MM&K news 2019

  • May 29, 2019

    Top Dogs and Fat Cats

    This new book from the Institute of Economic Affairs was published on 8 May 2019. It is a collection of essays on executive pay, providing fascinating insights into the nature of high pay and making a compelling contribution to one of today’s most contentious issues.

    The book is edited by Professor Len Shackleton of the University of Buckingham who has written the introduction which provides a critique of the top pay debate and summarises the individual contributions to the book.  He has also personally contributed an article on the consequences of “getting tough” on top pay. The contributors are a mixture of academics, practitioners and leaders of institutions.

    Below is a synopsis of each contributor’s essay.

    Why free marketeers should worry about executive pay

    Why free marketeers should worry about executive pay,  by Luke Hildyard, Director of the High Pay Centre. The HPC has a view that the greed of executives in large corporations has led to ever increasing pay differentials which are unjustifiable and damaging to society.

    This article begins the discussion by setting out the indictment against excessive CEO pay. Hildyard points out that executive remuneration in the UK has risen far faster than that of ordinary workers in recent decades, and claims that this has occurred without any corresponding improvement in company performance.  He dismisses the idea that international competition for rare talent justifies high CEO pay, pointing out that most firms promote their CEOs from within the company. His analysis suggests that long-established successful businesses (as opposed to entrepreneurial start-ups) are built on effective organisational systems rather than the abilities of the current incumbent CEO, who therefore has in many cases little influence over a company’s success. He draws attention, too, to elements of ‘crony capitalism’ that give many big businesses protected markets through their strong links to government.

    Hildyard suggests that the ultimate providers of capital – the beneficial owners of company shares – would like to see more modest levels of executive pay, but they are separated from the operation of corporations by a web of financial advisers, asset managers and pension funds. These intermediaries are themselves highly paid and see no problem in paying company executives generously.

    Listed companies are required to have remuneration committees which are independent of the company’s management structure, but members of these committees are themselves well-remunerated, are from similar backgrounds to company executives and often hold, or have held, executive posts at other companies. The committees are advised by consultants who (he claims) devise complex remuneration schemes to justify their existence, and act to bid up pay.

    In Hildyard’s view, this unsatisfactory situation is undermining the case for capitalism. Free-marketeers should be worried about this, and he supports reforms including worker representation on boards and remuneration committees, more detailed disclosure of pay structures and a requirement for institutional investors to consult ultimate beneficiaries on pay issues.

     

    Understanding the facts about top pay

    Understanding the facts about top pay,  by Damien Knight and Harry McCreddie, of MM&K.  This essay draws from the findings of a previous article we have published in our e-news.  The text of the article can be found here.

     

    The right and wrongs of CEO Pay

    The right and wrongs of CEO Pay,  by Alex Edmans, Professor of Finance at London Business School. Drawing on his own and others’ academic research, he demolishes a number of myths associated with the case against CEO pay. For example, he shows that, contrary to popular belief, CEOs who perform badly do suffer financially – though he points out that it is their wealth rather than their income which is affected, because much of their remuneration is in company shares and share options which lose value with poor performance. While Edmans believes strongly in the reform of company pay, he argues that disclosure of CEO/average pay ratios (a feature of the Government’s policy) can lead to inappropriate conclusions and have unintended consequences which may harm workers. For example, firms may outsource low-paid work to improve their showing. Edmans argues that reform efforts should focus on the structure of pay schemes, rather than the level of chief executive pay. Current pay schemes are complex, opaque and encourage short-termism. In particular, he argues that the use of LTIPs (Long-Term Incentive Plans) allows for ‘gaming and fudging’. He advocates instead that pay should simply be in cash and shares with a long holding period. If shares can at the same time be awarded to employees, they will gain in line with CEOs, which will help address concerns about fairness.

     

    What conclusions can we draw from international comparison of corporate governance and executive pay?

    What conclusions can we draw from international comparison of corporate governance and executive pay?  by Vicky Pryce, Chief Economic Adviser at the Centre for Economics and Business Research.  In her chapter, Vicky Pryce examines high executive pay in an international context. She points out that the phenomenon of rising pay for top executives is found in many countries, not just in the US and the UK. In continental Europe she highlights Germany. Large German companies are often held up as a good example of corporate governance, with wider stakeholder interests, including employees, represented on supervisory boards. Many British commentators argue that such representation will tend to inhibit excessive pay awards.

    However, as Pryce points out, CEOs of some leading German firms are paid extremely generously. She puts this down to the need to compete for international talent. Pryce also notes that, while the make-up of remuneration (the mix of salary, bonuses, shares and share options and so on) seems to differ in different parts of the world, high executive pay is also becoming a feature in Asia and Africa. She further points out that in some countries, for example China, recorded pay may understate the advantage executives enjoy from employment, as they also have access to a range of other benefits.

    Pryce notes that there is considerable opposition to excessive executive pay in many countries, although opinion polls suggest that antipathy is, perhaps oddly, rather less marked in those countries where executive pay is highest. Governments have been inhibited in their responses, she suggests, because they are concerned that precipitate action might produce little gain. International cooperation might encourage them to overcome their scruples, but so far this has been limited to some minor European Union initiatives.

     

    Two kinds of top pay

    Two kinds of top pay,  by Paul Omerod, an economist, author and entrepreneur, who is currently a visiting professor in computer science at UCL. In his chapter, Paul Ormerod tackles the differing reasons for the high pay received by entrepreneurs, top sports and entertainment stars (which is in his view acceptable) and by executives of large corporations (which isn’t). Entrepreneurs provide a product or service which did not previously exist, and are thus able to secure monopoly profits, at least until competitors produce something equivalent or superior. These high returns (whether in salaries or in personal wealth through share ownership) are a necessary stimulant to invention and innovation. Top athletes, artists and performers possess unusual talents which have been increasingly rewarded in recent decades as advances in communications technology have created worldwide markets for their services. But their highly visible achievements typically require exceptional personal effort and are not subject to great popular resentment. By contrast, Ormerod argues, executive pay has risen for reasons which have little to do with improved performance and exceptional individual effort. Drawing on network analysis, he argues that board opinions in favour of high pay have spread for reasons which defy traditional notions of rational, optimal behaviour. Networks of non-executive directors, management consultants and remuneration experts have in effect facilitated successful rent-seeking by CEOs.

     

    Top pay for women

    Top pay for women,  by Judy Z. Stephenson and Sophie Jarvis. Stephenson is the David Richards Junior Research Fellow at Wadham College Oxford; Jarvis is Head of Government Affairs at the Adam Smith Institute.

    Stephenson and Jarvis discuss the position of women in the top pay debate. While they recognise that women appear to be under-represented among top earners, they resist simplistic explanations in terms of discrimination and victimhood. They point out that the gender pay gap is widely misunderstood to involve women being paid less than men for the same work, when it is rather that men and women do different jobs, or work different hours, or have less continuous work experience. While this is partly the result of different choices and preferences, these are themselves gendered and reflect social, family and cultural expectations which are difficult to change. In an illuminating analysis, Stephenson and Jarvis see the labour market as essentially an ‘information market’ concerning job opportunities and workplace behaviours. Improving the flow of information to women is an essential element in improving employment trajectories and the possibility of higher pay. This may also be an analysis which has relevance to ethnic pay gaps: many ethnic groups are similarly under-represented in high-paying jobs. Stephenson and Jarvis welcome publication of gender pay gap data as a step towards improved information flows, while cautioning against ‘positive discrimination’ policies such as board quotas. The end goal should always be equality of opportunity rather than forced equality of outcome.

     

    Public service or public plunder

    Public service or public plunder,  by Alex Wild, a Director at Public First, a research and campaign consultancy, previously Research Director at the Tax Payers’ Alliance. Wild opens the discussion on the public sector, where the arguments for limiting high pay are apparently clearer. Wild points out that, particularly taking pensions and other benefits into account, lower-paid workers do markedly better in the public sector than in the private sector. But top earners in the public sector are paid substantially less than top earners in the private sector. However, few public sector jobs are directly comparable to those in the private sector. There are very limited opportunities in the public sector for independent judgement and actions, as politicians inevitably determine broad policy. There is also much less risk for people working in the public sector, as in most cases predetermined revenue comes from the government rather than the consumer. Senior civil servants, local authority chief executives and similar functionaries face many problems, but they do not operate in the same sort of competitive environment as that faced by company CEOs. It is therefore appropriate that they are paid less, though there should probably not be strict pay ratios or upper limits on public sector pay. Wild recognises, though, that the distinction between public and private is not as clear-cut as is often assumed. There are public sector leadership roles which do face competition, and private sector jobs which nevertheless have a close symbiotic relationship with the public sector. Here it may be appropriate to apply different criteria when determining pay.

     

    Are vice-chancellors paid too much?

    Are vice-chancellors paid too much?  by Rebecca Lowe, the Director of FREER, and liberal thinking think tank, and a Research Fellow at the Institute of Economic Affairs.  Lowe enlarges the public/private debate by looking at the specific problem of the pay of university vice chancellors, who straddle the two sectors. As so many people now have experience of university, and there is great concern over the levels of debt which graduates have accumulated, it is not surprising that the pay of vice-chancellors and other key staff has attracted considerable (perhaps disproportionate) attention, with the Office for Students now having a virtual power of veto over the pay of senior staff. Rebecca Lowe examines the issues in her chapter. Lowe points to the considerable range of institutions in the UK higher education sector, and suggests that they should not all be treated the same, whether in pay terms or anything else. She would prefer a formal segmentation of tertiary education as is found in some other countries. She notes that vice-chancellors are not particularly well paid in relation to their counterparts in the US, Canada or Australia, but points out that the roles in different countries may not be completely equivalent. Vice-chancellors are, however, paid reasonably well in relation to other staff in their institutions and Lowe argues against letting pay rip at the top end. While UK universities are less directly dependent on the public purse than they used to be, so long as significant government funding supports higher education it is reasonable that we should have special expectations about the way they are run, and how their staff are remunerated.

     

    Getting tough on top pay: what consequences

    Getting tough on top pay: what consequences, by Len Shackleton.  Professor Shackleton draws the themes together by considering the appropriate response to calls for action to rein in high pay in UK business.

    He looks at various proposals.  First Government policies to use “naming and shaming” as a soft pressure for companies to reduce pay – in particular the reporting of the pay ratio between CEO pay and employee pay quartiles (required of quoted companies with 250 or more employees by the 2018 disclosure regulations), and the publicising by the Investment Association of shareholder resolutions which obtain less than 80% of votes at the AGM.  The regulations also require companies to report the reasons behind increases in the ratio and explain how the ratio is justifiable.  Shackleton is not opposed to these measures, but feels that the majority shareholders will have little interest in them and they could have negative consequences such as outsourcing, delisting or going private, or changing the structure of CEO pay by reducing the proportion of variable pay or increasing benefits.

    Next he reviews proposals to put workers on the board.  He says that this has not been effective in restraining top pay in Germany and France and Labour Party plans to require one third of board positions to be reserved for employees are as much about introducing trade union influence to the board.  He thinks the measure will curb company growth.

    He turns to the idea of executive pay caps.  Already public sector salaries above £150,000 have to be signed off by the Cabinet Office.  The Labour Party is planning a cap on salaries in companies which benefit from Government contracts.  Shackleton questions the practicality of this and points out the negative impact for Government procurement.

    He believes that squeezing top pay will have a negative motivational effect on middle management, especially in organisations which employ scarce professional skills.  It could also have a serious effect on the UK’s ability to recruit top talent from aboard.  He points out that in 2017, 40% of FTSE-100 companies were headed by non-UK nationals.  The UK and France had less than 10% of top companies with non-national CEOs.

    He sees great danger in the general perception that top pay needs to be curbed and a risk that any control will creep into other aspects company management.  Governments need to be careful in how they react to populist calls for action, and giving governments the power to fix pay ratios or even pay caps brings dangers which are not sufficiently discussed by those demanding action.  He finds it disappointing to see so many of those ostensibly favouring free markets and limited government intervention joining the clamour against high pay.

  • May 29, 2019

    The effect on NEDs of proposed reforms to IR35

    Some non-executive directors (NEDs) also provide consulting services to the companies on whose boards they sit and to others. How will the proposed changes to IR35 affect the provision of those consulting services?

    HMRC published a consultation paper Off-payroll working rules from April 2020 on 5  March 2019. The consultation period closed on 28 May and the results will be taken into account when the Finance Bill is published in the summer. It seems likely, based on the consultation document, that existing public-sector legislation (Chapter 10, Part 2 of ITEPA 2003) will be the starting point for legislation governing the private-sector, but we will have to wait for the Finance Bill to find out for sure.

    Since 2017, public-sector companies have been responsible for determining whether those they engage to provide services are employees or independent contractors. Private-sector companies have been spared this responsibility, which hitherto has fallen on the service provider. From April 2020, however, medium-sized and large private-sector companies will also be responsible for determining whether an agreement to provide services amounts to a deemed employment. No new tax is being introduced; only a change to the person responsible for determining if a deemed employment exists and for accounting for income tax and NICs.

    Many individuals provide their services through a personal service company (PSC) which receives the fees paid for the services provided and from which the individual may receive a salary and possibly dividends. From 2020, private-sector companies will have to disregard the existence of a PSC and decide if the individual should be treated as an employee for tax and NIC purposes if engaged directly.

    From next April, if a private-sector company decides that its agreement for the provision of services amounts to a deemed employment, it (and not the PSC) will be required to deduct income tax and NICs from the fees it pays, for those services.  This change is likely to mean more work for in-house HR teams and their (internal and external) legal advisers and could involve a substantial increase in the fee-payer’s employer’s NICs liability. If the new legislation follows the public-sector regime, three key consequences will flow from the requirement to make an assessment as to whether, for tax and NIC purposes, an employment relationship exists between it and an individual contractor:

    • the company must inform its contracting party (agency or PSC) of the outcome of its assessment when the contract is made and may also have to inform the individual contractor of its decision;

    • if any questions are raised about the company’s assessment, it has 31 days in which to respond; and

    • the company must take reasonable care when making its determination as to whether a deemed employment exists.

    This will affect NEDs who are also contracted to provide consulting services in the same way as it affects other contractors. A directorship is separate from an engagement to provide consulting services. Fees for carrying out the office of director are subject to income tax and NICs, payable through the PAYE system.  However, whether consulting fees are subject to the same deductions depends on the nature and terms of the agreement and on whether a deemed employment exists. It would, therefore, seem sensible for any agreement to provide consulting services to remain separate from an agreement to carry out the office of director.

    For further information, contact Paul Norris.

  • May 29, 2019

    FRC publishes a guide on financial reporting for smaller listed and AIM companies

    The Financial Reporting Council (FRC) together with the Chartered Institute of Accountants have recently published a guide to help improve financial reporting within smaller listed and AIM quoted companies.

    It is specifically aimed as a guide for Audit Committee members and provides top tips for the members to consider and ask themselves (including questions which should be put to the external auditors and the management team) during each of the following stages:

    • Planning the audit

    • Production of interim and annual reports

    • Review of performance

    • Formulating an action plan for next year

    For the full report and more information click here.

  • May 29, 2019

    Proxy advisers: proposed US regulations are misguided

    This is a summary of an article written by Robin Ferracone, CEO of Farient Advisors, MM&K’s US partner in the Global Governance and Executive Compensation Group (GECN).

    Proxy advisers, such as Institutional Shareholder Services (ISS), review company disclosures and provide cost-effective, independent research and voting recommendations to institutional investors, using the investors’ own voting guidelines.  This enables resource-constrained investors to cover hundreds, if not thousands, of companies and to engage with each as necessary to protect their investments.

    Certain companies have criticised the increasing influence of proxy advisers, claiming that they are not fair, lack transparency, do not understand the company and are difficult to engage with.  In response, the US Congress has proposed legislation to require the advisers to register with the Securities and Exchange Commission (SEC) and to subject themselves to audits for conflicts of interest.

    However, does it make sense to regulate organisations that provide voting recommendations to shareholders cost effectively?  The power of proxy advisers may be overstated: research by Glass Lewis has found that their investor clients vote differently from their recommendations 37% of the time.

    Farient recently examined Say on Pay (SOP) votes cast for S&P 500 companies by 1,200 institutional investors, testing the hypothesis that smaller investors, with fewer resources, are more likely to follow ISS’s voting recommendations.  It found that:

    • The largest 200 investors voted in line with the recommendations of ISS 84% of the time, while the smallest 200 investors voted with the recommendations 89% of the time.

    • In contrast, looking at “AGAINST” recommendations only, larger investors are more likely to vote with ISS compared to smaller investors, 74% to 56% respectively.

    • The top 20 investors, ranked by assets under management, vote very differently relative to ISS recommendations. For example, BlackRock voted in support of SOP resolutions 97% of the time, following ISS recommendations 90% of the time; while BNY Mellon voted in support of these resolutions 56% of the time, following ISS recommendations only 64% of the time

    This evidence shows that institutional investors consult research by their proxy advisers to inform their voting decisions but in the end make up their own minds in casting their votes.

    Farient, like MM&K, encourages its client companies to engage with their investors and proxy advisers, to help them to understand what is happening.  Directors should tell the company’s story and provide a compelling narrative to ensure that proxy advisers do their jobs while the directors take the opportunity to explain that they are doing theirs.

    For further information, contact Mike Landon.

  • May 29, 2019

    Creating successful bonus structures – five things to think about

    Whether you think in these terms or not, the way a company sets up, manages and then settles its bonus plans will have a direct impact on the behaviour of people within the organisation. Here are five thinking points in respect of creating successful bonus plans for 2019 and beyond:

    1. Be clear about the company’s real values
    This is the single most important element in achieving a successful bonus structure. Many companies in the “open communication” era will have a set of values describing how they want people to behave – these may be found on the walls of the office or in a handy booklet. However, underneath this will be the “real” values of the company – the values which may not make a good soundbite but which accurately describe how your enterprise functions most successfully. Taking the time to unlock this is crucial in all aspects of remuneration design – including bonuses.

    2. Make sure it is affordable
    Some might consider this obvious but it is crucial to make sure that payments are tied to affordability. There are few things more demoralising than bonus numbers having to be scaled back due to miscalculations or when a line manager has to revise down bonus levels due to wider company bonus issues. It is possible to put bonus plans in place where this issue is mitigated or even eradicated.

    3. Back up bonus plans with hard decisions
    If you have created a bonus structure which rewards people for ‘how’ they have done things as well as for ‘what’ they have done, then a potential management decision may arise when a “star performer” delivers results in a way that goes against the expressed values of the company. Will the leadership team be willing to risk upsetting the star performer by not paying out some or all of the bonus? If they are not then the company should reconsider the structure of the bonus plan, as a bonus plan which rewards “bad” behaviour will send a clear message that the values of the business can be ignored.

    4. Decide how widely the bonus plan should apply
    It is tempting, especially when money is perceived to be tight, to decide to reward only those who are “high performers”. However, research evidence on this point indicates that bonus plans created in this way may be more harmful than plans which provide bonuses across a wider range of performers. Consider ways in which your bonus plan could have wider applicability.

    5. Communicate regularly
    The most successful bonus plans should form part of the management tool kit of the business and not just be something that is pulled out at the end of the year. There are a number of things that can be done to embed the bonus plan within the review process in order to get the most out of it.

    For further information or to discuss any questions you may have, contact Stuart James.

  • April 29, 2019

    Launch of MM&K’s 2019 UK and European Private Equity / Venture Capital Compensation Survey

    This month MM&K Launched its 24th annual Compensation Survey for the European Private Equity and Venture Capital Industry.  The 2019 Survey will provide participants with information on both quantum and structure in respect of salary, bonus plans, carried interest plans and co-investment plans. Through participation in our survey, participants will obtain data which allows them to:

    • Make the best choices on remuneration structures for their businesses

    • Have meaningful conversations on remuneration with partners and employees

    • Improve staff retention and morale

    If you are working in a Private Equity / Infrastructure / Venture Capital House and you believe that your firm might like to participate, please contact Margarita Skripina or request your questionnaire here.

    To find out more about MM&K 2019 PE/VC Compensation Survey click here.

     

  • April 23, 2019

    Gender Pay Gap – three things for businesses of any size to consider

    Legally, the reporting of the Gender Pay Gap (“GPG”) is only required by companies that have 250 or more employees who are based in England, Scotland or Wales. However, there are some important lessons for all organisations in respect of remuneration and the issue of divergence on gender pay can become an issue for any commercial enterprise.

    Here are three points to consider with the passing of the second anniversary of reporting on the GPG.

    1. Every company will have a GPG
    Unless you have exactly the same number of people of each gender at each of the levels within your organisation, it is a mathematical certainty that you will have a GPG inside your organisation, based on the way that the reporting model is constructed.

    Nonetheless, establishing your GPG – and then analysing it in order to understand how it has come about – is likely to be the most productive first step that an organisation can take to review its recruitment and promotion policies.

    2. “Blind recruitment” may not be the answer
    There is a notion that, either consciously or unconsciously, people tend to hire people in their own image . In order to overcome the first hurdle to this – getting a more diverse range of candidates through the initial CV vetting process – some firms have started using “blind” copies. These are documents which remove any trace of a person’s gender, or indeed any other area of diversity which may be from the subject of bias.

    However, whilst there is some superficial logic to this, a number of studies, most notably a high profile one undertaken in Australia (see here for coverage**), indicates that this method does not always deliver the intended outcomes.

    In our experience, better recruitment can come from identifying the core values of the business itself and then using these as guiding principles to develop and establish everything from recruitment processes to bonus and incentive structures. Given that values are not gender specific, using this approach has the advantage of making the recruitment process fairer to all.

    3. Pay gaps may really be rewarding certain characteristics
    Whilst some GPGs (or even part of a GPG) may be explained by “structural” differences, such as the number of people of each gender at each level of the organisation, among people who do similar jobs, the difference may not be so much about gender but may instead reflect varying individual skill-sets.

    Discretionary pay awards might favour the most skilled negotiators but, whilst it would not be appropriate to ‘punish’ those who have strong negotiating skills, it would be appropriate to consider whether people who are hired for a different set of skills might need a different approach to their remuneration. There may be short term gains from supressing the remuneration levels of ‘quieter’ employees, but such an approach often leads to growing resentment and can become self-defeating. Once resentment over remuneration takes hold, it can lead to people making a “no way back” decision to leave a company for new pastures. It may, therefore, be more cost-effective for remuneration policy to take account of a person’s skill-set and motivators, as well as their job role.

    For further information or to discuss any questions you may have, contact Stuart James.

  • April 20, 2019

    2019 MM&K Private Equity / Venture Capital Breakfast Seminar

    In early April, MM&K held a PE/VC Breakfast Seminar for the participants in its last three PE/VC Compensation Surveys. At the seminar the 2018 Landscape of the Private Equity / Venture Capital industry was discussed. We also discussed the outlook on what 2019 may hold for the industry.

    Prior to the event, MM&K organised a 2019 Pulse Survey, that was sent out to all of the invitees to the seminar, to get a picture of the most up-to-date Remuneration and Staffing trends in the UK and European PE/VC industries. Also, some of the interesting insights and findings from the 2018 MM&K PE/VC Compensation Survey were presented to compare with the results of the 2019 Pulse Survey.
    The event opened with a networking opportunity for all the attendees and closed with a vocal Q&A session.

    2019 MM&K Private Equity / Venture Capital Pulse Survey

    This short  Pulse Survey focuses on the most recent developments in the UK and European Private Equity / Venture Capital industry. The Pulse Survey is run for the benefit of MM&K’s PE/VC Compensation Survey participants, and provides them with an outlook on the most up-to-date trends in compensation and staffing levels in the PE/VC industry.

    91% of participating houses indicated a salary increase across all of their professionals at their most recent review date.  However, only 15% indicated increases in bonus levels for their investment professionals (over 2018).

    About 70% of the participants indicated they focused on selected groups of staff when determining bonuses for last year’s performance. 86% of firms expect an increase in the number of investment professionals in 2019.

    All in all, there remains perhaps a surprisingly high level of confidence in the industry, which is encouraging to see.

    If you are working in a Private Equity / Infrastructure / Venture Capital House and you believe that your firm might like to participate, please contact Margarita Skripina or request your questionnaire here.

  • April 18, 2019

    Recent HMRC announcements relating to EMI options

    HMRC recently made new announcements about tax-advantaged Enterprise Management Incentive (EMI) share options in its Employment Related Securities Bulletin 31 (21 March 2019) and in updated Share Valuations guidance (1 April 2019).

    Errors in notification of EMI options to HMRC

    When a company grants an EMI option, it must notify HMRC of the grant through the online reporting system within 92 days of the date of grant; otherwise the option will not qualify for tax exemptions.

    If the company realises that it has made a mistake in its notification about the grant of EMI options, the consequences depend on the period which has elapsed since the date of grant.

    • If it is still within 92 days of granting the options, the grants can be re-notified through the online system within that 92-day period. The originally notified options should then be cancelled on the next EMI annual return.

    • After 92 days, but within nine months of the original grant date, provided it has a reasonable excuse for not re-notifying within the 92-day deadline, the company should notify HMRC of the facts. If HMRC accept the explanation, they will issue a “reasonable excuse code” which will allow the company to re-notify the corrected options through the online system.  Again, the originally notified options must be cancelled on the next EMI annual return.

    • After nine months of granting the EMI options, the legislation does not allow errors or omissions to be corrected. The company must notify HMRC of the error.  If HMRC regard the error as material and that it may cause the options to fail to meet the legislative requirements, the options will remain in existence but will not benefit from the EMI tax exemptions.

    Impact of IFRS 16 on a company’s gross assets

    The tax advantages of EMI options are intended only for small companies. The EMI legislation therefore does not allow EMI options to be granted if the company’s gross assets (including the gross assets of its subsidiaries) exceed £30 million at the date the EMI options are granted.  (The test does not need to be met at the time of exercise.)

    HMRC has updated its guidance on the gross assets test to confirm that if a company uses international accounting standards, IFRS 16 will apply from January 2019 in determining the value of the company’s assets on its balance sheet.

    Working time declarations by EMI option holders

    At the time of grant of EMI options, the employees must sign written declarations that they spend at least 25 hours each week or, if less, 75% of their working time working as employees for the company or a qualifying subsidiary.  Employees have to make new working time declarations for each new grant of EMI options.

    HMRC have confirmed that the declaration must be made at the time of option grant and it cannot be backdated.

    Restrictions on shares to be acquired through EMI options

    The option agreements for EMI options should contain all the terms and conditions of the options and any restrictions on the shares to be acquired on exercise of the options.

    HMRC have stated that where restrictions on shares have not been notified to option holders at the date of grant the company should seek to remedy this as soon as possible.  HMRC’s advice should be sought as to whether any proposed retrospective action could result in the options losing their tax-advantaged status.

    Valuation of shares for EMI options

    Where shares to be acquired on exercise of EMI options are not listed on a recognised stock exchange, the value of the shares must be agreed by HMRC Shares & Assets Valuation (SAV) before the date of grant. This may be crucial in determining the taxable amount when the options are exercised.

    In practice, where the shares are traded on AIM, SAV often agree to accept the quoted AIM price.  However, the value for unquoted shares must be based on an accepted share valuation methodology.

    HMRC have confirmed that agreed valuations will remain valid for 90 days.  The previous limit was 60 days.

    For further information contact Mike Landon

  • April 17, 2019

    New Directors’ Remuneration Reporting Regulations

    On 10 April 2019, the Government laid before Parliament a new set of revisions to the Directors’ Remuneration Reporting Regulations (DRRR or “Schedule8”).

    After the wholesale revision to the DRRR in 2013, the regulations remained pretty much unchanged until July, 2018. The 2018 Companies (Miscellaneous Reporting) Regulations then introduced a number of changes to the Companies Act aimed at improving disclosure and corporate governance. Included in this Statutory Instrument were some key changes to the DRRR, in particular:

    1. The requirement for UK companies with more than 250 employees to publish, in the form of a table, the ratio of the total pay and benefits for the chief executive to the equivalent figure for UK employees at the lower quartile, median and upper quartile. The requirement, starting with FY 2020, is to report the most recent two years and then steadily build up to a nine-year table over time.

    The 2013 regulations required companies to compare the percentage change in the latest year of the remuneration of the chief executive with that of employees of the company taken as a whole; this comparison was to be made for the salary, taxable benefits and annual bonus figures in the single figure table. The 2018 regulations added a pay ratio as well as a pay movement comparison, and added the requirement to report this for a period building up to 9 years.

    2. A second important change was to break-out the impact on remuneration of the effect of company share price changes, both in the remuneration table for the year and in the scenarios charts for future remuneration. The old scenario charts ignored share appreciation completely, which proved a serious omission when the forecasts proved wildly low due to stock market movements.  The 2018 regulations went the other way – the scenario modelling had to assume 50% price appreciation over the plan period.

    As last year’s changes to the DRRR apply for reports for financial years starting 1 January 2019, no companies have yet had to apply them.  But the new 2019 regulations apply to reports for years starting on 10 June 2019, so companies with a year start between June and December will find themselves adopting both new sets of rules at once.

    The Government has introduced the latest changes to the regulations to bring them in line with the 2017 EC Shareholder Rights Directive II (SRD II).  This directive was mainly concerned with flows of information between companies, investors and intermediaries; however, it included some articles aimed at improving the governance of directors’ remuneration.

    It is important to note that, as well as requiring certain specific items of disclosure, SRDII mandated the EC to prepare full guidance on the contents of the remuneration report, and the Commission published this guidance on 3 March 2019.  Had BEIS followed this guidance for the UK regulations, the new DRRR would have become very onerous without adding any great benefit for companies or shareholders.  Fortunately, the guidance is not mandatory and the UK Government has chosen to ignore it and only to implement the specific points mentioned in SRD II.  These are limited in their scope.  The changes in the UK DRRR are as follows:

    1. The pay movement comparison in the earlier regulations has been extended from one year to five years on a “building up” basis. So there are now potentially five years of pay movement comparisons and nine years of pay ratios to be reported.

    2. The pay movement comparison has been broadened from the chief executive to all directors; but not the pay ratio analysis, which is curious. It is not evident that this change provides stakeholders with any insights that go beyond the movement for the chief executive for the additional work involved by the reporting company.   But these changes are necessary to comply with the specific requirements of Article 9b 1. of SRD II

    3. The Single Figure table is required to break out separate totals for fixed remuneration and variable remuneration.

    4. Where aspects of directors’ remuneration are required to be disclosed under the regulations, it is made clear that this includes the chief executive and deputy chief executive (if any). This prevents the company from hiding the chief executive’s pay by excluding him or her from board membership.

    5. The regulation introduces a privacy restriction on including certain categories of personal data. Subject to this, the directors’ remuneration report must be kept available for a period of at least ten years.

    6. Throughout the report, the requirement to report has been broadened from “quoted companies” (ie UK companies on the official list of a main exchange) to include “traded unquoted companies” (this covers companies that were previously listed on a main exchange but are no longer listed. It does not include AIM-traded companies.)

    7. The regulations expand on the detail that is required to be given about the decision making process for the determination, review and implementation of remuneration policy.

    For further information, contact Damien Knight


  • December 18, 2018

    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.

  • December 18, 2018

    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.

  • December 13, 2018

    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.

     

  • December 5, 2018

    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.

  • November 27, 2018

    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 Harry McCreddie

  • November 26, 2018

    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

  • November 26, 2018

    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

  • November 25, 2018

    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

  • October 30, 2018

    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

  • October 24, 2018

    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