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Printable Version
INTRODUCTION
The ABI Guidelines on remuneration are designed to provide a practical framework and reference point for both shareholders in reaching voting decisions and for companies in deciding upon their remuneration policy.
In conjunction with these Guidelines, institutional shareholders continue to expect companies to follow good practice under the Combined Code by establishing Remuneration Committees of independent non-executive directors. They will also expect companies to demonstrate best practice as regards disclosure as well as compliance with statutory regulation.
Shareholders believe that the key determinant for assessing remuneration is performance in the creation of shareholder value. The overall quantum of the remuneration package and the employment costs to companies must be weighed against the company's ability to recruit, retain and incentivise individuals.
Remuneration Reports should provide a full and clear explanation of the policy, establishing a clear link between reward and performance. Effective consultation by companies when formulating policy can help to avoid inappropriate outcomes. Companies should ensure that an appropriate policy is in place and followed, rather than to risk controversy when remuneration outcomes are disclosed in the Annual Report. Appropriate disclosures on remuneration for executives at below board level can be best achieved on a banded basis in order to illustrate the coherence of the company's remuneration policy.
During the transition to international accounting standards, shareholders expect Remuneration Committees to confirm that they are using a consistent approach to performance measurement and to explain how they are achieving this. In the context of impending changes to pensions taxation we expect companies will be addressing any appropriate structural changes to remuneration. The Remuneration Report should disclose the policy intentions in this area.
CONTENTS
Introduction
Remuneration - Principles
Guidelines for the Structure of Remuneration
Guidelines for Share Incentive Schemes
Best Practice on Executive Contracts and Severance - A Joint Statement by The Association of British Insurers and The National Association of Pension Funds
REMUNERATION - PRINCIPLES
1. Remuneration Committees should maintain a constructive and timely dialogue with their major institutional shareholders and the ABI on matters relating to remuneration such as contemplated changes to remuneration policy and practice, including issues relating to share-based incentive schemes. Any proposed departure from the stated remuneration policy should be subject to prior approval by shareholders.
2. Companies should ensure that Remuneration Committees are properly established and constituted to exercise independent judgment with appropriate powers of authority delegated from Company Boards.
3. Boards should demonstrate that performance based remuneration arrangements are clearly aligned with business strategy and objectives and are regularly reviewed. They should ensure that overall arrangements are prudent, well communicated, incentivise effectively and recognise shareholder expectations.
It is particularly important that Remuneration Committees should bring independent thought and scrutiny to the development and review process together with an understanding of the drivers of the business which contribute to shareholder value.
4. Remuneration Committees must guard against the possibility of unjustified windfall gains when designing and implementing share-based incentives and other associated entitlements. They must also ensure that variable and share-based remuneration is not payable unless the performance measurement governing this is robust. They should satisfy themselves as to the accuracy of recorded performance measures that govern vesting of such remuneration. They should work with audit committees in evaluating performance criteria.
5. Remuneration Committees should have regard to pay and conditions throughout the company and demonstrate that appropriate analysis supports the level of remuneration. They should use external comparisons with caution, in view of the risk of an upward ratchet of remuneration levels with no corresponding improvement in performance and should avoid paying more than is necessary.
6. Remuneration Committees should pay particular attention to arrangements for senior executives who are not board members but have a significant influence over the company's ability to meet its strategic objectives.
7. All new share-based incentive schemes should be subject to approval by shareholders by means of a separate and binding resolution. Where the rules of share-based incentive schemes, or the basis on which the scheme was approved by shareholders, permit some degree of latitude as regards quantum of grant or performance criteria it is expected that any changes will be detailed in the Remuneration Report. Any substantive changes in practical operation of schemes resulting from policy changes or modifications of scheme rules as previously approved should be subject to prior shareholder approval.
8. Where there is any type of matching arrangement or performance-linked enhancement in respect of shares awarded under deferred bonus arrangements, there should be a separate shareholder vote. (see Paragraphs 6.6 and 13.4)
9. There should be transparency on all components of remuneration of present and past directors and where appropriate other senior executives. Shareholders' attention should be drawn to any special arrangements and significant changes since the previous Remuneration Report.
10. Remuneration paid and awards made should be within the scope of the policy outlined in the Remuneration Report approved by shareholders. Where, in exceptional circumstances for reasons of recruitment or retention, Remuneration Committees have made provision for remuneration beyond the scope of the previously outlined remuneration policy relevant details must be disclosed and the reasons for this explained to shareholders.
11. Shareholders consider it inappropriate for chairmen and independent directors to be in receipt of incentive awards geared to the share price or performance, as this could impair their ability to provide impartial oversight and advice.
12. Awards should be structured to promote as close as possible an alignment of participants with the risks and rewards faced by shareholders. It is undesirable for directors to seek out leveraged arrangements on the price of the company's securities.
GUIDELINES FOR THE STRUCTURE OF REMUNERATION
1. Remuneration Committees should look at overall remuneration, at whether there is an appropriate balance between fixed and variable remuneration and between short and long-term variable components of long-term remuneration, and, if not, how the remuneration package should be rebalanced in order to accommodate new elements.
2. When setting salary levels Remuneration Committees should take into consideration the requirements of the market, bearing in mind competitive forces applicable to the sector in which the company operates and to the particular challenges facing the company. Disclosure of policy in this regard is helpful to shareholders. Remuneration Committees should be able to satisfy shareholders that the company is not paying more than is necessary to attract and retain the directors needed to run the company successfully. It is also appropriate to evaluate other elements of the overall remuneration package, which are usually expressed by reference to base salary. Simple structures assist with motivation and enhance the prospects of successful communication with the employees involved and with shareholders.
3. A policy of setting salary levels below the comparator group median can provide more scope for increasing the amount of variable performance based pay and incentive scheme participation. Where a company seeks to pay salaries at above median, justification is required.
4. Annual bonuses, normally payable in cash, can provide a useful means of short-term incentivisation, but should be related to performance. Both individual and corporate performance targets are relevant and should be tailored to the requirements of the business and reviewed regularly to ensure they remain appropriate.
5. Shareholders understand that considerations of commercial confidentiality may prevent disclosure of specific short-term targets. However they expect to be informed about the main performance parameters, both corporate and personal, adopted in the financial year being reported on. When the bonus has been paid, shareholders expect to see analysis in the Remuneration Report of the extent to which the relevant targets were actually met. The maximum participation levels should be disclosed, and any increases in the maximum from one year to the next should be explicitly justified. As provided for under the Combined Code, annual bonuses should not be pensionable.
6. Remuneration Committees are responsible for ensuring that targets set out in bonus arrangements have been properly fulfilled. Where there is doubt they should work with the Audit Committee to ensure that the basis for their decision is correct.
7. Any material payments that may be viewed as being ex-gratia in nature should be fully explained, justified and subject to shareholder approval prior to payment. Shareholders are not supportive of transaction bonuses which reward directors and other executives for effecting transactions irrespective of their future financial consequences.
8. Boards should review regularly the potential liabilities associated with all elements of remuneration including share incentive participation and pension arrangements and should make appropriate disclosures to shareholders.
9. IShareholders recognise that pension entitlements accruing to directors represent a significant, and potentially costly, item of remuneration which is not directly linked to the performance of the company.
There should be informative disclosure identifying incremental value accruing to pension scheme participation and any other superannuation arrangements and related contingent commitments, arising from service during the year in question.
Changes to transfer values should be fully explained. Where there are discretionary increases in pension entitlement, significant changes in actuarial and other relevant assumptions, or ex-gratia awards or contributions, these should be fully explained and justified.
Companies should recognise the risks of changes to future mortality rates and investment returns and how to limit the potential liability created by pension commitments.
10. Companies are not responsible for compensating individuals for changes in personal tax liabilities such as those resulting from changes to pensions taxation. In the context of the changes coming into effect in 2006 companies may wish to consider whether there may be ways of delivering remuneration that are more cost-effective than a pension fund and more aligned with shareholder value creation.
The extent to which actual and potential liabilities such as pension promises or early retirement benefits are funded should be disclosed, together with any aggregate outstanding unfunded liabilities.
11. Remuneration Committees should scrutinise all other benefits, including benefits in kind and other financial arrangements to ensure they are justified, appropriately valued and suitably disclosed.
12. Remuneration Committees should have regard to outstanding dilution in accordance with Guideline limits (see Section 20) and where appropriate available dilution capacity should be disclosed so that this can be compared with previous years.
13. Institutional shareholders encourage companies to require their senior executives to build up meaningful shareholdings in the companies for which they work. Consistent with this approach, consideration should be given to incorporating provisions in the rules of incentive schemes to require retention of a proportion of shares to which participants become entitled until such times as shareholding guidelines are met.
14. The chairman and non-executive directors should be appropriately remunerated either in cash or in shares bought or allocated at market price. The granting of incentives linked to the share price or performance is not appropriate as this could impair the ability of chairmen and independent directors to provide impartial oversight and advice.
Where, in exceptional circumstances, specific reasons arise for wishing to grant share incentives to a chairman, these should be fully discussed and approved by shareholders in advance. Recipients would be expected to hold all shares awarded under such schemes for the duration of their term of office.
GUIDELINES FOR SHARE INCENTIVE SCHEMES
1.1 Institutional shareholders generally support share incentive schemes that link remuneration to performance and align the interests of participating executive directors and senior executives with those of shareholders.
1.2 The implementation of such schemes involves either the commitment of shareholder funds or the dilution of shareholders' equity. It is important, therefore, that they be objectively costed, well-designed and form a coherent part of the overall remuneration package.
1.3 These Guidelines apply to all share-based schemes including any arrangements whereby the value of an option gain will be paid either in the form of cash or shares (cash or share-settled share appreciation rights respectively).
1.4 Shareholders expect all share incentive schemes to follow the spirit of the Guidelines.
2. General Principles
2.1 Share incentive schemes should emphasise the importance of linking remuneration to performance, limits on dilution and individual participation, and a structure that effectively aligns the long-term interests of management with those of shareholders, having due regard to the cost of the schemes, which should be disclosed.
2.2 Shareholders strongly encourage the adoption of phased grants and welcome the trend towards awards being applied on a sliding scale in relation to the achievement of demanding and stretching financial performance against a target group or other relevant benchmark
2.3 Dilution is a matter of particular concern to investors. These Guidelines re-affirm the basic principle that overall dilution under all schemes should not exceed 10% in any 10-year period with the further limitations of 5% in any 10-year period on discretionary schemes (see Section 20).
3. Scope
3.1 These Guidelines apply to all share incentive schemes or arrangements sponsored by UK listed companies whether option-based or involving conditional awards of shares, and including arrangements whereby awards on vesting or exercise are made in cash, or the transfer of shares to the value of the imputed gain at vesting date. Other companies should have regard for them, whenever possible.
4. Remuneration Committees
4.1 Remuneration Committees should:
• regularly review share incentive schemes to ensure their continued effectiveness, compliance with current Guidelines and contribution to shareholder value
• provide a statement in the Remuneration Report as to whether a review of the current share incentive schemes has been undertaken both as regards their operation, including how discretion has been exercised, and whether grant levels, performance criteria and vesting schedules which have been previously approved by shareholders remain appropriate to the company's current circumstances and prospects
• obtain prior shareholder authorisation for any substantive or exceptional amendments to scheme rules and practice including changes to limits and changes which make it easier to achieve performance targets, and where significant exercise of discretion is proposed by the Remuneration Committee.
5. Disclosure
5.1 Companies must make full and relevant disclosure in their Remuneration Reports and in new proposals regarding share incentive schemes. Their rationale should be fully explained in order to enable shareholders to make informed decisions. In the absence of clear disclosure, shareholders may not be able to take the informed decision that will enable them to give their support.
5.2 Scheme and individual participation limits must be fully disclosed in share incentive schemes. Disclosure should, inter alia, cover performance conditions and related costs and dilution limits as set out in the relevant sections below. The reasons for selecting the performance conditions and target levels, together with the overall policy for granting conditional share or option awards, should be fully explained to shareholders.
6. Performance Conditions
6.1 It is now widely recognised that the desired alignment of interests is best achieved through the vesting of awards under share incentive schemes being conditional on satisfaction of performance criteria. These should demonstrate the achievement of demanding and stretching financial performance over the incentivisation period.
6.2 Challenging performance conditions should govern the vesting of awards or the exercise of options under any form of long term share-based incentive scheme. These should:
• relate to overall corporate performance
• demonstrate the achievement of a level of performance which is demanding in the context of the prospects for the company and the prevailing economic environment in which it operates
• be measured relative to an appropriate defined peer group or other relevant benchmark
• be disclosed and transparent.
The reasons for selecting the performance condition(s), together with the overall policy for granting conditional share or share option incentive awards, should be fully explained to shareholders.
6.3 Threshold vesting levels should not be significant by comparison to annual base salary. Furthermore, award structures with a marked "cliff-edge" vesting profile are considered inappropriate, particularly where there may be clustering of performance outcomes around the average.
6.4 Where companies have a policy of making awards with high potential value shareholders expect the vesting of such awards to be linked to commensurately higher levels of performance i.e. the greater the level of potential reward to individual participants the more stretching and demanding the performance conditions should be. Full vesting should be dependent upon achievement of significantly greater value creation than that applicable to threshold vesting. Companies should explain clearly how this is achieved, especially when annual grants of options in excess of one times salary, or equivalent long term share incentive awards, are made.
6.5 Sliding scales that correlate the reward potential with a performance scale that incorporates the provisions of these Guidelines are a useful way of ensuring that performance conditions are genuinely stretching. They generally provide a better motivator for improving corporate performance than a "single hurdle".
6.6 When Share Schemes provide for awards of matching shares in respect of annual bonuses, such awards should be kept within reasonable limits and further performance conditions should be satisfied before the matching shares are permitted to vest. (see Paragraph 13.4)
7. Performance Criteria
7.1 All types of performance measures should be fully explained. It should be demonstrated that they are robust and demanding, and linked clearly to the achievement of enhanced shareholder value. Remuneration Committees should satisfy themselves that the vesting of awards accords with these objectives.
7.2 Remuneration Committees should take particular care to ensure that comparator groups used for performance purposes remain both relevant and representative. Where only a small number of companies are used for a comparator group, Remuneration Committees should satisfy themselves that the comparative performance will not result in arbitrary outcomes which are inconsistent with the Guidelines. Awards should not be made for less than median performance.
7.3 Total shareholder return (TSR) relative to a relevant index or peer group is one of a number of generally acceptable performance criteria. However, Remuneration Committees should satisfy themselves prior to vesting that the recorded TSR or other criterion is a genuine reflection of the company's underlying financial performance, and explain their reasoning.
7.4 Where TSR is used as a performance criterion and the chosen comparator group includes companies listed in overseas markets, it is essential that TSR be measured on a consistent basis. The standard approach should be for a common currency to be used. Where there are compelling grounds for the calculation to be based on local currency TSR of comparator group companies, then the reasons for choosing this approach should be fully explained.
7.5 Remuneration Committees should be careful to ensure that the definition of earnings per share (EPS) or any other financial measure that they may employ will fully reflect performance of the business on a consistent basis in respect of the measurement period.
7.6 Shareholders need to have sufficient data to judge the appropriate size of the award for any given performance level. They also expect a maximum level of grant to be disclosed.
7.7 Other than in exceptional circumstances, the setting of a premium exercise price is not of itself a substitute for the adoption of relative performance conditions in accordance with these Guidelines.
8. Retesting
8.1 It is increasingly recognised that retesting of performance conditions for all share-based incentive schemes is unnecessary and unjustified as is clearly the case for Long Term Incentive Plans (LTIPs) and similar nil-priced option schemes. The stipulated performance conditions should never combine a fixed performance hurdle with measurement from a variable base date.
9. Vesting of Awards
9.1 Performance conditions should be measured over a period of three or more years. Strong encouragement is given to use of longer performance measurement periods of more than 3 years and deferred vesting schedules, in order to motivate the achievement of sustained improvements in financial performance.
9.2 Where LTIP awards are made over whole shares1, a better alignment of interest with shareholders will be achieved if, in respect of those shares that do vest, equivalent value to that which has accrued to shareholders by way of dividends during the period from date of grant also vests in the hands of LTIP recipients. To the extent that the shares conditionally awarded do not vest then nor should any scrip or cash amounts representing the rolled-up dividends.
Remuneration Committees should also be mindful to ensure that the size of grants made on this basis takes into account reasonable expectations as to the value of the dividend stream on the company's shares over the period to vesting. Where the facility for rolled-up dividends is introduced a smaller initial grant size is required in order to target a similar level of value in the conditional share award.
1 This term covers awards structured in the form of either 'restricted shares' or 'nil-cost options'.
10. Performance on Grant
10.1 Where competitive factors genuinely make awards of performance-linked grants impossible then shareholders will consider alternative proposals carefully and only in the most exceptional circumstances approve them. For example, Remuneration Committees may consider the application of challenging performance conditions to govern the grant instead of the vesting of options. However shareholders are likely only to consider such proposals in certain specific and exceptional circumstances, and in particular that the company has clearly demonstrated to the satisfaction of shareholders that it is operating in a global environment which genuinely requires it to pay attention to global remuneration practices. Shareholders will expect that at least the conditions (see Appendix A) have been met.
11. Change of Control Provisions
11.1 Scheme rules should state that there will be no automatic waiving of performance conditions either in the event of a change of control or where subsisting options and awards are "rolled-over" in the event of a capital reconstruction, and/or the early termination of the participant's employment. Remuneration Committees should use best endeavours to provide meaningful disclosure that quantifies the aggregate payments arising on a change of control.
11.2 Shareholders expect that the underlying financial performance of a company that is subject to a change of control should be a key determinant of what share-based awards, if any, should vest for participants. Remuneration Committees should satisfy themselves that the performance criterion genuinely reflects a robust measure of underlying financial achievement over any shorter time period. They should explain their reasoning in the Remuneration Report or other relevant documentation sent to shareholders.
11.3 Where share incentive awards vest early as a consequence of a change of control, awards should vest on a time pro-rata basis i.e. taking into account the vesting period that has elapsed at the time of change of control.
12. Cost
12.1 The cost of share incentive schemes (and any amendments to existing schemes) should be disclosed at the time shareholder approval is sought in order that shareholders can assess the benefits of the proposal against the total costs and award justification. The following information should be disclosed:
• The total cost of all incentive arrangements.
• The potential value of awards (see Appendix B Note 1) due to individual scheme participants on full vesting. This should be expressed by reference to the face value of shares or shares under option at point of grant, and expressed as a multiple of base salary.
• The expected value (see Appendix B Note 2) of the award at the outset, bearing in mind the probability of achieving the stipulated performance criteria.
• The maximum dilution which may arise through the issue of shares to satisfy entitlements.
12.2 There should be prudent and appropriate arrangements governing acquisition of shares, and financing thereof, to meet contingent obligations under share-based incentive schemes.
12.3 The use of phased grants of share options and restricted shares, and utilisation of both new and purchased shares to satisfy the vesting of awards, requires a comprehensive approach to valuation. Assessment should focus on expected value, which should be disclosed, and it should take account of the performance vesting schedule which is adopted as well as the existence of any "retesting" and "replacement option" facilities such as have been prevalent under traditional schemes. Shareholders are helped in this task by disclosure of face value of any share award or option grant as well as of expected value.
13. Participation
13.1 Participation in share incentive schemes should be restricted to bona-fide employees and executive directors, and be subject to appropriate limits for individual participation which should be disclosed.
13.2 There should be no absolute right of participation in share incentive schemes. Grant policy should be disclosed and consistently applied and, within the limits approved by shareholders, reflect changing commercial and competitive conditions. In the event of declining share price levels it is particularly important to avoid unjustified increases in the actual number of shares or options awarded.
13.3 Participation in more than one share incentive scheme must form part of a well-considered remuneration policy, and should not be part of a multiple arrangement designed to raise the prospects of payout.
13.4 Institutional shareholders are not supportive of arrangements whereby shares or options may, in effect, be granted at a discount. This principle applies in circumstances where Remuneration Committees provide for awards of matching shares in respect of annual bonuses payable in the form of shares where these are then held for a qualifying period of, say, 3 years. In these cases, institutional shareholders will generally expect that satisfaction of further performance criteria will be required in order for the matching element to vest. (see Paragraph 6.6)
14. Phasing of Awards and Grants
14.1 The regular phasing of share incentive awards and option grants, generally on an annual basis, is encouraged because:
• It reduces the risk of unanticipated outcomes that arise out of share price volatility and cyclical factors.
• It eliminates the perceived problem that a limit on subsisting options encourages early exercise.
• It allows the adoption of a single performance measurement period.
• It lessens the possible incidence of "underwater" options, where the share price falls below the exercise price.
The phased vesting of awards in specific tranches following the minimum three year performance measurement period is not an alternative to phased grants. However, it can help to enhance the linking of vesting of awards to sustained performance and maintain incentivisation.
15. Pricing of Options and Shares
15.1 The price at which shares are issued under a scheme should not be less than the mid-market price (or similar formula) immediately preceding grant of the shares under the scheme.
15.2 Options granted under executive (discretionary) schemes should not be granted at a discount to the prevailing mid-market price.
15.3 Repricing or surrender and regrant of awards or "underwater" share options is not appropriate.
16. Timing of Grant
16.1 The rules of a scheme should provide that share or option awards normally be granted only within a 42 day period following the publication of the company's results.
17. Life of Schemes and Incentive Awards
17.1 No awards should be made beyond the life of the scheme approved on adoption by shareholders, which should not exceed 10 years.
17.2 Shares and options should not vest or be exercisable within three years from the date of grant. In addition, options should not be exercisable more than 10 years from the date of grant.
17.3 Options or other conditional share awards are normally granted in respect of the year in question and in expectation of service over the performance measurement period of not less than 3 years.
17.4 Where individuals choose to terminate their employment before the end of the service period, or in the event that employment is terminated for cause, any unvested options or conditional share-based award should normally lapse.
17.5 In circumstances where the individual is unable to complete the period of service, it is to be expected that some portion of the award will vest, at least to the extent of the service period that has been completed but subject to the achievement of the appropriate performance criteria.
17.6 Where, in the event of death or cessation of employment of the option holder or where a company is taken over (except where arrangements are made for a switch to options of the offeror company), outstanding options vest or have already vested, they must be exercised (or lapse) within 12 months.
17.7 Any shares or options that a company may grant in exchange for those released under the schemes of acquired companies should normally be taken into account for the purposes of dilution and individual participation limits determined in accordance with these Guidelines.
18. Retirement
18.1 The treatment of awards in the event of retirement of the holder should reflect the principle that awards are granted in respect of the year in question and in expectation of service over the performance period of at least 3 years. Where the treatment does not follow that provided for in Paragraph 17.5, awards made within 12 months of actual retirement date must in any event be subject to pro-rating in respect of the balance of the 12 month period following grant which falls after the actual date of retirement. In determining the size and other terms of a grant made within 3 years of the anticipated retirement date, Remuneration Committees should have regard to the executive's ability to contribute to the achievement of the performance conditions.
18.2 Any unvested options or other conditional share awards which are outstanding at a participant's retirement date should be subject to performance measurement over the original stipulated period. Where the rules of the scheme require early exercise on retirement, performance should be pro-rated over the shorter period. In any event options should vest no later than the end of the initial performance measurement period, and should be finally exercisable no later than 12 months following the date of vesting.
19. Subsidiary Companies and Joint Venture Companies
19.1 It is generally undesirable for options to be granted over the share capital in a joint venture company.
19.2 In normal circumstances grants over the shares in a subsidiary company should not be made. However shareholders may consider exceptions where the condition of exercise is subject to flotation or sale of the subsidiary company. In such circumstances, grants should be conditional so that vesting is dependent on a return on investment that exceeds the cost of capital and that the market value of the shares at date of grant is subject to external validation. Exceptions will apply in the case of an overseas subsidiary where required by local legislation, or in circumstances where at least 25% of the ordinary share capital of the subsidiary is listed and held outside the group.
20. Dilution Limits
20.1 Where the terms of any incentive scheme provide that entitlements may be satisfied through the issue of new shares or utilisation of treasury shares, then the rules of that scheme must provide that, when aggregated with awards under all of the company's other schemes, commitments to issue new shares or re-issue treasury shares must not exceed 10% of the issued ordinary share capital (adjusted for scrip/bonus and rights issues) in any rolling 10 year period. Remuneration Committees should ensure that appropriate policies regarding flow-rates exist in order to spread the potential issue of new shares over the life of relevant schemes in order to ensure the limit is not breached.
20.2 Commitments to issue new shares or re-issue treasury shares under executive (discretionary) schemes should not exceed 5% of the issued ordinary share capital of the company (adjusted for scrip/bonus and rights issues) in any rolling 10 year period. This may be exceeded where vesting is dependent on the achievement of significantly more stretching performance criteria, with full vesting threshold at top quartile or above.
20.3 The implicit dilution commitment should always be provided for at point of grant even where, as in the case of share-settled share appreciation rights, it is recognised that only a proportion of shares may in practice be used.
20.4 For small companies, up to 10% of the ordinary share capital may be utilised for executive (discretionary) schemes, provided that the total market value of the capital utilised for the scheme at the time of grant does not exceed £500,000.
21. Employee Share Ownership Trusts - ESOTs
21.1 ESOTs should not hold more shares at any one time than would be required in practice to match their outstanding liabilities, nor should they be used as an anti-takeover or similar device. Furthermore an ESOT's deed should provide that any unvested shares held in the ESOT shall not be voted at shareholder meetings. The prior approval of shareholders should be obtained before 5% or more of a company's share capital at any one time may be held within ESOTs.
21.2 Where companies have provided for an ESOT to be used to meet scheme requirements, they should disclose the number of shares held by the ESOT in order to assist shareholders with their evaluation of the overall use of shares for remuneration purposes. The company should explain its strategy in this regard.
22. All-Employee Schemes
22.1 All-Employee schemes, such as SAYE schemes and Share Incentive Plans (SIPs) - (formerly known as AESOPs), should operate within an appropriate best practice framework. If newly issued shares are utilised, the overall dilution limits for share schemes should be complied with. Guidelines relating to timing of grants (except for pre-determined regular appropriation of shares under SIPs) apply.
Appendix A
The following are the minimum criteria that shareholders will expect to be satisfied in respect of any share incentive scheme adopting performance at point of grant instead of performance criteria governing the vesting of awards or exercise of options. (See Paragraph 10.1)
• The scheme should be tailored to executives who are exposed to global remuneration practices and the approach should not be applied automatically to UK-based participants. Comparisons with overseas companies should take account of the different practices for setting remuneration, including pension provision, when compared with UK practices.
• Performance conditions covering the grant should refer to overall corporate performance as a reference, not just individual performance of the grantee.
• The basis of performance criteria should be fully disclosed and explained.
• Performance-linking at grant does not alter the requirement that the minimum period for exercise of options should be three years from the date of grant.
• The dilution limits set out in Section 20 are adhered to.
• Participants in schemes are expected by the Board to build up a significant and disclosed shareholding through retention of awards that vest. Holding share options is not a substitute for share ownership in meeting ownership targets.
• Disclosure concerning the scheme should comply with the highest standards relevant to the other jurisdictions in which the company operates e.g. those applied by the US Securities and Exchange Commission.
Appendix B
Note 1
Potential Value of the Award
Shareholders are likely to have regard to the potential value of the award assuming full vesting. This should be expressed on the basis that a conditional award is made of shares, or options over shares, with a face value, at current prices, equal to a given percentage of base salary. However the potential value will also be a function of share price at the time of vesting and of illustrative disclosures of potential outcomes may also be helpful. Full vesting of awards of higher potential value should require the achievement of commensurately greater performance.
Note 2
Expected Value
The concept of expected value (EV) should be central to assessment of share incentive schemes. Essentially, EV will be the present value of the sum of all the various possible outcomes at vesting or exercise of awards. This will reflect the probabilities of achieving these outcomes and also the future value implicit in these outcomes. The calculation of the EV of share schemes is often complex and relies on a range of assumptions, and reliance on this concept by Remuneration Committees will require a sufficient measure of disclosure to enable shareholders to make informed judgments about such arrangements.
The nature of performance hurdles governing exercise is also crucial to calculations of EV and it must also be recognised that any facility for "retesting" will also increase the EV of the award whereas in contrast if the exercise price is set at a premium to the share price at the outset, this will reduce the value of the EV of the instrument.
Institutional investors welcome efforts towards ensuring that accounting for share options and other share-based payment awarded under incentive schemes fully reflects the true cost to shareholders.
BEST PRACTICE ON EXECUTIVE CONTRACTS AND SEVERANCE - A JOINT STATEMENT BY THE ASSOCIATION OF BRITISH INSURERS AND THE NATIONAL ASSOCIATION OF PENSION FUNDS
1. Introduction
1.1 Institutional shareholders believe top executives of listed companies should be appropriately rewarded for the value they generate. However, they are also concerned to avoid situations where departing executives are rewarded for failure or under-performance. This is a matter of good governance, about which the ABI and NAPF have been concerned for many years.
1.2 It is unacceptable that failure, which detracts from the value of an enterprise and which can threaten the livelihood of employees, can result in large payments to its departing leaders. Executives, whose remuneration is already at a level which allows for the risk inherent in their role, should show leadership in aligning their financial interests with those of their shareholders.
1.3 Our two organisations, whose members are leading institutional investors in UK markets, are therefore publishing this statement of best practice, which sets out the expectations of shareholders that boards will give careful consideration to the risk that negotiation of inappropriate executive contracts can lead to situations where failure is rewarded.
1.4 If companies are to recruit executives of sufficient calibre, Boards must bear in mind the basic demands of the market. These require them to offer incoming executives a degree of protection against downside risk. Contract law also provides employees with certain rights that must be respected.
1.5 However, shareholders also believe it is the duty of Boards to develop and implement recruitment and remuneration policies which will prevent them being required to make payments that are not strictly merited. When companies recruit senior executives, they do so in a mood of optimism and expectation of success. They may therefore tend to overlook the consequences of failure, which is clearly inappropriate.
1.6 At the outset, Boards should calculate the potential cost of termination in monetary terms. This should cover all elements of the severance package, including any property liabilities the company may be required to assume on behalf of the departing executive. They must also consider and avoid the serious reputational risk of being obliged to make and disclose large payments to executives who have failed to perform.
1.7 Shareholders will hold Boards accountable for the design and implementation of appropriate contracts. The primary responsibility resides, however, with Remuneration Committees.
1.8 Remuneration Committees should have the leeway to design a policy appropriate to the needs and objectives of the company, but they must also have a clear understanding of their responsibility to negotiate suitable contracts and be able to justify severance payments to shareholders.
1.9 This statement provides a reference point, both to make companies aware of the reasonable expectations of shareholders and to inform voting decisions under the new legislation giving shareholders an annual vote on the remuneration report. We expect that this guidance will be reviewed periodically and refreshed as necessary to take account of changing market circumstances.
2. Basic Principles
2.1 The design of contracts should not commit companies to payment for failure. Shareholders expect Boards to pay attention to minimising this risk when drawing up contracts. They should bear in mind that it may be in the interest of incoming executives and their personal advisers to exaggerate their potential loss on dismissal. Boards should resist consequent pressure to concede overly generous severance conditions.
2.2 Choices made when the contract is agreed have an important bearing on subsequent developments. Companies should have a clear, considered policy on directors' contracts which should be clearly stated in the remuneration report. Boards should calculate and take account of all the material commitments which the company would face in the event of severance for failure or underperformance. The Nomination Committee needs to see through the process of appointment by working with the Remuneration Committee to ensure that the contract is fair to all parties.
2.3 Objectives set for executives by the Board should be clear. The more transparent the objectives, the easier it is to determine whether an executive has failed to perform and therefore to prevent payment for failure. Wherever possible, objectives against which performance will be measured should be made public.
2.4 It should be clearly understood that investors do not expect executives to be automatically entitled to cash or share-based payments other than basic pay. Bonuses should be cut or eliminated when individual performance is poor. From the outset, Boards should therefore establish a clear link between performance and bonus as well as other aspects of variable pay.
2.5 Compensation for risks run by senior executives is already implicit in the absolute level of remuneration. Boards should ensure that there is an appropriate balance between contractual protection and total remuneration and be able to justify their policies to shareholders. Shareholders prefer short contracts of one year or less, and Boards must be able to justify the length agreed. The one-year period provided for under the Combined Code best practice should thus not be seen as a floor. Shorter periods would be appropriate if other remuneration conditions would mean that a one-year contract period would lead to excessive severance payment.
2.6 In highly exceptional circumstances - for example, where a new chief executive is being recruited to a troubled company - a longer initial notice period may be appropriate. These cases should be justified to shareholders and the longer notice period should apply to the initial term only with reversion to best practice at the earliest opportunity.
2.7 Experience suggests that courts take account of some elements of variable pay, such as bonuses, when making awards to departing executives. This can be limited through the attachment of clear performance conditions to variable pay. Boards may also wish to specify that a proportion of the bonus is for retaining the executive and this should fall away in the event of severance. A remuneration policy that favours relatively low base pay and a higher proportion of variable pay is a good way of linking remuneration to performance.
3. Contract Setting
3.1 There is no standard form of contract that can apply in all circumstances. Companies have taken a number of different approaches to severance in the past. These include phased payments, liquidated damages, and reliance on mitigation. It is important that Boards consider the relative merits of different approaches as they apply to their own company's situation, follow their chosen approach consequentially and are able to justify it to shareholders.
3.2 A welcome recent innovation has been the use of phased payments, which involve continued payment, eg on a normal monthly basis to the departing executive for the outstanding term of his or her contract. Payments cease when and if the executive finds fresh employment. Shareholders believe this approach has considerable advantages, which deserve the active consideration of Boards, but this approach does need to be specifically provided for in the contract and specific reference made to the legal obligation to mitigate. It does not involve payment of large lump sums, which cannot be recovered. In many cases, executives will wish to seek further employment rather than remain idle till the monthly payments lapse. Allowing the contract to run off may also obviate the need for pension enhancement (see below).
3.3 The liquidated damages approach involves agreement at the outset on the amount that will be paid in the event of severance. It is clear from the beginning how much will be paid, but the amount cannot be varied to reflect under-performance. Shareholders do not believe the liquidated damages approach is generally desirable. Boards which adopt this should justify their decision, and should therefore consider a modified approach. This would involve reaching agreement in advance that, in the event of severance, the parties would go to arbitration to decide how much should be paid. This approach needs to take account of the likely cost of arbitration.
3.4 The concept of mitigation refers to the legal obligation on the part of the outgoing director to mitigate the loss incurred through severance, for example by seeking other employment and reducing the need for compensation. Where this is the sole approach, shareholders expect reassurance that the Board has taken steps to ensure that the full benefit is obtained. As with liquidated damages, boards need to have considered at the outset what the cost of severance would be under the proposed contract as well as the relative merits of arbitration as opposed to litigation.
3.5 An essential problem is that it is not normally possible for under-performance to be established as a ground for summary dismissal without compensation. Under the Employment Act 2002, however, a statutory disciplinary procedure will be implied into every employment contract, including those of executive directors. Boards should be aware of this and be prepared to use disciplinary procedures if warranted.
3.6 In the wake of this legislation contracts should also make clear that, if a director is dismissed in the wake of a disciplinary procedure, a shorter notice period than that given in the contract would apply. A reasonable period would be the statutory period, comprising one week for each year's service up to a maximum of 12 weeks. Without such a provision the full notice period would continue to apply even after dismissal following a disciplinary procedure.
3.7 Companies should also consider including in contracts a safeguard for more extreme cases, for example, that compensation would not be payable in case of dismissal for financial failure such as a very significant fall of the share price relative to the sector.
3.8 Other than in highly exceptional circumstances, such as the recruitment of a new chief executive of a troubled company, contracts should not provide additional protection in the form of compensation for severance as a result of change of control. Where exceptional circumstances apply, any additional protection should relate to the initial contract term only and not be a rolling provision.
3.9 Companies may consider other options, including a provision for compensation to be paid by reference to shares with the amount of shares set at the outset of employment. Where such an option is proposed it should, however, be clearly explained both as to purpose and to the details of its operation. Remuneration committees should satisfy themselves that it is workable and will yield advantages greater than the phased payment and other approaches outlined above. Compensation paid by reference to shares should be paid in cash rather than directly in shares to prevent unmerited windfall gains.
3.10 The use of shareholding targets for senior executives and directors is likely to be a powerful and therefore more effective means of aligning the financial interests of executives with those of shareholders.
4. Pension Arrangements and Other Remuneration Issues
4.1 Pension enhancements can represent a large element of severance pay and involve heavy cost to shareholders, the full extent of which may not be immediately evident. It is important that Boards state the full cost for pension enhancement at the earliest opportunity. Boards should not support enhanced pension payments without making themselves fully aware of the costs.
4.2 A large liability looms in the future where companies choose not to fund an enhanced pension liability but to pay it as it arises. In all cases, whether the pension is funded or not, Boards must disclose the cost, justify their choice to shareholders and demonstrate that they have chosen a route that involves the least overall cost to the company.
4.3 An important principle with regard to pensions is that Boards should distinguish between the amount that is a contractual entitlement and the amount of discretionary enhancement agreed as part of a severance package. Contracts should state clearly that the pension would not be enhanced in the event of early retirement unless the board was satisfied that the objectives set for the executive had been met or that the enhancement was merited. Shareholders are likely to question enhancement decisions when they are doubtful of the merit and, if not satisfied with the board's justification, they may vote against the remuneration report.
5. General Considerations and Conclusion
5.1 Boards should have a clear and explicit policy on contracts and on how Remuneration Committees will play a primary role. It should include calculation of the cost of severance at the time the contract is drawn up and an approach to implementation which ensures that all payments made on severance take account of performance in relation to objectives set for the departing executive by the board.
5.2 Companies should fulfil their legal obligations to make contracts readily available for shareholders to inspect, together with any side letters relating to severance terms and pension arrangements. Shareholders will take account of contracts and the way they are implemented in considering their vote on the remuneration report.
15 December 2005 | 
