the steps they have taken to prevent modern slavery in both their own business and their supply chains
employers with more than 250 employees will need to report by April 2018 on gender pay issues
large companies and large LLPs will need to report on their “prompt payment practices and on their performance against these practices” for financial years starting from April 2017
The green paper asks whether all reporting requirements be applied based on size rather than on legal status. Such a change could apply to new strategic report requirements and/or remuneration reporting requirements.
Clearly not all of these proposals will survive the consultation process, but the green paper is careful to note that many are not mutually exclusive and could be implemented in tandem with each other. Almost all of the current proposals, most importantly, continue to be within the voluntary ‘comply or explain regime’ which appears to be working extremely effectively for U.K. plc.