Executive Compensation and Stock Option in the UK
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Published: Wed, 28 Feb 2018
1 – Introduction
Today’s highly competitive world consists of numerous corporations and these corporations are so huge and so large that it cannot be controlled by the people who own them. The control of these corporations is separated from shareholders who are the owners and vested into the hands of professional executives who are specifically hired for its management. This separation of ownership and control gave rise to agency problem or the principal-agent problem. Principal is referred to the stockholders and the agents are the executives who work for the stockholders. Although stockholders are the owners of the company to whom the executives are accountable, their actual powers are restricted except in the case of those corporations where stockholders are also the directors of that corporation. Stockholders have no right to inspect the books of accounts nor are they aware of the exact functioning and position of the firm. As a result, executives tend to work inefficiently without even bothering to look for profitable new investment opportunities, as well as they may use the firm’s assets for private purposes and also work to achieve their personal goals – all at the expense of the shareholders. Some managers do not take any action whatever state or condition the corporation may be as they are risk averse and fear the threat of losing their job if a decision taken by them goes wrong. Therefore in order to avoid the various problems that arise due to the agency problem, executives must be properly and promptly compensated along with proper monitoring.
In the beginning of 1990s, debates on corporate governance mainly focused on directors’ remuneration and ‘fat cats’. ‘Fat cats’ are referred to those executives who provided themselves with huge compensation packages without any performance criteria. In UK, the most famous Fat Cat episode which saddened the shareholders of many large public companies and dragged the attention of the media was the notorious British Gas incident of the mid 1990s. Various issues arising out of executive compensation and the trouble of framing the deserved level of compensation, that has to be provided to an executive, made executive remuneration a main area of concern under corporate governance. According to Jensen (1993), providing the right level of remuneration to the executives and creating positive incentives in order to achieve the interest of the shareholders has been an important study conducted in many academic literatures. An improvement in corporate governance is brought about by filtering certain aspects of executive remuneration.
There exists a wide gap between the remuneration paid to the executives and the remuneration paid to the other employees on the company. This gap keeps on increasing year after year as executives demand more and more for their services and decision making process to boosts the productivity and reputation of the firm which thereby increases the market price of the company’s share. In a research mentioned in the Higgs Report (2003), chairmen of FTSE 100 companies in 2003 earned an average of £ 426,000 as remuneration. Moreover, executives are being rewarded with stock options which would enrich them with abnormal profits in the future when the options granted to them are exercised. Critics argue that, executives are not worth for the remuneration paid because of their poor and unsatisfactory performance. According to Blitz (2003), MORI – a leading market research company in the UK, through a survey, found 78% of the people unsatisfied by the remuneration paid to the executives. The public in UK believe that executives are being overpaid for the amount of work they actually do.
2 – Methodology
This paper is a critical review on the various aspects of executive compensation in the UK and how the executive compensation especially the executive stock option encourage the managers and top executives, for their personal benefit, to take short term high risks and boost up the current value of shares rather than looking into the future and acting in favour of the stakeholders of the company. The tools used for the research mainly consist of various literature reviews of past articles and current working papers with some analysis of some statistical data regarding executive compensation. On the basis of the above mentioned area of research certain questions have been framed which will be critically looked into:
a) Brief description of the executive compensation and corporate governance in the UK.
b) Basic structure of executive remuneration in the UK and their disclosure requirements in United Kingdom.
c) Are stock options considered the best means of remuneration in an executive compensation package?
d) A brief historical overview of the introduction of executive stock option in the UK.
e) What are the various manipulations done with executive stock option and what are the risk incentives created by executive stock option?
f) Brief comparison of the UK executive compensation with the US executive compensation.
g) The role of executive compensation in the UK banking towards the current financial crises.
3 – Executive Compensation and Corporate Governance in the United Kingdom:
During the past decade, various issues on corporate governance established the emergence of many reports and codes of best practice in the United Kingdom. These include the Inland Revenue (1988), Cadbury Report (1992), Greenbury Report (1995), Hampel Report (1998), The Combined Code (1998), Hermes Statement on Corporate Governance and Voting Policy (1998), Internal Control: Guidance for Directors on the Combined Code (Turnbull Report)(1999), Company Law Reform (1999) and Financial Services Market Act (2001) (Konstantinos Stathopoulos, Susanne Espenlaub, Martin Walker, 2003). Among these reports the Cadbury Report, Greenbury Report and the Combined Code, which emerged from the Hampel Report, focused on issues regarding executive compensation.
3.1 – Cadbury Report (1992):
The first guidelines of “good practice” on various issues of corporate governance were provided in the year 1992 by the Cadbury Committee which was established in May 1991 and was chaired by Adrian Cadbury. The Cadbury Committee discussed issues that were broader in nature than the executive remuneration but certain suggestions the committee made on altering the executive pay was accepted as permanent. The Cadbury report was titled as the Financial Aspects of Corporate Governance and came out with the Code of Best Practice, which insisted that decisions based on executive remunerations should not be made by the executive directors nor they have to get involved in making such a decision (1992, paragraph 4.42 p. 31). The report therefore recommended the appointment of a remuneration committee which will act in the interest of the shareholders of the firm and express a good opinion on various matters regarding executive compensation to the board. Companies in the UK responded spontaneously to this recommendation made in the Cadbury Report and established a remuneration committee within the firm (Bostock, 1995). The remuneration committee consists of a non-executive director as the chairperson and non-executive directors as its members who are all independent and free from the influence of the management. According to Williamson (I985), there always arises a question of doubt whether the directors make remuneration contracts for their own huge benefits and sanction it, if an independent pay committee does not exist. The role of remuneration committee is to ensure that executive compensation levels are set up in a formal, transparent way along with the goals required to be achieved by the executives for any schemes that are performance related. The remuneration committee can take advice from outside sources whenever necessary. The Cadbury report also suggested the establishment of an audit committee within each company which comprises of three non-executive directors (Martin Conyon, Paul Gregg and Stephen Machin, 1995). According to a questionnaire survey conducted by Conyon and Mallin (1997), by 1995, 98% of the companies followed the suggestions made by the Cadbury report and has reported the involvement of the remuneration committee in their annual reports.
3.2 – The Greenbury Report (1995):
Cadbury report failed to provide detailed guidance on how compensation packages have to be structured. However, it pointed out ‘executive compensation’ to be the main area of study for the next committee known as the Greenbury Committee. The Greenbury Committee chaired by Sir Richard Greenbury, was formed by the United Kingdom Confederation of Business and Industry, and in 1995 it submitted the Greenbury report which dealt with matters regarding the determination and accounting of top executive pay. The main issues discussed in the Greenbury Report includes the role of the remuneration committee in an organisation, the disclosure requirement required by the shareholders of the organisation, the remuneration policies for compensating the executives and the service contracts provided to the executives. The remuneration policies recommended in the Greenbury Report are:
a) Compensation packages must be provided by the remuneration committee to quality executives in order to influence, secure and encourage them and any payments extra to this intention must be avoided (Greenbury Report – Paragraphs 6.5 – 6.7).
b) The payments made and the subsequent resulting performance by other companies in the same industry must be evaluated by the remuneration committee. On the basis of this evaluation, the remuneration committee should relatively place their company (Paragraphs 6.11 – 6.12).
c) While making changes to the annual salary of the executives, the remuneration committee should look into the payment and employment situations in other areas of the company rather than only concentrating on the executive pay and increasing them so as to satisfy the executives (Paragraph 6.13).
d) The part of remuneration that is related to performance should be designed in such a way that the executive’s incentives go hand in hand with the interest of the shareholders and the executives are motivated to perform their duties with high standards (Paragraph 6.16).
e) The performance conditions for executives to avail their annual bonuses, if any, should be designed to support and widen the operations of the business. The maximum possible amount of annual bonus an executive can avail should be taken into consideration by the remuneration committee and in some cases a part of these bonus payments can also be made by shares (Paragraphs 6.19 – 6.22).
f) Under the long term incentive scheme, the Greenbury Report suggested that the shares and options granted to the executives should neither vest nor be exercisable, at least for a period of 3 years after such grant. The remuneration committee should encourage its executives to keep possession of their shares, after its vesting or exercise, for a long period of time (Paragraphs 6.23 – 6.34).
g) The present existing long term incentive scheme should either be replaced by the new incentive scheme proposed or, the new incentive scheme proposed when combined with the old existing scheme should formulate a well structured incentive plan. The remuneration committee should make sure that the new long term incentive plan does not pay in excess than what is actually required for the executives and this new plan is accepted by the shareholders (Paragraph 6.35).
h) The criteria for any long term incentive grant should be challenging and the performance of the executives should help achieve the goals set by the company in order to stand out from rest of its competitors. Key variables like the total shareholder’s return are used to judge the performance of the company with respect to its competitors (Paragraphs 6.38 – 6.40).
i) Executive stock option grant or any other long term incentive grant must not be presented in lump-sum but should be awarded in series of stages. Moreover, no discount should be provided to the executives on the issue of executive stock option (Paragraph 6.29).
j) While increasing the annual basic salary of the executives, the remuneration committee should look into the effect of such increase on the executives’ pension entitlement and on the future expenses of the company particularly in case of those executives who are nearing retirement. The annual bonuses paid or any benefits paid in kind are not entitled for any pension payment (Paragraph 6.42 – 6.45).
The aim of the Greenbury Report was not to cut down the executives’ remuneration but was to establish a balance between the compensation paid to the executives and their respective performance. On publishing the report in 1995 by the Greenbury Committee, certain tax advantages that was permitted on newly issued share options which comes under the approved executive share option scheme was withdrawn by the UK government. A new type of option scheme was introduced in November 1995 which had an upper limit of only £20,000 on individual option holdings. Further, executive share options whose exercise price was earlier accepted at a discounted price of 15% on the existing share price at the time of grant was prevented (Konstantinos Stathopoulos, Susanne Espenlaub & Martin Walker, 2003). According to Conyon (1994) in UK, the top executive director of a company was also made member of its remuneration committee before the launch of the Greenbury Report. However, the old fashioned executive share options schemes was not benefitted from the recommendations made by the Greenbury Committee as it not only seized the tax benefits but also encouraged to substitute options with long term incentive plans which in the UK is just awarding shares and not cash. The recommendations made by the Greenbury Report were not widely accepted as many of the critics believed that the report failed to link the executive pay with the performance of the company.
3.3 – The Combined Code (1998):
The Combined Code of the London Stock Exchange controls the various remuneration practices adopted by the companies listed in the London Stock Exchange. It has combined the recommendations given by the Cadbury Report and the Greenbury Report in order to form a regulation for efficient remuneration practice. The annual report of the companies listed should contain in a separate section the remuneration policy adopted by the company. The Combined Code requires a statement, in the annual report, showing that the remuneration standards mentioned in the code are being followed by the company and if any set standard is not complied with, the statement should point out the reason for the non compliance. A high level of executive remuneration disclosure is also required under the combined code and clear explanations about the various compensation packages provided to each executive director and non executive director should be stated (Konstantinos Stathopoulos, Susanne Espenlaub & Martin Walker, 2003).
4 – Structure of Executive Remuneration in the UK:
The typical structure of executive compensation in UK comprise of base salary, annual bonus, share options and long term incentive plans along with certain additional components like restricted stock and retirement plans. In 1997, an average executive compensation package consisted of 54% of base salary, 24% of annual bonus and 22% of non cash items which include share options and long term incentive plans (Martin J. Conyon, Simon I. Peck, Laura E. Read and Graham V. Sadler, 2000).
Base Salary –
Determination of the base salary of an executive is done by taking into consideration the base salaries paid to executives of other companies in the same industry through surveys and analysis. This system of setting up and providing base salary is known as “competitive benchmarking”. Certain modifications are carried out on the base salary depending on the size of the firm, thereby linking executive compensation and firm size. In UK, base salary form the major part of the total executive remuneration paid. Base salary is that component of executive remuneration which is fixed and do not vary according to the performance, experience, age, etc of the executives. A £1 increase in the base salary is preferred by executives who are risk averse than a £1 increase in other components of executive compensation that are variable.
Annual Bonus –
Bonus is provided to the executives on the basis of their performance during the relevant financial year. It is provided on an annual basis and the amounts paid as bonus to each executive vary from year to year. The performance of the executives is generally measured by taking into consideration accounting numbers which can be cross checked and audited. Executives have a clear idea of their daily performance by looking at the accounting numbers and they can forecast how overall profit of the company is going to look like at the end of the year. The drawback of relying on accounting numbers for measuring performance is that it is fully under the control of the executives and if wanted executives can manipulate the accounts in order to increase their annual bonus entitlement.
Share Options –
Share options are contracts provided to the executives that cannot be traded which gives the executives the right to buy the shares of the firm at a price that is pre-determined known as the exercisable price for a specified time period. These contracts become void and have to be surrendered if the exercisable period mentioned has elapsed or if the executive resigns from the company before the exercisable period. This component of executive compensation is looked more into detail in the later section.
Long-Term Incentive Plans –
Long-Term Incentive Plans are provided to the executives in order to motivate and compensate them for achieving long term performance for the company. Grant of shares is the most typical form of LTIPs provided in the UK. These shares are vested to the executives only on achieving the objectives set by the company that is related to future performance. Earnings per Share and Total Shareholders Return are the two main elements by which the performance of the company is measured in the UK.
Retirement Plans –
Apart from the basic pension plans provided by the company, in UK, executives are encouraged to participate in an additional retirement benefit plan. These plans are a major source of concern because it symbolises invisible compensation. The actual value of executive retirement plan cannot be calculated by the available information provided in the books of accounts and the annual report.
4.1 – Disclosure Requirement of Executive’s Remuneration in the UK:
The Greenbury Report in 1995 identified three fundamental principles, which are accountability, transparency and performance linkage, in respect to executives’ remuneration. In UK, the current best practice disclosure pattern failed to compile with these fundamental principles therefore the government introduced certain necessary additions to the existing disclosure pattern. These latest requirements regarding disclosure of UK executives’ remuneration unifies the existing law, regulation and best practices that are mentioned in the UK Companies Act of 1985, the UK Listing Rules and the UK Combined Code of Principles of Good Governance and Code of Best Practice. The new requirement requires every company in the UK to adopt and prepare the directors’ remuneration report along with other necessary requirements.
4.1.1 – Directors’ Remuneration Report (DRR):
Companies listed in the London Stock Exchange should prepare the directors’ remuneration report for every financial year (Section 234B Companies Act) and should publish this report along with the accounts and annual report of the company (Section 244 Companies Act). The preparation of the remuneration report is done by the board of directors and not by the remuneration committee being, a committee accountable and responsible to the board and consisting only the non executive directors of the company. The remuneration of both the executive and non executive directors is clearly mentioned in the remuneration report. The fully prepared remuneration report should be filed with the registrar of companies (Section 242 Companies Act) and made available and provided to all the parties interested in the company such as the shareholders, debenture holders, and other persons who are required to attend the general meetings (Section 238 Companies Act).
The remuneration report should contain all the information regarding the remuneration of the directors for the financial year completed i.e. the “relevant financial year” which includes disclosure of the amount receivable by the directors, whether paid or not, during the financial year as well as the disclosure of any amount paid as directors’ remuneration for any other period during the financial year (Companies Act, Schedule 7A, paragraph 19). The remuneration report should include the payments made to a third party for any services provided to the directors (Companies Act, Schedule 7A, paragraph 18(3)) and a statement showing the future remuneration policy of the directors. In UK, only the disclosure of directors’ remuneration is needed in the remuneration report. The name and information of every person who is the director, during the relevant financial year, has to be mentioned in the remuneration report.
The remuneration report contains information that has to be audited by an external auditor (Companies Act, Schedule 7A, Part 3) and information need not be audited (Companies Act, Schedule 7A, Part 3).
a) Information in DRR subject to audit:
With regards to information subject to audit, the external auditor in his own consent should mention whether the information provided are prepared according to the necessary requirement and if any information is not complied as needed, the auditor should provide a statement showing them (Sections 235 and 237 Companies Act). The auditor will also look into disclosure information that are not subjected to audit and verify them with the company accounts as well as with the disclosure information that are audited. The various information included in the DRR that are subject to audit are:
Emoluments and compensation –
For the services provided to the company as an executive or for any other services relating to the company’s management, the salary, bonus, fees or compensation as termination of “qualifying services” received or receivable by the executives should be disclosed in the DRR. The overall value of non monetary benefits provided to the executives should be mentioned and the total aggregate of each kind of executive compensation provided in the relevant financial year should be compared with the previous financial year (Companies Act, Schedule 7A, paragraph 6).
Share Options –
The different types of shares options a company have should be mentioned along with their terms and conditions and besides each share option the total option each executive hold in the beginning of the relevant financial year as well as in the end should be disclosed. Detailed information of the various options provided during the year, its date of grant, its exercise price, date of expiry, number that have become void and number exercised and unexercised by the executives should be mentioned. If the share options are subject to any performance condition then the criteria has to be clearly described. For those shares that have been exercised, the market price during the time of exercise and for those shares unexercised ,the highest, lowest and the year end market prices have to be also mentioned. Since the disclosure of share options is a lengthy process, the aggregate of options each director hold is stated and the disclosure can be made on the basis of weighted average exercise prices (Companies Act, Schedule 7A, paragraphs 7-9).
Long-term incentive schemes –
Disclosure of “scheme interests” at the beginning and end of the current financial year which each executive hold must be made. Details of the type of scheme interest provided to the executives, its value and when it is vested in the year should be mentioned. If there are any conditions on the basis of which scheme interests will be granted then the relevant conditions should be specified (Companies Act, Schedule 7A, paragraphs 10 and 11).
Other Information –
Details of executives’ pension scheme transfer value, any benefits that are accumulated over time and amount paid or payable by the company towards the money purchase pension scheme and retirement benefit scheme should be mentioned (Companies Act, Schedule 7A, paragraph 12). Amount received or receivable by the executives as benefits over and above the retirement benefit which he is entitled after 31st March 1997 should be included in the DRR (Companies Act, Schedule 7A, paragraph 13). If any person, who was once the executive of the company, has been given a special reward or if any third party is paid for their services provided to the executives during the relevant financial year it should be stated and disclosed (Companies Act, Schedule 7A, paragraph 14 – 15).
b) Information in DRR not subject to audit:
The information in the DRR that are not subject to audit is:
Remuneration Committee –
If any decision regarding the remuneration of the executives is taken by a committee during the financial year then the DRR must contain the name of all the non executive directors who were the members of such a committee and also should mention the name of any other person who is not the member of the committee but has been appointed by the members to assist them with certain services and advice. The details of the services rendered by the outside party should be clearly mentioned and this is done to ensure that the executive director play no role and influence the decision making of the committee (Companies Act, Schedule 7A, paragraph 2).
Statement of policy on executives’ remuneration –
A statement of future policy on executives’ remuneration for the coming financial years has to be included in the directors’ remuneration report (Companies Act, Schedule 7A, paragraph 3). The statement of policy should therefore disclose the conditions of performance, by an executive, for the entitlement of share option and long term incentive scheme along with the reasons for setting up such performance condition and the method used to assess the performance condition. If any executive fails meet the performance condition and does not benefit from the stock option grant or long term incentive scheme, the report should clearly state the conditions that are unsatisfactory. Details of the company on the basis of which the performance is measured should be provided in the report. Changes or amendments proposed to the existing terms and conditions for executive’s entitlement should be highlighted. Explanation should also provide for non-performance related remuneration and company policies on executives’ service contracts. This statement covers all directors from the end of the current financial year till the time when the report is put for voting by the shareholders of the company
Performance graph –
Publication of preceding 5 years performance graph should be included in the DRR showing the “total shareholder return” for holding shares whose listing transformed the company into a “quoted company” and for holding shares on the basis of which calculations are made for a broad equity market index. A “fair method” is used for the calculation of the total shareholder return along with various assumptions like the interest received on shares being reinvested (Companies Act, Schedule 7A, paragraph 4).
Service Contract –
During the relevant financial year if any executive is provided with a service contract, the date at which the service contract has been provided, its duration and its terms and conditions should be mentioned in the remuneration report. A detail of the termination compensation the executive is entitled to receive along with the company’s liability on early termination is to be included (Companies Act, Schedule 7A, paragraph 5).
On the complete preparation of the remuneration report, in the annual general body meeting it is introduced and called for a vote by the shareholders of the company (Section 241A Companies Act). This concept of voting the remuneration report was a controversial topic as many commentators suggested the voting to be limited to only the remuneration policy rather than the whole remuneration report. The reason they point out is that the executives’ remuneration policies are futuristic in nature so the shareholders can express their opinion on the policies adopted rather than making aware of the actual remuneration paid to each individual director.
4.1.2 – Other Requirements:
a) Along with the preparation of the DRR, disclosure of the aggregate compensation of the executive, loan given to the executives and other company transactions with the executive should be done in the notes of the annual accounts as mentioned in Schedule 6 of the Companies Act.
b) As per Section 251 of the Companies Act and Companies Regulations (1995), listed companies in their summary financial statements should as a statement, state its policies regarding the remuneration of executives and the company’s performance graph.
5 – Stock/Share Options – Are they the Best in an Executive Compensation package?
The most prominent and important component of executive compensation, in order to merge the interests of the executives with that of the interests of the shareholders, is providing the executives with stock options in the firms they serve (Jensen and Meckling, 1976). According to Jeffrey A. Williamson and Brian H. Kleiner, “A stock option is a security that represents the right, but not the obligation, to buy or sell a specified amount of stocks at a specified price within a specified period of time”. Stock options granted to executives of many large multinational firms are much higher in value than the annual cash pay they are entitled to be paid which in-turn boosts up the overall total compensation provided to the executives. This makes stock options the single largest ingredient in the current scenario of executive compensation. In the United States itself, stock options are held by more than 10 million employees (Simon R. and Dugan J., 2001) out of which around 160,000 of them turned out to be millionaires (Tate E.A. and Wilson T.E., 2001). Initially stock options were provided as a bonus to all the key executives of a company, but during the recent years its use is restricted only to the top level management. Providing stock options have resulted in increased productivity of the organisations. Executives are aware that their gain is linked with the stock performance of the organisation therefore they strive harder and work more efficiently to achieve progress.
The main objective behind granting stock options is to make sure that executive make a profit on the success of the company’s operations and in case of failures they suffer. Hence executive stock options link pay to performance. Critics argue to provide shares of stock rather than providing stock options in order to link pay and performance. The value of a stock option is only one third the value of a share, in case of companies having an average volatile stock price and yielding an average dividend the reason being stockholders receiving the whole value along with the dividend payment and the option holders benefitting only from the additional returns that is over and above the exercise price. This implies that options have a greater leverage and at the same cost, a company can provide its executives with options that are three times as much as that of shares. Stock options are incentive plans that are future
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