The Advisors' Blog

– Subodh Mishra, ISS Governance Exchange

Concurrent to the ushering in of new regulations governing executive remuneration across the U.K., Britain’s Financial Reporting Council (FRC) released for consultation Oct. 1 proposed changes to the U.K. Corporate Governance Code dealing with remuneration. Specifically, the FRC is now consulting on three proposals, including on clawback arrangements, whether non-executive directors who are also executive directors in other companies should sit on the remuneration committee, and what actions companies might take if they fail to obtain “at least a substantial majority” in support of a pay resolution.

This announcement was timed to coincide with the introduction of sweeping new pay rules for U.K. companies contained in Enterprise and Regulatory Reform Act 2013 and the Large and Medium-sized Companies and Groups (Accounts and Reports) (Amendment) Regulations 2013. Under the new rules, companies would provide for separate “policy” and “implementation” sections within the directors’ remuneration report with the former subject to a binding vote at least once every three years, and the latter to an advisory vote annually, as has been the case since 2003.

The new rules also require companies to report all elements of directors’ pay in a single, cumulative figure and to provide enhanced disclosure on performance conditions determining variable pay awards. Other elements of the new regulations govern disclosure around exit payments, and other requirements unrelated to remuneration.

In June 2012, the FRC agreed to a request from the government to consult on whether to amend the market’s governance regime to address the three aforementioned issues. The FRC decided that the consultation should be conducted after the government’s legislation on voting and reporting on executive remuneration took effect this week.

With regard to clawbacks, the FRC seeks comment on whether the current code requirement is sufficient, or whether to include a comply-or-explain presumption that companies have provisions to recover and/or withhold variable pay. At present, the code currently states that “consideration should be given to the use of provisions that permit the company to reclaim variable components [of remuneration] in exceptional circumstances of misstatement or misconduct.”

New rules that took effect Oct. 1, meanwhile, require companies to disclose in the directors’ remuneration policy if there are provisions for clawback, and to disclose in their annual reports the details of any sums recovered or withheld and the reason why. Given this, the FRC also seeks comment on whether the code should adopt the terminology used in the regulations and refer to “recovery of sums paid” and “withholding of sums to be paid,” and whether it should specify the circumstances under which payments could be recovered and/or withheld.

“It seems to me that the incorporation of clawback into the code is the most important of the three suggestions,” said David Paterson, head of corporate governance at the National Association of Pension Funds, in comments to Governance Weekly. “It is already common among large companies and with the growing use of deferred bonuses is implied in many more arrangements. Logically it is hard to see how a company can object to adopting a policy giving it the right to withhold a bonus which, with the benefit of hindsight, was not really ‘earned.'” Paterson’s comments reflect personal observations, with the NAPF still to consult with members on a formal response to the consultation.

Backing Paterson’s assertion regarding the adoption of clawback provisions, institutions in the U.K. have pressed companies on the issue, while a growing number of companies have moved in recent years to adopt such policies. An analysis of ISS Governance QuickScore data for the U.K. markets finds 76 percent of 88 large capital firms studied disclosing the existence of clawback policies as of Oct. 1, a jump of 34 percentage points over figures evidenced in 2011.

Responding to a claim by Secretary of State for Business, Innovation and Skills Vince Cable in 2012 that “there is a perceived conflict” that non-executive directors on remuneration committees who serve as executives elsewhere “have a personal interest in maintaining the status quo in pay setting culture and pay levels,” the FRC seeks comment on whether to “deter” such appoints under an updated code.

In its consultation, the FRC notes the presence of such directors has declined markedly in the 10 years to 2012 across the FTSE250, dropping from 42 percent of companies with such a director in 2003, to 15 percent in 2012. Still, the consultation notes, dissent on remuneration voting was higher, on average, at the companies in all 10 years, save for 2006 and 2009, suggesting shareholder concerns over pay are more prevalent at firms where remuneration committees include directors serving as executives at other firms.

Under the current code, executive directors of other companies would normally be classified as independent unless they “hold cross-directorships or have significant links with other directors through involvement in other companies or bodies.” Any changes will likely face opposition from directors’ groups and others, with critics likely to question the barring of otherwise well suited board members over perceived conflicts.

Similarly, the final issue for consultation will likely engender controversy with corporate advocates and others arguing boards are best suited to determine the level of remuneration report voting dissent warrants engagement with shareholders. The FRC is seeking comment on criteria for determining what constitutes a “significant percentage” as well as the time period within which companies should report on post-meeting discussions with shareholders and subsequent disclosure to the market.

Under rule rolled out, companies must include in the annual remuneration report details of the vote on any remuneration resolutions at the previous general meeting and, where there was a “significant percentage” of votes against a resolution, give “a summary of the reasons for those votes, as far as known to the directors, and any actions taken by the directors in response to those concerns.” However, because this only requires companies to report yearly, some suggest that an additional, earlier disclosure, explaining how the company intended to respond to the concerns raised might be helpful.

The new rules fail to provide a figure defining a “significant percentage,” but recent guidance from the GC100 and Investor Working Group suggests “companies may wish to consider votes against in excess of 20 percent as being significant, although there may be reasons why, for some companies, a higher or lower level might be more appropriate.” According to the results of ISS’ 2011-12 benchmark policy survey, on a cumulative basis, 86 percent of investor respondents (and 52 percent of issuers) believed an explicit response is warranted if the say-on-pay vote received more than 40 percent opposition, and 72 percent of investors (versus 40 percent of issuers) believe that opposition in excess of 30 percent requires an explicit response. Those figures apply to the U.S. market and came in the wake of the inaugural year of mandatory pay votes in 2011. Such voting in Britain dates back to 2003, as noted earlier. “The 20 percent test for ‘significant dissent’ is highly subjective,” cautioned Paterson. “It is for companies to judge whether a particular level of opposition to their remuneration policy warrants a review.”

If changes to the code are ultimately proposed, they will be subject to consultation in the first quarter of 2014. The new code would then apply to accounting periods beginning on or after Oct. 1, 2014.