MM&K News

Launch of the Wates Principles for large private companies

As we have already mentioned in our “Executive Remuneration Landscape” article, which was published in our September e-newsletter, 2018 has been one of the most eventful years in terms of remuneration governance in the UK.

Earlier this year we saw the publication of the 2018 UK Corporate Governance Code, which is applicable to all companies with a premium listing on the London Stock Exchange and states general corporate governance principles for them to comply with.

Now, as we reach the end of the year, the Wates Principles for large private companies have been launched for companies to adopt for financial years starting on or after 1 January 2019. This new requirement applies to companies that have either or both of the following characteristics, and will cover about 1,700 private businesses:

• more than 2,000 employees;

• a turnover of more than £200m, and a balance sheet of more than £2bn.

The companies that adopt the Wates Principles as a suitable framework are expected to apply them fully and provide a supporting statement explaining how the Principles have been applied to create good corporate governance.

Ahead of the Launch of the Principles, the FRC organised a consultation, which closed on the 7 September 2018. As a result of this, we can see that a lot of respondents support the initiative; however, some expressed a concern about the ambiguity of the Principles.

We, in MM&K, support the initiative of the Wates Principles; the proposed Principles are short, logical points that map out the way towards a transparent corporate governance practice. The companies that apply the Principles will be able to develop/improve all aspects of their corporate governance. We also think that application of the Principles will generate a positive change in the relationship with stakeholders.

Without a doubt, the “BHS scandal” was a trigger to the formalisation of corporate governance practices in the UK for private companies. It is unlikely that the Principles would have prevented the scandal from happening; however, there is hope that it would have made the board aware of the damaging effect of their actions for other stakeholders. And this is one of the purposes behind the Principles – to bring awareness into the boardroom.

An especially remarkable aspect of the Principles, in MM&K’s view, is their “apply and explain” nature. It highlights the point that one size doesn’t fit all. Private companies have an opportunity to apply the Wates Principles the way they see fit. The freedom of interpretation makes the Principles appealing for a larger number of companies.

On 12 December, the FRC held a launch event for the Wates Principles, which yet again affirmed that the Principles are welcomed by the attendees, as many large businesses already have similar corporate governance policies in place; the Principles are viewed as a guideline to consistent reporting practice. The discussion panel saw additional value created for companies that adopt the Principles, and view it as a competitive advantage.

One of the points raised, as a part of a discussion at the launch even, was an adoption of a “Name and Fame” practice for monitoring purposes by the FRC. As a result, the FRC hopes to provide an illustrative guide on the good examples of the Principles’ adoption or of good corporate governance in general.

The Wates Principles were not designed for companies to “tick the boxes”, but to provide guidance towards a healthy corporate governance environment. The Principles are designed to help companies of all sizes and types to understand the good leadership and performance essential for a successful business.

For further information contact Margarita Skripina.

The Investment Association’s new principles of remuneration for 2019

Introduction

On 22 November 2018, the Investment Association (“IA”), wrote to the chairmen of the remuneration committees of FTSE 350 companies attaching its updated Principles of Remuneration.

These changes to the IA guidelines have been made against the backdrop of the new remuneration provisions in the UK Corporate Governance Code and the changes to the reporting of directors’ remuneration which is due to come into force for accounting periods beginning on or after 1 January 2019.

However, it appears that many of these principles are aimed at reducing the risk of “excessive” pay or increasing the justifiability of pay.

Main areas in respect of the principles of remuneration

The main policy areas for the new principles are as follows:

Levels of Remuneration

It was noted that levels of remuneration must reflect corporate performance and pay should be no more than necessary and linked to long term value creation.

The remuneration committee should seek points of reference against which appropriateness and quantum of pay is judged. Useful reference points are:

• prescribed policy that links remuneration to overall corporate performance

• the remuneration policy of the company as a whole

• fairly constructed peer universe

• remuneration paid to groups of employees including the median, upper and lower quartile through the use of pay ratios

Discretion

The IA observed that the discretion of the remuneration committee can assist in ensuring that executive pay schemes properly reflect overall corporate performance and value creation. It also observed that payment of variable remuneration to executive directors should be discouraged even if specific targets are met where the business suffers a negative effect and in such circumstances shareholders should be consulted.

The IA recommends that:

• the remuneration committee should be accountable for the way in which discretion is used and should have sufficient legal power to exercise discretion

• discretion should be used diligently, aligned with shareholders’ interest

• discretion to be exercised within policy boundaries

• use of discretion should be clearly disclosed

Pay for Employees below Board Level

The IA recommended that:

• the remuneration committee should have a role in pay for senior management and review workforce remuneration especially where the levels of pay or the risks associated with the activities are material to the overall performance

• the remuneration committee should fully explain why the pay figures are appropriate where they are reported and disclose any action necessary to rectify issues

Shareholder Consultation

IA expressed its concern that shareholder consultation is being used as a validation of decisions taken by the remuneration committee rather than taking and understanding shareholders’ views.

IA recommends that:

• consultation needs to focus on major strategic remuneration issues

• details of whole remuneration structure should be put forward so that the investors are provided with a full picture and sufficient information so that they can make an informed voting decision

• shareholders’ feedback and response should be listened to by companies

• remuneration committee should understand the voting policies of the shareholders

• after the end of the consultation process and before finalising details in the remuneration report, the remuneration committee should review policies taking into account subsequent events occurring in between so that the proposal remain appropriate

Malus and clawback

The IA observed that the current standard trigger events (gross conduct or misstatement of results) for malus and clawback are rarely used in practice. Moreover, even if a trigger occurs, it is difficult to relate the same to an individual director. It therefore recommends a significant strengthening of these provisions.

The new principles recommend that:

• a “more substantial” list of specific circumstances should be established when malus and clawback could apply and they should also be disclosed to the shareholders

• the malus and clawback terms are set out clearly and accepted by the executive (executives should sign a form of acceptance at the time of the award)

• LTIP rules, allied documentation and communications materials are consistent in relation to the scope and application of malus and clawback provisions

• remuneration committees should develop clear processes for assessing whether malus or clawback is triggered and how and when they will exercise a discretion to apply the such provision; the process and decision must be clearly documented

Shareholding requirement

The new principles include a recommendation that:

• executive directors and senior executives should build up a significant shareholding

• executives are encouraged to purchase shares out of their own resources to align their interests with the other shareholders

• remuneration committees should set out minimum shareholding levels and the time period in which to reach them for executives and also the consequences for non-compliance

• shares only count towards an executive’s shareholding if vesting is not subject to any further performance conditions; unvested shares not subject to performance conditions can count on a net of tax basis; vested shares subject to a holding period or clawback count towards the shareholding requirement

• shareholding used in hedging arrangements or as collateral for loans should be fully disclosed

Post-employment shareholdings

The new principles include a recommendation that:

• companies should set up post-termination shareholding requirement for a period of at least two years and at a level equal to the lower of the company’s shareholding requirement in force immediately before leaving or the executive’s actual shareholding on leaving

• remuneration committee should determine the structure and processes (which might involve using an employee benefit trust or nominee arrangements) to ensure compliance with the post-employment shareholding requirement

• the post-termination shareholding requirement should be introduced for all new and existing executive directors as soon as possible and by the next remuneration policy vote at the latest.

Pensions

The new principles include a recommendation that:

• pension contribution rates for executives should be aligned with those available to the majority of the workforce

• new executive directors and directors whose roles are being changed should be appointed on the new pension contribution level

• contribution rates for existing directors should be reduced over time to comply with this requirement. Clearly this reduction cannot be made without the agreement of the director concerned

Restricted Share Awards

Restricted shares (in the UK) are awards of shares (or nil cost options) which vest to the relevant director based on time only and not according to main performance conditions. The new principles include detailed recommendation on the awards of restricted shares, including:

• restricted share awards may be appropriate depending on the sector and situations such as turnaround situations; they should be assessed on a case-by-case basis, considering the context and the strategic rationale

• remuneration committees should have the ability to exercise discretion on vesting outcomes to ensure there is an appropriate connection between pay and performance and non-payment on failure; some investors have expressed a preference for a quantitative underpinning condition to be achieved prior to vesting

• vesting periods for restricted share awards should be at least five years; in addition, the post-employment shareholding rules should also apply

• if there is a proposal to switch to restricted share awards, investors will consider the company’s previous approach to remuneration, comparing the proposed award levels, performance and vesting criteria with previous award levels and performance conditions

• if the company moves from an LTIP to a restricted share awards, the remuneration committee should consider the appropriate discount to award levels; the discount should be at least 50% and grant levels should be held without gradual increase.

Leaver provisions

A new ‘leaver provision’ has been added with a recommendation that:

• individuals who are not ‘good leavers’ should be regarded as ‘bad leavers’; in other words there should not be any ‘intermediate leaver’ category

• for ‘good leavers’, only a portion of the award may vest based on time in service and achievement of the original performance conditions; however, if the award needs to vest early, for example on death, awards should vest by reference to performance criteria achieved over the shorter period

• deferred bonus and LTIP awards should continue to be satisfied in shares and subject to appropriate performance conditions

• appropriate mitigation clauses should be included in awards to deal with individuals retiring as a good leaver to take up further executive roles

For further information contact JD Ghosh or Michael Landon.

MM&K Annual Survey shows positive trends for Venture Capital Firms but a slowdown for Private Equity Firms

MM&K has published its 2018 PE/VC Compensation Report. The Report, published annually, provides participating houses with comprehensive and incisive up-to-date information and data on both the quantum and structure of remuneration paid to individuals working in and for PE & VC fund management entities in the UK and continental Europe.

2018 Outlook

The outlook for 2018 is now becoming clearer and in terms of deal activity, the statistics show a rather mixed picture.

European Private Equity (“PE”) activity, as measured by deal count, declined throughout the first three quarters of 2018. At the end of Q3, annual deal flow throughout Europe is showing a 15% decrease in the number of deals compared to the same period in 2017. Deal Value is also down by some 15%, suggesting perhaps that the uncertainty over Brexit is having an effect.

In contrast to PE, the Venture Capital (“VC”) industry appears to be booming with European VCs deploying capital at a record pace. However, the number of deals is slightly down on the same period as last year.

Looking at exits, it appears that there has been a 24% decrease in the number of PE exits in the first three quarters compared to the same period last year. This is in contrast to Venture, which has seen European exit activity at a four year high. The value of VC exits in the first nine months has exceeded their value in the whole of 2017.

But on another downbeat note for PE, LPs have so far committed €56bn to European funds that closed in the first nine months of the year, a noticeable decrease in committed capital compared to the same time period last year.

What all this will mean for PE and VC compensation next year is difficult to predict, although it suggests that the VC community will for once be seeing better rewards (relatively) than the PE houses. We would expect though that the industry’s focus on ensuring that the middle ranking investment roles are well rewarded (and therefore able to be retained within their current firms), will continue.

Whether these trends will affect the remuneration structures of both VC and PE portfolio companies, is another question…

If you are interested in finding out what else our 2018 Survey has to say, or are already thinking ahead to remuneration in 2019, please contact Nigel Mills or Margarita Skripina for further details.

New Investor Remuneration Guidelines

As we move into 2019, the investor institutions and proxy agencies have been busy, producing their revised remuneration guidelines.  After a very active year in corporate governance there are, not surprisingly, a lot of changes.

Starting with Glass Lewis: this major voting advisory agency has just issued its 2019 Proxy Guidelines specifically for the UK .  It is really worth reading, not least because the document provides the best summary we have seen of all the UK corporate governance regulations and other initiatives from 2018, put together in one place.

Their new guidelines focus particularly on the capability and evaluation of the board and its committees and the guidelines on remuneration itself are generally modest. One curious rule is that target bonuses should not exceed 50% of the bonus maximum.  MM&K considers that that this is misguided. The right relationship between the maximum bonus and the on-target bonus is not a matter to be dictated by rules.  It depends on the dynamics of the business, the extent to which out-performance is possible or likely and the sensitivity of forecasting.  There are businesses where target and maximum should be the same and others where 50% is fully justifiable.

On 22 November, The Investment Association (IA) issued its new Principles of Remuneration,  with a letter to Remuneration Committee Chairs from Andrew Ninian, its Director of Stewardship and Corporate Governance.

The new principles generally tighten up remuneration governance along the lines that the IA has been advocating since its Working Group reported in July 2016.  The circumstances and requirements for describing Malus and Clawback have been clarified further; further guidelines around the use of restricted shares have been introduced; and tougher requirements for directors’ shareholding are stipulated, including the need for a post-retirement shareholding period of at least two years.

It is clear that the IA sees reduction in the levels of executive remuneration as a legitimate goal.  For example, it mandates that, as soon as it is achievable within the limits of existing contracts, directors’ pension contributions should be aligned with those available to the workforce.  This rule, of course, is there to meet the requirement of Provision 38 in the 2018 UK Corporate Governance Code which comes into force from 1 January.  But it is also evident that IA members are coming under pressure from their clients to keep a ceiling on pay in “issuing companies” and curbing pensions is a gesture in this direction as well as appearing to be a move to reduce the gap between executive and general employee remuneration.  The IA press release says that “investors  will expect companies to pay pension contributions to Directors in line with the rate given to the majority of the rest of the workforce, rather than giving higher payments as a mechanism for increasing total remuneration.” In fact, the level of directors’ contribution has never been used as such a mechanism.   It has its roots in history, when all directors were on final salary schemes and the level of contribution was dictated by much higher final salary directors earned.  The DC contributions have been coming down over time as they could never be sustained at a level to match the old DB benefits. In any case, it is all rather academic as the HMRC Annual Allowance reduction of contributions to £10,000 a year means that most executives will receive cash in lieu and over time we expect that to become part of salary.

The IA is turning up the gas on corporate governance compliance. On 5 December it wrote to 32 companies in the FTSE All-Share which have appeared on the Public Register for both years. The letter expresses concern that these companies are on the Public Register for the exact same resolution in 2017 and 2018, suggesting that they did not respond sufficiently to investor views and in doing so are risking more shareholder dissent in the future. 15 of these are for Remuneration Report resolutions.

JD Ghosh will be writing a fuller article on the new IA guidelines for our December Newsletter. Click here to subscribe to our monthly e-newsletter.

The new IA guidelines are reflected in new house guidelines from Legal and General Investment Managers (LGIM), who updated their Principles on Executive Remuneration on 28 November.

The largest proxy agency, ISS, updated its 2019 Proxy Voting Guidelines for Europe, the Middle East and Africa on 19 November.  Changes include the criteria for voting down a director and a requirement for remuneration committees to develop a formal policy for post employment shareholding.  Like Glass Lewis, they say that the target bonus should typically be set at no more than 50% of the maximum bonus potential, with a demand for a robust explanation for any payments above target.  The intention behind this is to stop excessive payments for mediocre performance.  But we consider it is a blunt instrument.

ISS have sharpened up the guidelines on LTIP performance measurement and shareholding periods. They encourage performance periods longer than three years and a total holding period of five years. They suggest that on-target vesting for LTIPs should be less than 25% if the total grant is a large multiple of salary.

If a company’s share price has materially declined, the guidelines say, committees should consider reducing the size of LTIP grants.  ISS are trying to avoid the situation where the number of shares covered by the grant is increased in order to preserve the face value of the grant.  This can lead to excessive reward if the share price bounces back.

Finally they advise dilution limits in line with the IA guidelines.

The various guidelines can be downloaded by clicking on the links.  For further information contact Damien Knight.

Valuation of share-based remuneration:  importance of underlying assumptions

There are particular circumstances when a company needs to calculate a fair value of share options or performance share awards.  As the majority of performance shares in the UK are structured as nil-cost options this article refers throughout to options only. The most common circumstances are:

1. To recognise an accounting expense under IFRS2 or FRS102 (the Finance Director’s nightmare)

2. To agree the taxable value of the grant with HMRC – this can be needed, for example, to determine the taxable value (if any) on the acquisition of restricted securities, including growth shares or JSOP interests.

3. To ‘benchmark’ share-based rewards against competitive practice more precisely than would be possible using the ‘face value’ of the shares involved, for example where there are different performance conditions for the company’s own share-based rewards and for those of a comparator company.

4. To compare the value of share-based incentives with other parts of the remuneration package, where a trade-off between elements is being considered: such as a choice between share-based incentives and cash payments, or between different forms of long-term incentive.

In each case, another party has to be satisfied that the resulting fair value is indeed fair – the auditor on behalf of the shareholders, HMRC, the remuneration committee and the executives receiving the grants.  Executives frequently prove to be the hardest to convince.

Nevertheless, it is probable that very few of these parties really understand the mathematics involved, and most take the calculation on trust or apply some standard formula.  In fact, the final value is surprisingly sensitive to the valuation assumptions, such as share price volatility and the expected period before an option-holder chooses to exercise (“option life”).

Volatility is the key to calculating the value of share options and performance share awards with market-based vesting hurdles.  The future pay-off from an option is a positive value or zero, depending on whether the share price at the time of exercise is higher than the exercise price (which is usually, but not necessarily, the share price at grant).  There are two components to the price increase: the underlying drift of the share price (a function of market expectations) and the extent to which the seemingly random daily changes add up to produce a resultant increase or decrease. If a share price experiences large daily fluctuations, we say that it has high volatility.  With a more volatile share price there is more chance of a high gain at exercise.  There is also more chance of a low downside in the share price, but because the pay-off cannot be less than zero (the option holder just would not exercise), this does not cancel out the extra value from the possibility of a high upside.

Before we consider how different volatility assumptions affect the value of a share option, we need to find a workable definition of volatility.  To calculate the daily volatility, we look at the standard deviation of the logarithm of the ratio of each day’s share price to that of the previous day. We then multiple this daily volatility by the square root of the number of trading days in the year to get the annualised volatility, which is the measure used in valuing options. We take the natural logarithm because it results in a normal “bell curve” for compounding returns – which makes it possible, later in the valuation process, to model future outcomes randomly in our valuation model. A key assumption in share price forecasting is that returns are normally distributed.

Not surprisingly, the value of a share option is highly sensitive to the assumption about share price volatility.  The graph below shows how the fair value of an option varies with volatility in a typical company. For clarity, we have expressed the fair value as a percentage of the face value of the shares under option.

At 10% volatility, the fair value is 15% of the face value of the share. At 40% volatility, the fair value is 43% of the face value, with close to a straight line relationship in between.   The fair value per share is almost three times as much at 40% volatility as it is at 10% volatility.

We can see that this variation matters when we make assumptions about likely future volatilities.    The reality is we do not know what the future volatility will be or how it will vary.  Most companies rely on the past as a predictor of the future.  If the company issues traded options, we can work out the implied volatility (ie the volatility assumed by market makers) but this will not apply for most smaller companies.

The situation is even more difficult if we are dealing with a private company. The company is probably valued once a year for tax purposes or for internal share transfers.  The valuation methodology typically uses a profit multiple, or maybe a projection of future profits.  In this circumstance, there is no measurable “wiggle” in the share price.  The company has to estimate its volatility, for example by using an average of the observed volatilities of listed peer companies in its sector to provide a proxy.

The table below shows how the volatility of one listed company’s shares has fluctuated, depending on the quarter over which it is measured.  The volatility varied by a factor of three, depending on the period chosen, ie Q1 2017 vs Q2 2015.  Neither historical period has a superior claim to representing the future.  There may be industry characteristics for 2017 which suggest that figure is a better predictor because it is more recent, but it depends largely on judgement.  As shown in the graph above, the volatility assumption has a crucial impact on the value of an option or performance share award.

Conclusion

Depending on the purpose of valuation, the company has a lot of opportunity to choose volatility assumptions which suit its own purpose, provided it can persuade the interested parties, HMRC, shareholders or executives, that the final result is reasonable – one might say “fair”. This persuasion/ negotiation is more important than the mathematical result.  It could well be easier to take a rule of thumb of, say, 30% of face value (MM&K uses 30% of face value for share options in surveys and this is often talked about as a market norm) and agree with the relevant parties that that is a fair figure for the particular purpose in hand.  Unfortunately HMRC is currently insisting that a Black-Scholes or similar option-pricing model is used for valuation of growth shares and JSOP interests, which therefore requires the use of a volatility assumption, even though we have shown this is effectively arbitrary.

Volatility is not the only assumption that introduces a large degree of imprecision.  We also have to decide the likely behaviour of participants in exercising their options – in order to determine the option life (grant to exercise period).  The graph below shows the impact of different option lives for the value of the option in a typical company.  This is yet another reason for agreeing a rule of thumb.

For further information contact Damien Knight

Changes announced in the Budget to the rules for entrepreneurs’ relief

Introduction

While there had been concerns whether entrepreneurs’ relief (which reduces the rate of capital gains tax for higher and additional rate taxpayers from 20% to 10% on the first £10 million of an individual’s qualifying lifetime gains) would be significantly reduced, or even abolished, in the Autumn budget, the Chancellor has confirmed that the relief will be retained, albeit with a couple of changes.

Until 28 October 2018, entrepreneurs’ relief was available on the disposal of shares in a trading company (or shares in a parent company of a trading group) by an employee shareholder provided that throughout the period of one year ending with the date of disposal (the ‘qualifying holding period’):

(a) the company is the individual’s ‘personal company’, and

(b) the individual is an officer or employee of the company (or, if the company is the parent company of a trading group, of a group member).

For a company to be a ‘personal company’, the individual is required to hold at least:

• 5% of the issued ordinary share capital of the company and

• 5% of the voting rights of the company.

Changes effective from 29 October 2018

The first change to entrepreneurs’ relief is that, with effect from 29 October 2018, a company only qualifies as a ‘personal company’ if, in addition to the requirements relating to share capital and voting rights, the individual is also beneficially entitled to at least:

• 5% of the company’s distributable profits, and

• 5% of its assets available for distribution to equity holders on a winding up.

How does this change affect employee incentives?

There is no immediate effect on EMI Option holders, including holders of EMI Options over ‘growth shares’ (i.e. a special class of shares which gives the holder the right to share in the growth in value of the company in excess of a pre-determined hurdle). EMI Option holders continue to enjoy the benefits of entrepreneurs’ relief on the disposal of their qualifying shares.

However, other employee shareholders who typically only hold 5% or more of a class of ‘growth shares’ with voting rights will be adversely affected. With effect from 29 October 2018, their rate of capital gains tax on disposal of their shares will increase from 10% to 20%, because they will not meet the two additional requirements of having a beneficial entitlement to 5% of the company’s assets and distributable profits.

These changes have been brought in to counter incentive structures that the Government considers to be tax avoidance, where the incentive arrangement has been designed to comply with the letter but not the spirit of the conditions for entrepreneurs’ relief.

Changes effective from 6 April 2019

The second change to the entrepreneurs’ relief is that, for disposals on or after 6 April 2019, the ‘qualifying holding period’ (see above) has been increased from one year to two years.

In other words,  entrepreneurs’ relief will only be available on the disposal of shares in a trading company (or shares in a parent company of a trading group) by an employee shareholder provided that throughout the period of two years ending with the date of disposal (the ‘qualifying holding period’):

(a) the company is the individual’s ‘personal company’ and

(b) the individual is an officer or employee of the company (or, if the company is the parent company of a trading group, of a group member).

How does this change affect employee incentives?

Practically speaking, this extension to two years is unlikely to have much impact on the majority of employee shareholders (who are otherwise eligible for entrepreneurs’ relief including EMI Option holders). The press release suggests that 95% of disposals already meet the two year qualifying holding period.  To qualify for the relief, an EMI Option holder must not dispose of the shares acquired through the option until at least two years after the option grant date.

Dilution protection

Legislation will also be introduced from 6 April 2019 to protect an individual’s entrepreneurs’ relief entitlement up to the point that the individual’s shareholding is diluted below the 5% qualifying requirement as a result of funds raised for commercial purposes by the issue of new shares.

A new provision will apply where a company has issued shares for cash consideration for genuine commercial purposes, which has caused an individual’s shareholding to fall below the 5% personal company threshold. If gains on share disposals prior to the issue would have qualified for entrepreneurs’ relief, individuals may elect to be treated as having sold and reacquired their shares at market value immediately prior to the dilution, giving rise to a chargeable gain on which they can claim entrepreneurs’ relief.

There will also be a provision for a second election to defer the gain until an actual disposal of (or of interests in) the shares or securities.

For further information contact JD Ghosh or Michael Landon

Largest AIM companies stick with UK Corporate Governance Code

AIM companies are required to adopt a recognised corporate governance code – which one do they choose? One of the main attractions of listing on the AIM market is the reduced regulatory requirements compared to a main market listing, but do the biggest AIM companies take advantage of this, or do they stick with the UK Corporate Governance Code?

This summer we saw a number of significant changes in light of the UK Government’s wider corporate governance agenda. Alongside the introduction of a new UK Corporate Governance Code and an updated QCA Corporate Governance Code, the amendment to AIM Rule 26 requires all AIM companies to select a corporate governance code.

Under this rule, as of 28 September 2018, every AIM quoted company must state on its website which recognised corporate governance code it has decided to apply and to explain how it complies with that code. They also need to provide an explanation of any departures from that code.

Many AIM quoted companies previously stated that they complied with the UK Corporate Governance Code or QCA Code “so far as appropriate for a company of this size” or something similar, i.e. that they do not comply in full (a qualified compliance statement). Such terminology is no longer acceptable and substantive disclosure is expected.

MM&K has investigated the corporate governance statements of the 20 largest AIM quoted companies (by market capitalisation).

11 of these companies have adopted the UK Corporate Governance Code, eight have chosen to comply with the QCA Code and one, Burford Capital, reports against the Guernsey Finance Sector Code of Corporate Governance. Research by the QCA itself into the practice of all AIM listed companies (over 900 companies) shows that 89% have adopted the QCA Code rather than the UK Corporate Governance Code. It is clear that the dominance of the UK Corporate Governance Code among the top AIM quoted companies is a feature of company size.

In terms of level of detail, the corporate governance statements are generally similar. Companies following the UK Corporate Governance Code give a broad explanation of how they comply with its five main principles under the following headings:

1. Leadership

2. Effectiveness

3. Accountability

4. Remuneration

5. Relations with shareholders

Those following the QCA Code provide a broad explanation of how they comply with its 10 principles, which are:

1. Establish a strategy and business model which promote long-term value for shareholders;

2. Seek to understand and meet shareholders’ needs and expectations

3. Take into account wider stakeholder and social responsibilities and their implications for long-term success

4. Embed effective risk management, considering both opportunities and threats, throughout the organisation

5. Maintain the board as a well-functioning, balanced team led by the chairman

6. Ensure that, between them, the directors have the necessary up-to-date experience, skills and capabilities

7. Evaluate board performance based on clear and relevant objectives, seeking continuous improvement

8. Promote a corporate culture that is based on ethical values and behaviours

9. Maintain governance structures and processes that are fit for purpose and support good decision-making by the board

10. Communicate how the company is governed and is performing by maintaining a dialogue with shareholders and other relevant stakeholders

The majority of companies make references in their website statement to their Annual Report, for example by providing a link to the Remuneration Report for further details on the committee’s activities. Several also point the reader towards the corporate governance statement in their Annual Report.

At the beginning of their statement, some companies clarify whether they believe they have complied fully with the code. For example, Fevertree Drinks plc’s statement includes “Given our stage of development there are certain provisions of the Code which we do not feel are appropriate for the Group at this point in time and therefore do not fully comply, further details on which are set out below”. However, only five companies include a statement similar to Fevertree’s, with a further four proclaiming they have not departed from the code in any way. For example, Secure Income REIT plc state “As of 6 September 2018 the Board does not consider there to be any areas relevant to the Company where it does not comply with The Code”. The remaining 11 companies are less explicit on departures from their chosen code.

The five companies referred to above are clear in explaining how and why they have not complied; a common departure was from provision B.1.2 of the UK Corporate Governance Code, which states that, except for smaller companies, at least half the board, excluding the chairman, should comprise non-executive directors determined by the board to be independent. The reason typically given is that despite non-compliance, the board has an appropriate balance of skills, knowledge and experience to enable it to discharge its duties and responsibilities effectively.

Another trend is the inclusion of an introduction outlining the company’s beliefs and philosophy surrounding corporate governance. ASOS plc, for example, included the following one by the Chairman:

“For ASOS Plc, ‘Doing the Right Thing’ is pivotal to every part of the business model and good corporate governance is a key part of this. As an AIM listed company with a significant market capitalisation, we recognise the need for ensuring that an effective governance framework is in place to give our external investor community and our employees and suppliers, the confidence that the business is effectively run”.

Seven companies divulge their corporate governance philosophy (in six cases it is in the form of a chairman’s introduction).

Hurricane Energy plc provides an interesting example of switching from the QCA to the UK Corporate Governance Code. In 2017, the Board decided to change due to the company’s size (Hurricane’s market capitalisation rose from under £65m at the start of 2016 to a peak of over £800m in 2017). Still, company size is not the only factor in deciding which code to follow, both Boohoo Group plc and RWS Holdings plc follow the QCA Code and have larger market capitalisations than Hurricane (£1.3bn and £2.4bn respectively).

The requirement of AIM Rule 26 is very recent. The test of any code and disclosure under it is whether it provides shareholders with the information they need to exercise their stewardship or make decisions on their own behalf in the case of beneficial shareholders. We would expect shareholders to assess over the coming year whether companies are providing this information and to influence companies to change code if necessary. It will be interesting to see if the higher “outcome focus” rather than procedural focus in the QCA Code will lead some shareholders to prefer the AIM companies they invest in to use the QCA Code.

For further information contact Harry McCreddie or Margarita Skripina

Remuneration Consultants Group (“RCG”) Recruitment of New Chairman

The Remuneration Consultants Group comprises the 11 UK consultancies that advise the remuneration committees of larger companies. The RCG manages the voluntary Code of Conduct (‘the Code’) that sets out the role of executive remuneration consultants and the professional standards by which they advise their clients. It was formed following the Walker Report in November 2009.

The Board is looking to appoint an independent Chair to replace the current chairman who is stepping down after 8 years in the role. The Chair provides strategic direction to the Board – gained by prior experience as a senior NED able to demonstrate a clear understanding of the operation of remuneration committees (ideally as Chair of such a committee at a FTSE350 company). The time commitment is in the region of 10 days each year.

In addition to attending Board meetings, the Chairman will be required to lead the Board in the review of the Code and of its effectiveness which may include interviews with representatives of institutional shareholders and chairs of remuneration committees on an annual basis. The Chair is responsible for leading on the appropriate communication strategy for of the Code. To date this has included occasional press interviews.

The appointment will normally be for an initial term of three years commencing on or shortly following 1 January 2019.  Fees are currently £40,000 for this role.

To obtain full details of the role and how to apply, please contact Damien Knight

Changes announced in the Budget to the rules for entrepreneurs’ relief and their impact on employee incentives

Entrepreneurs’ relief reduces the rate of capital gains tax from 20% to 10% on the first £10 million of an individual’s qualifying lifetime gains. It is available on the disposal of shares in a trading company (or shares in a parent company of a trading group) by an employee shareholder provided that throughout the period of one year* (see below) ending with the date of disposal:

(a) the company is the individual’s ‘personal company’ and

(b) the individual is an officer or employee of the company (or, if the company is the parent company of a trading group, of a group member).

Until 28 October 2018, for a company to be a ‘personal company’, the individual was required to hold at least:

• 5% of the issued ordinary share capital of the company and

• 5% of the voting rights of the company.

Changes effective from 29 October 2018

With effect from 29 October 2018, a company will qualify as a ‘personal company’ if, in addition to the requirements relating to share capital and voting rights, the individual is also beneficially entitled to at least:

• 5% of the company’s distributable profits and

• 5% of its assets available for distribution to equity holders on a winding up.

How does this change affect employee incentives?

There is no immediate effect on EMI Option holders, including holders of EMI Options over ‘growth shares’ (i.e. a special class of shares which gives the holder the right to share in the growth in value of the company in excess of a pre-determined hurdle). EMI Option holders continue to enjoy the benefits of entrepreneurs’ relief on the disposal of their qualifying shares.

However, other employee shareholders who typically only hold 5% or more of a class of ‘growth shares’ with voting rights will be affected as, with effect from 29 October 2018, their rate of capital gains tax on disposal of their shares will increase from 10% to 20%, because they will not meet the other two requirements re having a beneficial entitlement to 5% of the company’s assets or distributable profits.

These changes have been brought in to counter incentive structures that the Government considers to be tax avoidance, where the incentive arrangement has been designed to comply with the letter but not the spirit of the conditions for entrepreneurs’ relief.

Note also that the Government has announced proposals to introduce new legislation, applicable to disposals after 5 April 2019, increasing from one to two years the holding period that must be met. This change will affect holders of EMI options, who after 5 April 2019 will need to have held their EMI options (or shares) for at least two years before their disposal for Entrepreneur’s Relief to be available.

* Also for disposals after 5 April 2019 the requirements that need to be met throughout the period of one year* ending with the date of disposal (referred to in the Introduction above) will need to be met for a period of two years ending with the date of disposal.

For further information contact JD Ghosh or Stuart James

Are chief executives overpaid?

In October 2018, Deborah Hargreaves published a new book, under the title “Are Chief Executives Overpaid?”. The question, of course, is rhetorical.

Hargreaves is an ex Guardian business editor and FT journalist who has made it her life’s work to attack fat cat pay, which she believes is having a corrosive effect on the cohesion of our society and is putting liberal capitalism at risk.

Hargreaves has been most effective at creating visibility in this area, although I suspect she fans the flames of discord rather than dampening them down. She was the original Director of the High Pay Commission in 2009 which was founded and funded by Compass, the centre-left pressure group, aligned with the Labour Party.  Compass’ mission was to get the Labour Party re-elected, and they figured that dissent over executive pay was a good lever for winning votes.  Mirroring the name of an existing official body, the Low Pay Commission, was a clever ploy.  It gave the High Pay Commission immediate credibility and a quasi-official status.

In 2012, Hargreaves set up The High Pay Centre (the HPC), its successor organisation.  She describes it as an independent think tank, not aligned with any political party, although its spiritual affiliation to the Labour party is evident.

Hargreaves has very firm beliefs on executive remuneration.  She believes it is a manifestation of human greed and is escalating far beyond the pay of the average worker and in a way that bears no relation to company performance.  Current pay differentials are essentially unfair. Chief executives are not worth anything like the amounts they are paid.  She is more sympathetic to entrepreneurs who are people creating wealth through their energy and ideas.  But “captains of industry” are essentially bureaucrats – they administer a system someone else has created. This refusal to believe they add so much more value than the average worker leads Hargreaves to use such ploys as “a captain of industry in the UK take 129 times the annual income of someone on average wages” and the more dramatic statement that before the end of the first week in January they will have “notched up” more income than the average annual wage.

In keeping with those beliefs, Hargreaves’ language is heavily value-laden.  Executives “pocket” their pay. She talks about “late-stage capitalism”. Remuneration governance is a “religious cult”.  Thatcherism was intended to free the “supposed” entrepreneurial spirits in people.

In her criticism of the conspiracy of excessive executive pay Hargreaves takes a swipe at pretty much everyone. US business schools take a lot of stick – principal-agent theory “doing the rounds of US business schools”.  Head-hunters are a “coterie” drawing from the same pool of usual suspects.  Institutional shareholders are too self-interested to act as effective policemen for executive excess. They provide “weak oversight”.  Government crumbles in the face of corporate UK and US. Remuneration committees are afraid of the executives. Former civil servants (in nationalised industries) were “pitched into the premier pay league”.  Remuneration consultants, the “high priests of the religion”, work to create high pay through benchmarking, chasing the upper quartile and opaque and complex incentive design.  Tony Blair and New Labour sought a cosy relationship with big business. Even Joe Public comes in for criticism: “The modern economy has succeeded in turning peoples’ needs (the basic material goods required to achieve a secure standard of living) into wants which are never-ending.”  The puritanical nature of these views indicate an aversion to people earning “loads-a-money” and a desire to produce any argument as to why they do not deserve it.

You can feel sympathy for Hargreaves’ view point.  But what disturbs me is her careless use of statistics to support her case and the willingness of business editors and politicians of all parties to accept these statistics without question.  One notorious piece of earlier HPC “research” served up again by Hargreaves is the report of October 2014, Performance-related pay is nothing of the sort, produced for HPC by the now defunct Incomes Data Services. This was an appalling piece of sophistry: a fishing expedition which showed no real understanding of statistics or maths.  It was full of errors, but one notorious example will suffice here.  IDS plotted executive bonuses against company profit for 350 companies on one chart.  They showed there was virtually no correlation between profits and bonuses on their graph, and their conclusion was there was no relationship between pay and performance. But this was just nonsense maths. I will demonstrate why. Let us say you paid a CEO a share of profits in his or her company and nothing else, there will be a 100% correlation between his or her bonus and his or her performance.  If you accept profit as the measure of performance, his or her pay is perfectly related to performance.  Now If you do the same thing for CEOs in five companies – all paid on a profit share, but with a different profit percentage, the correlation for each company is still 100%, but the overall picture become blurred and the overall correlation falls dramatically.  Graphically, the points are all over the place because the percentage share varies by company.

In fact IDS did this exercise not for five, but for 350 companies, the FTSE 100 and FTSE 250 combined, again making the assumption that profit was a good performance measure. Not surprisingly they found the correlation to be vanishingly small for the sample as a whole.  Does this mean that bonuses bore no relation to profit for these companies?  Of course not: you have to look at the correlation company by company, not the market as a whole– but that is what the IDS study concluded.  They then went on to do the same thing with long-term incentives and relative TSR.  Same conclusion: no relationship to performance.  At the report launch meeting, John Plender, the FT financial journalist sighed with relief “I always suspected this was the case” and heads all around the room nodded.  Since then the canard has been repeated time and again.  David Davis, the right wing Tory MP wrote an essay for the High Pay Centre in which he said “CEO pay has massively outpaced anything with which it can even remotely be correlated”.

Rachel Reeves, chair of the Commons BEIS select committee told the Mail on Sunday the committee is going after the fat cats again later this Autumn.  Their April 2017 report said “executive pay is increasing at a rate that vastly exceeds increases for ordinary employees and which seemingly is at odds with the value created in the company”.  This statement is wrong on both counts – Minerva (formerly Manifest) data shows that, since 2010, CEO salary increases have fallen to a level much in line with the 2%-3% increases in the general workforce and this is has been the case for the past eight or so years.  What have gone up are the earnings from long-term incentives but this is precisely due to share price increases and consequent shareholder returns ie “the value created in the company”.

Does this inaccurate propaganda matter?  Well yes it does.  It becomes accepted as fact and it affects Government policy and inflames public disenchantment with business.

Hargreaves takes another swipe at non-executive boards, who she thinks are not doing their jobs effectively. Then she adds “ remuneration committee members are well-paid too.  Average pay for a remuneration committee member was £441,383 in 2015 (remember they are part-time jobs), 16 times the average for a UK employee”. This suspiciously precise figure is in fact dangerous rubbish.  The proxy agency Minerva produced an analysis for the MM&K Chairman and Non-Executive Director survey covering 2015.  The average total fees for a FTSE 100 NED was £115,386 (median £94,000).

These figures are accepted by journalists and politicians simply because they want to believe them.

This is from Margaret Hefferman in the FT on 1 October 2018:

“Hargreaves amasses devastating data to prove that performance-related pay massively outpaces all rational measures, and that rewarding failure is routine”.

Powerful stuff, except it is not true.  People want to believe it because they resent the pay for top executives in a way they do not, for example, resent pay for international football stars (Ronaldo and Messi each earn about £40m gross per annum at Real Madrid).

Hargreaves devotes quite a lot of the book to arguing that companies introducing performance related pay fail to understand human motivation.  Executives do not need all this money.  But this misses the point. By blaming executive greed, Hargreaves’s book does not follow through on the real economic issue, which is low pay for the average worker. She blames low wage growth on low investment which in turn she blames on executive incentives with a short-term focus.  She would rather pay the money directly to the workers than increase investment.  She claims to believe in free markets, but doesn’t like it when the market decides some people are worth a lot of money and pays them accordingly.  This jars with her puritanical viewpoint.  Hargreaves ends her book with a menu of actions that could be taken to pull down the share of wealth taken out by top executives:

• Put up top taxes for executives and corporations.  Block loopholes.

• Publish tax returns on-line like Sweden does (the “shaming” approach).

• Move corporate focus away from achieving returns for shareholders towards achieving benefits for stakeholders, especially workers so as to create a new corporate ethos. She (wrongly) claims that the legislation for requiring the delivery of benefits to wider stakeholders already exists in Section 172 of the Companies Act.  (In fact Section 172 requires boards to have due regard for the interests of these other groups, but shareholder interests clearly have primacy.)

• Give the workers a say in bosses’ pay – by a worker representative on the remuneration committee or board (“to inject some common sense”) or even by having a worker’s vote on the remuneration policy.

• Improve companies’ consultation with workers.  Introduce a structure of councils.

• Give the FRC the power to investigate and prosecute company directors for poor corporate governance. Create new statutory bodies in the UK and US focused purely on corporate governance, with new enforceable guidelines.

• Phase out LTIPs.

• Make any bonuses a pure profit share only.

• Pay cash only – no shares.  Executives should buy their own shares.

• Have a binding vote once the non-binding vote falls below 75%.

• Reduce salaries to a reasonable level – all stakeholders to decide what is “reasonable”.

She summarises by saying “a critique of the self-serving justification is often attacked for relying on the wrong data, a misunderstanding of the way companies work and plain old envy.  But if capitalism is not seen to be fair by much of the public there will be moves for something more drastic to replace it.  It is time for the business sector to listen to the moderate voices for reform or reap the consequences of growing inequality, anti-business sentiment and possibly more dramatic clashes. If it does not rise to the challenge, the fundamental trust that makes a liberal market democracy function could be damaged beyond repair.

In fact there are only a few companies with the excessive pay arrangements this book is railing against.  Hargreaves’ proposals would result in a regime which would restrict legitimate reward and damage companies generally, without helping in any way to address the key problem, which is low wages.

For further information contact damien.knight@mm-k.com