We have looked at companies, but what of the men and women – and at the new millennium it was still predominantly men – who run them? The escalating pay and perks of the directors of listed companies had been a major political issue for much of the decade. A little background helps in understanding the frequent press and television reports on the pay and perks of board members, particularly in the previously nationalized industries. It also provides the background for the inordinately lengthy corporate governance statements and remuneration committee reports that nowadays occupy many pages of a listed company’s annual report and accounts.
The starting point is a paradox that explains some of the confusion on this issue shown first by the Conservative government and later by its New Labour successor. Capitalism, by and large, is about allowing the owners of capital to enjoy the fruits of their capital. Yet, by amending the tax laws to promote executive share option schemes and the like, the Conservative government of the 1980s had paved the way for extensive transfers of value from the owners of a business (the shareholders) to the directors and managers (the senior employees who run the business on the owners’ behalf). This process of ‘reverse capitalism’ – taking money from the owners to give to the senior employees – was a curious interpretation of the capitalist ethic.
Press reports tend to focus on massive jumps in boardroom pay or multi-million-pound profits made from the exercise of executive share options or long-term incentive plans. But the full picture is often more complex (and sometimes even more startling) than these reports would suggest. In the late 1990s, the directors of many of Britain’s larger listed companies were rewarding themselves in five or six different ways, sometimes more, including:
• a basic salary
• a short-term performance-related bonus on top of basic salary, probably up to a maximum of 50 per cent of salary
• executive share options, which deliver profits when the share price rises
• longer-term incentives geared to performance over a three- or four-year period. These might take the form of cash payments or an outright grant of free shares
• a variety of benefits in kind such as cars, life and medical insurance and, in some cases, company-owned accommodation
• a pension based on final salary (sometimes with a non-tax-approved top-up scheme where the tax rules limited the amount that could be paid out by the main scheme)
• various generally less publicized devices such as employee share ownership plans (ESOPs) or phantom options (see below)
• the prospect of a golden handshake if the director is ousted for one reason or another.
Short-term bonuses or annual bonuses tend to be linked to a measure of short-term performance: perhaps the growth in earnings per share over the year. They account for many of the wilder percentage jumps in a director’s pay – when a good year succeeds a bad one – that the press picks up. Sometimes they are actually paid a year later, when company earnings may have turned down again, making it more difficult for shareholders to discern a link between pay and performance.
The 1984 Finance Act smoothed the way for executive share option schemes, and most companies have adopted them. For no payment, a director used to be granted options over, say, a million shares, usually exercisable (see Chapter 18) at the market price at the time of grant. Normally, he had to wait three years before the options could be exercised. Suppose the share price was 100p at the time of grant and five years later had risen to 250p. The director had the right to buy a million shares (normally, new shares that the company created) at 100p each, costing £lm. He immediately sold them at the market price of £2.5m, making a profit of £1.5m. The creation and sale of new shares at a price below that in the market represented a transfer of value from the shareholders of the company to the director concerned.
Longer-term incentive plans (LTIPs) were introduced in the 1990s to counter some of the criticisms of executive share options (see below). In a typical scheme, a director receives a conditional gift of free shares. He actually receives some or all of these shares later if his company beats some pre-ordained performance target over, say, a three-year period. A popular performance trigger is the total shareholder return (or TSR) provided by the company to its shareholders over the three years, compared with that achieved by other companies. Total shareholder return is the combination of share price movement with dividends paid. Thus, a large company might compare itself to the other 99 constituents of the Footsie index. If the company is in the bottom half of companies in terms of total shareholder return, the directors get none of the free shares. If it is in the top 25, they might get all of the conditionally gifted free shares. In between, the number would depend on their position in the league.
The benefits in kind that directors receive are taken for granted nowadays and they excite little comment, but pensions are worth a closer look. Most schemes will pay a pension geared to final salary and it is noticeable that directors frequently ensure that their salaries are bumped up substantially in the years leading to retirement. The effect is to give the director a pension considerably larger than the contributions made to the scheme on his behalf over the years would justify. The cost therefore falls indirectly on the other scheme members. Where the tax laws limit the pension a director can receive from a tax-approved scheme, the company frequently contributes on his behalf to a separate non-tax-approved scheme. For pension calculations based on salary, however, bonuses are normally disallowed.
Phantom options and employee share ownership plans (ESOPs) rarely receive the attention they deserve, particularly as it may have been difficult in the past for a shareholder to find out anything much about them. A phantom option is an option on non-existent shares – but if that sounds crazy, wait a minute. The company tells the director, say: ‘The share price is now 100p. We will grant you phantom options over a million shares, which you can exercise at any time over the next ten years. If, some years later, the share price has risen to 250p and you decide to exercise, the company will pay you the difference between 100p and 250p on a million shares. In other words, we will pay you £1.5m.’ The effect is much the same as with the example we quoted of a traditional executive share option, but the tax treatment of the profits may be different and no new shares are created. Phantom options are sometimes used legitimately to reward directors of overseas companies who cannot benefit fully from a UK executive share option scheme. They have in the past been used more questionably to generate rewards for directors that shareholders know nothing about in advance.
ESOPs really deserve a chapter to themselves. They are employee share ownership plans or employee share ownership trusts. The type run by large companies is generally the so-called ‘non-statutory ESOP’, which attracts no special tax benefits. It works like this. The ESOP buys shares in the sponsoring company, financing them with bank loans guaranteed by the company or with loans from the company direct (in effect, the company buys its own shares). The shares are bought in the market, so no new shares are created. These shares are then available for allocation to employees as part of a bonus scheme, profit-sharing scheme, option scheme, or whatever. The rules will usually say that all employees can benefit from the ESOP, but in practice they are used predominantly to provide further benefits for directors and senior executives. They are not without risk to the company and therefore to its owners. If the share price falls, the ESOP may end up with shares worth less than the loans it raised and the loss will generally fall on the company in one way or another. This happened with, among others, a container-leasing group then called Tiphook, which suffered a share price collapse and had to write off more than £20m on guarantees for loans to its ESOP. ESOPs are sometimes used to acquire shares which are then used to satisfy share option schemes or LTIPs.
Golden handshakes also hit the headlines. Directors often used to be employed under rolling contracts of three years (evergreen contracts). This means that there would always be three years of their contract outstanding. Under institutional pressure this has tended to reduce to two years or even one year nowadays. If a director is forced out, he will be able (virtually regardless of the reason) to claim for most of what would have been due to him had he completed his contract. Companies are usually anxious to avoid litigation and want to wind the affair up as quickly as possible. Thus, even directors who have run their companies into the ground frequently depart with a ‘golden handshake’ of several years’ salary. Cynical observers have a rule of thumb: the bigger the cock-up, the bigger the payoff (mainly because the company wants to get rid of the director in question rapidly and with the minimum of fuss).
The declared objective behind bonus schemes and the like is to ‘incentivize’ management so that it produces improved performance from which shareholders and the economy also benefit. This poses a second paradox. Why is it that the highest-paid people in a company need extra payments to persuade them to give of their best?
But there are more detailed objections to some of the incentive schemes in force today and these are raised sometimes in the press. Annual bonuses focus on short-term performance, may encourage short-term attitudes, and the basis on which they are granted may be far from clear. It is also fairly easy to manipulate earnings per share in the short term, and this is often the measure on which the bonus is based.
Executive share options are open to the objection that they may reward even poor management when the share price is carried up by a bull market – though the company itself has underperformed. They also dilute the interests of existing shareholders and provide little long-term incentive since the director almost always immediately sells the shares he receives from exercise of his options. Institutional shareholders have pressured managements to introduce a further performance criterion before options could be exercised, but these criteria are often undemanding. Options can only be exercised if the rise in company’s earnings per share has outpaced the rise in retail prices by a given percentage over a three-year period, and the like.
The longer-term share incentive plans (LTIPS) were introduced to counter some of the objections to share options though many companies operate the two in tandem. They do encourage a slightly longer-term view on the part of company management and sometimes introduce a more realistic performance criterion than share option schemes. But the criteria are again often relatively undemanding. Whether directors usually demonstrate confidence in their company by holding on to the free shares that they are given is questionable.
ESOPs are open to the objection that the company is exposing itself to a risk in the movement of its own share price. A second objection in the past was that they were often remarkably opaque – shareholders knew little if anything about them (but see below).
But the overriding criticism voiced of virtually all incentive schemes is that they offer directors a carrot, but no stick. Directors collect extra loot if the company or the share price does well. They do not suffer – as shareholders in the company suffer – if the company does badly. The frequent statements from companies that their schemes equate the interests of management and shareholders should therefore be viewed with a little cynicism. Incentive schemes may, it is sometimes argued in the press and elsewhere, encourage directors to take excessive risks with the company. If it works, they benefit. If it does not, shareholders suffer. And there is always the golden handshake at the end of the day as the ultimate reward for failure.
While shareholders do not have a great deal of direct influence on the pay and perks of directors, they had – by the end of the 1990s – a great deal more information than in the past. The Accounting Standards Board (ASB) and the related Urgent Issues Task Force (UITF) had done sterling work in insisting on more information on share options and ESOPs in the accounts.
The other pressures had come through the corporate governance process. It happened like this. A committee of the financial community’s great and good – the Cadbury Committee – produced a code of conduct on the financial governance of company affairs: the Cadbury Code. It recommended, inter alia, openness by companies on directors’ remuneration, though in terms so general that their effect was weakened. A later committee, the Greenbury Committee, was set up specifically to examine boardroom pay and perks in response to the Conservative government’s embarrassment on the issue. Greenbury strengthened Cadbury’s recommendations on remuneration committees, which were committees consisting mainly of independent non-executive directors who were charged with setting the remuneration of the executive directors. Reporting in 1995, Greenbury made a number of other recommendations including the phasing of share option grants and expressed a preference for longer-term incentive plans (LTIPs) over share options in any case. It also, crucially, required companies to disclose additional pension benefits acquired by directors over the year rather than merely the payments made into the scheme on their behalf. As we saw earlier, the two may be very different. Subsequently corporate governance was reviewed by yet another committee, the Hampel Committee. The strings of all these different recommendations were finally pulled together in a new combined code which drew its strength from the fact that its recommendations were incorporated in the listing requirements for companies on the stock exchange.
The effect of all these initiatives is as follows. Company reports now contain a great deal of information on directors’ pay and perks plus numerous statements of compliance with various corporate governance requirements. There is a lengthy statement by the remuneration committee which sets out the policy on executive pay and gives some detail on incentive schemes in force. Either here or in the notes to the accounts you will find the nitty-gritty. The total remuneration received by each director has to be itemized. This will give his basic salary, bonuses received, benefits in kind and so on. Here or elsewhere you will also find the value of additional pension benefits acquired during the year.
There will probably be a separate item giving details of each director’s interest in share option schemes. This shows options held at the beginning of the year, exercise prices, new options granted and existing options exercised during the year. Yet another table will give comparable information on the LTIP (if there is one): number of conditionally granted shares held on behalf of each director, and so on.
Finally, shareholders or journalists interested in knowing a little more about the directors’ terms of employment than is disclosed in the report and accounts can take advantage of a long-standing provision of company law. The employment contracts of individual directors of a company must be available for inspection at certain times, notably during the annual general meeting and for a few weeks beforehand. A little digging may produce interesting insights which occasionally surface in the press.
Thus, shareholders have moved from being deprived of information to being swamped with it, and it is not always easy to interpret. Are share options a benefit in the year in which they are granted or the year when they are exercised? Likewise with free shares conditionally granted under an LTIP, which the director may or may not receive at a future date.
Moreover, many of the incentive plans devised by remuneration consultants for companies are extremely complex – company directors will sometimes admit privately they do not understand exactly what they are entitled to or in what circumstances – and no two are exactly the same. Analysts trying to compare boardroom pay and perks at different companies hit a problem similar to shoppers who are offered their money back if they can find the product at a lower price in another store. They will find the product is marginally different in weight, constituents or packaging in each outlet. And there is still the problem that the big bonus may actually be delivered at a time that company performance has already turned down.
Shareholders do not – as of the end of the 1990s – have an opportunity to vote directly on directors’ pay levels, and there would be practical difficulties in giving them the right to do so. They can, of course, vote to remove a director, but in practice any pressure to moderate pay is more likely to come from the investing institutions and to take place behind the scenes. Shareholders have, however, always been required to vote on the establishment of an executive share option scheme, largely because it will normally involve the creation of new shares. And nowadays they will also have the opportunity to vote on the establishment of a new longer-term incentive plan (LTIP).
Individual shareholders are generally all too ready to take their directors’ advice on how they should vote on company affairs and are rarely in a position to exercise much influence on boardroom pay levels – though there have been attempts. With less than a fifth of listed shares they are, anyway, a minor force.
UK institutions, with around 50 per cent of listed shares, should be in a far stronger position. But they are frequently reluctant to use their muscle. There are several reasons for this. First, they have a genuine belief that incentives will produce performance from which all shareholders will benefit. Second, they need to work with the City establishment, which will not thank them for rocking the boat. Third, the insurance groups which are major institutional shareholders are mainly companies with boards of directors of their own. These boards have their own pay and perks to consider and might not welcome excessive intervention in the pay affairs of other companies.
It is also questionable whether the system of remuneration committees has worked in the way that was ostensibly intended and sometimes the results have been hilarious. Many of the non-executive directors who sit on these committees are executive directors of another company and have very little interest in restraining boardroom pay levels. In addition, they tend to rely heavily in their deliberations on surveys of boardroom pay and perks produced by numerous firms of remuneration consultants. It is an unusually brave non-executive director who will insult the executives by suggesting that they should be paid less than the average for companies of a similar type and size. But if every executive director’s salary is raised at least to the average by the remuneration committee, then it is a mathematical inevitability that the average itself must rise each year by leaps and bounds. There are strong grounds for thinking that the remuneration committee system has accelerated rather than moderated the explosion in boardroom pay and perks.
It is the pay and perks of the directors of previously nationalized companies – British Gas, the water companies and the electricity companies, in particular – that have attracted most media attention, and the reasons for these specific attacks on the reverse capitalism process need explaining. First, these directors were generally very badly paid by private industry standards when they were running their businesses for the state. Indeed, the prospect of moving over to a private-sector salary scale was a prime inducement for them to co-operate in privatization plans. Given the low starting point, the percentage increases in their pay were thus very large and caught the press’s eye.
Second, share options for the executives were also built in at the time of privatisation. These have delivered far bigger profits for the directors than were ever envisaged, mainly because the businesses have proved far more profitable than had been expected and share prices have thus risen very rapidly. In many cases the government had seriously underestimated the cost savings to be made in the previously state-run businesses – mainly through sacking employees – and had therefore sold them much too cheaply. Via their share options the directors have benefited, whereas the taxpayer has lost out.
The directors claim they are running major competitive businesses and should be remunerated accordingly. Critics maintain they are running monopoly utilities with assured revenues and that there is no valid comparison with directors running competitive businesses in the marketplace. The debate is likely to rumble on and to be reported in the media for years to come.
But what are the private-sector salaries and perks that the utility bosses seek to match? Remuneration consultants New Bridge Street Consultants conducted a survey of the annual reports of the FTSE 100 and the FTSE Mid 250 companies in 1999. For the FTSE 100 companies the median base salary of the chief executive was £435,000 and for the next tier of companies it was £275,000. Annual bonuses added over 35 per cent in the case of the largest companies and over 32 per cent in the Mid 250 companies. Together with benefits in kind, this brought the median total pay of chief executives up to £586,000 in the biggest companies and £386,500 in the next tier. These figures are, of course, before taking account of additional benefits in the form of share option profits or free shares from an LTIP.
Analysis of incentive plans by New Bridge Street showed that 84 per cent of the Footsie 100 companies operated executive share option schemes, against 90 per cent of the Mid 250 companies. Among the largest companies, 71 per cent of the boards qualified for long-term incentive plans (LTIPs) against 52 per cent in the next tier, where share options are more commonly used. Some companies may use an LTIP to reward their top management and use options for those further down the line.
Finally, a search through the Datastream database of market, company and economic information in 2000 showed that over 70 companies paid at least one director £lm a year or more, excluding share option profits or LTIP benefits, and a further 181 paid their top-earning director between £500,000 and £lm. Since more than one director in a company may be earning a salary above these levels, the total number of super-earners is certainly higher.
High boardroom pay is frequently defended as the reward for high company performance. In practice, surveys on this issue frequently have problems in establishing a correlation. It is also justified on the basis that ‘directors in other countries get more, and we would lose our top entrepreneurial talent if we did not match overseas pay rates’. Again, in practice it is difficult to compare pay and perks across frontiers as there are too many variables. While some UK executives undoubtedly have a value in the international marketplace, very many probably do not. Finally, there is the argument that, if pop stars can earn millions, why not the boardroom stars whose efforts are generally more important to the UK economy? But it is not unrealistic to ask – as the press occasionally has the temerity to do – if the performance of British industry would be one jot better or worse if company directors were paid a decent basic salary and ‘incentives’ were scrapped across the board.
Where will the pay and perks explosion stop? The median base salary of a chief executive in a Footsie 100 company is now about 21 times average pay across the population as a whole, or 28 times if his bonuses are allowed for. It is difficult to see what will limit further escalation.
The pattern of share ownership and control in Britain means that the owners of companies who foot the bill cannot (or are unlikely to) exert restraint on the directors they elect to manage their businesses. Thus, company directors themselves control the marketplace for their services – and the rates of pay. It is an odd interpretation of the free market philosophy. But the whole phenomenon of reverse capitalism is more than a little odd.
It will come as no surprise that regular information on the pay and perks of UK company directors is one of the few topics which it is very difficult to find on the Internet. In whose interest would it be to provide it? Two organizations that sometimes provide information or conduct surveys on managerial pay, and also maintain websites, are Incomes Data Services at www.incomesdata.co.uk/ and the Trades Union Congress at www.tuc.org.uk/. For information on the investing institutions’ attitude to various aspects of corporate governance, try www.ivis.computasoft.com/. If any reader knows of a source on boardroom pay, other than the occasional newspaper article or those mentioned above, we would be glad to hear of it.