Article by Alan Judes – published by RREV Autumn 2004
There are three major themes that we have observed over the past year that we would
like to discuss in a little more detail. The major driver of change is the new accounting
standard requiring the expensing of options – in general terms we support the levelling of
the playing field for the various equity instruments available to a Company, and can trace
recent developments back to the emergence of this standard. However, the underlying
themes are older and more constant, and have been debated for many years. The three
themes are:
- the emergence of share settled share appreciation rights as a replacement instrument to the share option
- the emergence of omnibus plans (called the portfolio approach by RREV), and
- the use of performance measures and alignment with Corporate Strategy.
The option is dead. Long live the Share Appreciation Right (SAR)
The economic benefit to a holder of a share option and a SAR is virtually identical –
the holder of each benefits from the appreciation in value of the shares underlying the
instrument. However, prior to the emergence of IFRS 2/FRS 20/mandatory FRS 123 the
option had no cost visible in the income statement and the SAR had an expense equal to
the intrinsic value of the gain derived by the executive holding the SAR. The accountancy
profession has got one thing right in its new standard – if the economic benefit of the
instrument is the same so should its expense be in the income statement.
FRS 20 will require the expensing of both an option and a share settled SAR, and the
expense will be identical. With this levelling of the playing field companies are looking
in much greater depth at the consequences of reintroducing the share settled SAR. In our
view, in the world of expensing of options, the share settled SAR will replace the generic
share option. The main reason for this is that for the same accounting expense as a share
option, the share settled SAR will have much less of an impact on the number of shares
issued by the Company.
Under an option plan, the executive exercises the option to acquire the shares. Most
often executives do not have the cash to exercise the option and so undertake cashless
exercises where the shares acquired are sold to provide the Company with the option
exercise price. The executive benefits from the growth in value but the Company issues
all of the shares under option. By contrast, with a share settled SAR the Company issues
shares to the executive equal only to the value of the growth in shares underlying the
instrument. This can save significant numbers of shares from being issued.
The example below shows the shares that would be issued under an option or an SAR
and demonstrates the savings that a company can achieve by using an SAR. Clearly, a
company issuing SARs will not receive a cash inflow whereas a Company issuing shares
under an option will. However, the companies monitored by RREV do not typically use
their option plans as a source of funding their business strategy. The examples below
show share usage for a 25% share price growth and a 100% share price growth.
Example of share settled SAR
|
|
25% Growth Share Option |
100% Growth Share Option |
25% Growth SAR |
100% Growth SAR |
|
Number of shares in instrument
|
100,000 |
100,000 |
100,000 |
100,000 |
|
Share price on grant date |
1.00 |
1.00 |
1.00 |
1.00 |
|
Share price on exercise date |
1.25 |
2.00 |
1.25 |
2.00 |
|
Shares consumed in option exercise |
100,000 |
100,000 |
N/A |
N/A |
|
Shares consumed in SAR |
N/A |
N/A |
20,000 |
50,000 |
|
Shares saved by SAR |
|
|
80,000 |
50,000 |
Thus the use of share settled SARs will save companies many shares. We have seen with
interest the use of share settled SARs in UK companies. In 2003 The British Land
Company PLC introduced a share settled SAR feature as part of its new executive share
option plan. In 2004 P&O went further and obtained shareholder consent to reclassify
existing options as share settled SARs. We confidently expect many more companies to
follow in their footsteps – the issues are well understood by institutional investors and are
not contentious
The emergence of omnibus plans
Since the publication of the Greenbury report in 1995, companies have been encouraged
to have one main plan for long term incentives for their executives. The stock market fall
after the bubble of 2000 has seen many option plans deeply underwater. We understand
the desire of the Companies to deliver an instrument where the value can be seen by the
executive and the desire to benefit from the gearing effect of share options as well. A
natural reaction is to introduce a plan that allows more than one type of long term
incentive to be used in the same year.
The USA gives us a model to follow; for very many years now US companies have
introduced omnibus plans that allow the grants of restricted shares, restricted share units,
performance shares, share options, share appreciation rights, performance unit plans etc
.
We see four forces coming together to make this trend more than just common sense and
providing flexibility to the Company to cope with future changes.
- the expensing of options means that the cost of each alternative can be calculated and communicated to shareholders and executives
- the requirement to articulate the total remuneration policy and put it to shareholder votes annually
- the change in the markets and the uncertainty that we all face when trying to estimate future returns from equity investments
- Companies can consider the most suitable instruments for executive incentives because designs can be cost neutral.
The above forces in combination mean that increased flexibility can be given to companies
but they will have to have their policies approved by shareholders before the full usage of
each component of the omnibus can be used. The policy will replace a plethora of
individual plans. It is also much easier to take one omnibus plan to shareholders, to
maintain and administer it over time than a whole spate of individual plans each one of
which has obtained a separate shareholder consent.
We note with interest the description of “portfolio approach” used by RREV and other
consultants. We prefer omnibus plan as a descriptive label, and it will be immediately
understood by US shareholders.
Performance measures and alignment with corporate strategy
Companies have strived for many years to identify the appropriate measure to deliver long
term value creation for shareholders. The “metric wars” are now very old indeed.
We are very interested to see what companies measure in their management accounts on
a monthly, quarterly, and annual basis, and which measures correlate most highly with
actual share price performance in the past. This gives us a feel for what matters to
management and what matters to analysts.
Our experience over many years has taught us that each company is different and that
there is no “one size fits all” solution. Many companies have adopted TSR almost on
autopilot. Our concern lies in the design of the TSR performance measure which almost
universally is a simple ranking mechanism against a comparator group. The objective is to
come near the top of the list with the maximum number of shares released when the
Company is at the upper quartile or above. But no-one seems to pay any attention as to
where the actual level of out performance falls. It seems evident that a company that
achieves its position and beats the nearest comparator with a 15% greater return should
do better than one that achieves the same position but with only a 0.1% out performance.
But no, winning by a nose delivers the same number of shares as winning by five furlongs.
We feel that there is a better way to quantify TSR as a performance measure. But a bigger
problem with TSR is whether it is relevant to management performance at all.
Here we are pleased to note the comments of RREV in the context of annual performance
measures and also the helpful examples given of Tesco and ICI that use ROCE and EPS
targets respectively for their long term incentive plans.
It seems to us that it is vital for management to identify those key drivers of its business
success, to communicate the strategy for achieving them to its shareholders and to use
appropriate measures in its annual and long term incentive plans to get executive focus on
these key drivers.
We are most pleased to note that RREV is sensitive to the current dynamics affecting
executive remuneration and is happy to engage in the debate with the Company.
[ Sponsor’s ommentary
Readers of UK newspapers are confused about what happened some ten years ago, and so are the journalists who seem to look at one aspect of events at a time. Why did Mr. Ed Balls say that he had the support of the CBI when Lord Turner denies it? I suggest that it is because they are talking about different sides of the same coin. Mr. Balls is thinking about the problems that UK companies had with Unrelieved ACT, Lord Turner is responding to the unexpected and indeed unnecessary withdrawal of Dividend Tax Credits “DTC” from picked-upon pension funds.
The confusion is all about the connection between Advance Corporation Tax “ACT” and DTC. This means that there is some tax technicality involved and unfortunately most people simply switch off at the mention of such acronyms
The imputation system of corporation tax works well in a closed economy. The tax paid by the company on its profits is imputed into the hands of the shareholders with a tax credit when dividends are paid by the company. To give the Inland Revenue the necessary cash flow to repay the DTC to shareholders such as pension funds and charities that are not liable to income tax, companies had to pay ACT at the time they paid a dividend. In a closed economy this was no problem as the ACT payment by the company offset its liability to mainstream corporation tax. So companies paid their tax liabilities earlier than necessary if they paid a dividend but the liability was not increased by the payment of the dividend.
However, by the time that we reached the late 1990s the UK economy was not closed but rather was wide open. Some 18 years after Margaret Thatcher removed exchange controls corporate UK had invested massively abroad, and a significant portion of the dividends paid by UK companies came from overseas profits that had paid overseas corporation tax not UK corporation tax. This in itself is not a problem as UK companies get credit relief for overseas taxes paid: relief for the amount of overseas tax paid is claimed and reduces the mainstream UK corporation tax liability.
Just waiting a year would have saved Mr. Browns reputation, but the tax consultant in me feels he could have moved much more elegantly. Australia has managed to retain the imputation system by allowing companies to choose whether a particular dividend is “franked” with a tax credit or is “unfranked” and so comes without one. Using this technique companies with profits that are liable to mainstream corporation tax could give tax credits and those without could decide not to. This would have protected the pension funds but introduced a new level of complexity into UK corporation tax.
What is clear is that Gordon Brown acted impetuously and either without decent advice or as is reported having ignored advice. He could have very easily have achieved his objectives and won the praise of pension funds who are major investors in corporate UK and not their censure. His actions of 1997 must now be giving him much to regret. The interesting question is whether he has learned from the experience and is now taking appropriate advice.
