Why UK listed companies are now considering replacing their LTIPs with Restricted Stock Plans
April 30, 2020
Back in November last year, the Investment Association (the “IA”) came out with these dramatic words:
“Alternative remuneration structures – We encourage all Remuneration Committees to evaluate their remuneration structures to ensure that they are appropriately aligned with the implementation of the company’s strategy.
In recent years, there has been a growing debate on the benefits of various long-term incentive structures. For many years, Long Term Incentive Plans have been introduced by companies and generally accepted by shareholders. However, IA members are increasingly of the view that the traditional Long-Term Incentive Schemes are not working as effectively as they could for all companies and can sometimes drive outcomes which can cause concerns for shareholders such as increasing grant levels or volatile and significant vesting outcomes.”
Research from the Purposeful Company has recently shown that there is a growing body of investors who are willing to consider alternative remuneration structures, if the Remuneration Committee can argue the strategic benefits of adopting such schemes. Following the Purposeful Company report, IA members commit to working with other stakeholders to look at the circumstances in which such schemes may be more widely implemented in the UK market. If needed the IA, will look to review the Principles of Remuneration as soon as possible after next year’s AGM season to reflect on any developments or changing expectations.”
These comments from the IA followed soon after the publication by the Purposeful Company of its Study on “Deferred Shares”. The Purposeful Company was established in 2015 with the support of the Bank of England to identify changes to policy and practice to help transform British business with purposeful companies committed to creating long term value through serving the needs of society.
The reference to “Deferred Shares” is really a reference to Restricted Stock (or Share) Plans. Under these types of plans, executives are simply granted a right to receive a number of shares in their employing company in three or five years’ time and provided the executive is still employed by that company at the end of the vesting period, he or she will receive that number of shares (subject to any tax and social security deductions that may be applicable) at that time. They will typically also receive the value of any dividends declared on their restricted shares over the course of the deferral or restricted period.
In effect the only performance criterion that will apply to a restricted share award is the continued employment of the award recipient throughout the vesting period.
These types of plans are already quite common in the US where they are typically structured and referred to as “RSUs” or Restricted Stock Units.
In The Purposeful Company’s Key Findings Report, it made (inter alia) the following statements:
• There is widespread support amongst investors and companies [in the UK] for greater adoption of deferred share models than we see in the market today.
• Overall the consensus is that such plans might be appropriate for 25% of companies or more, as opposed to the c. 5% that we see in practice today.
• Investors and companies generally see behavioural and practical benefits from a move to deferred shares, including long-term alignment and encouraging long-term behaviour, as well as greater simplicity and spending less time on executive pay and target setting. The academic evidence largely supports these views.
The Report also commented: “Investors highlighted two behavioural impacts above all others. Most investors believe that changing to deferred shares will encourage executives to take decisions in the long-term interests of the business and to execute strategy more effectively because they will not be distracted by LTIP targets.” Furthermore, they also highlighted a more practical benefit of these types of plans, they avoided the difficulties of long-term target setting.
The situation we now find ourselves in and which a large number of companies are struggling to deal with, is highlighting, more than ever before, just how difficult long-term target setting can be. For many companies in these worrying economic times, it will be practically impossible to say now, or even in the next three months, what are the right three year performance metrics that they should apply to their planned upcoming award of performance shares.
It is interesting in this context that the IA have just published another missive, this time about the effects of COVID-19 on executive remuneration policies. In this they say:
“There are concerns from companies and shareholders over the ability to set meaningful three-year targets at the current time and questions over the appropriate grant size given the share price reaction to COVID-19. In particular, Committees should be considering if it is appropriate to make LTIP grants at the current time and whether given the current market environment it might be more appropriate to postpone the current LTIP grant. Members believe that there are a number of options depending on the individual circumstances of the company:
1) Grant on the normal timeline setting performance conditions and grant size at the current time.
2) Grant on the normal timeline setting the grant size now but committing to set performance conditions within the next six months.
3) Delaying the grant to allow the committee to more fully assess the appropriate performance conditions and grant size. In such circumstances Committees should aim to make the grant within six months of the normal grant date.”
We are surprised that the IA is not suggesting a fourth option: to replace the current LTIP (presumably a Performance Share Plan) with a new Restricted Stock Plan and make awards under the new plan as soon as possible after shareholders’ approval for such a plan is obtained.
Perhaps one of the biggest questions around the concept of Restricted Share Plans is at what level should awards of deferred shares be made?
Again referring to the Key Findings Report of the Purposeful Company it had the following to say: “Investors and companies were broadly in agreement. Half of investors said they would require a discount of at least 50% in grant level, compared with the previous LTIP, to support a restricted share plan. Around half of companies also felt that this was appropriate. However, nearly 40% of companies said a discount less than 50% was required to make restricted shares attractive to executives (with responses evenly distributed between a 25% and 40% discount). Equally, 43% of investors said they would consider a lower discount than 50%.”
This provides very useful contextual background, and if asked to comment as a generality, MM&K would suggest that it would be appropriate that Restricted Stock Awards be made annually at around 60% of current Performance Share Plan Award levels.
So what is the experience of companies that have adopted Restricted Share Plans? For the most part they feel they are working well. However, they did acknowledge that they all encountered problems in getting agreement from shareholders at the time they were being implemented and that some proxy advisers challenged them purely on the grounds that they were “non-standard” and they were not able to tick the boxes which expected them to see long term performance metrics.
We hope and, in some ways, expect that the current economic climate will change investor attitudes towards these types of plans. In any event, any company considering going down this route will need to engage with its principal shareholders at an early stage and the remuneration committee will need also to put together a convincing argument that a new long term incentive structure of this kind is right for the company and all its stakeholders. MM&K would be pleased to assist any company considering a new plan of this kind.