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'Fairness and simplicity' should be at heart of executive pay debate, says Institute of Business Ethics

Out-Law News | 12 Feb 2016 | 11:17 am | 3 min. read

The way in which executive pay is set should be simplified, with the relative fairness of pay awards placed at the heart of the debate, according to a new report published by the Institute of Business Ethics (IBE).

In its 'Fair or Unfair? Getting to grips with executive pay' report, the IBE said that restoring public trust in executive pay awards depended on companies' remuneration committees being able to justify the awards "in a way that ordinary people can understand". It recommended that a greater proportion of executive pay be made in cash and in shares purchased on the open market, rather than through complex share schemes which make it difficult to establish how much a particular executive is actually paid.

"One of the reasons why executive pay has become so problematic is that it is too complicated and the outcomes often seem quite random," said Peter Montagnon, the report's author and an associate director of the IBE. "Another is because it enables some executives to earn very large amounts over a short period of time, while others reap only modest rewards. That can easily drive short-term decision-making."

"The link between remuneration and performance is not clear, so nobody, including sometimes the recipients, can tell what they are really being paid for. A system that operates like that is bound to attract charges of unfairness and trust will ebb away. The more remuneration committees try to manipulate short-term behaviour, the less likely they are to succeed," he said.

The IBE is a charitable body set up to encourage high standards of business behaviour based on ethical values. It conducts frequent research into business attitudes and publishes regular 'boardroom briefings' containing practical advice and guidance for corporate decision-makers.

Share plans and executive remuneration expert Lynette Jacobs of Pinsent Masons, the law firm behind Out-Law.com, noted the timing of the publication of the IBE report, close to the expected issue this spring of recommendations by the Investment Association (IA) "Executive Remuneration Working Group" set up in September last year to propose a "radical simplification of executive pay". The IA is the trade body which represents the interests of the asset management industry.

"The timing of the IBE report, like that of the IA review, fits well with the three-year cycle for listed companies' executive pay policy approvals, with the majority of companies set to return to shareholders in the 2017 AGM season for approval of their policy," she said. "It will be interesting to see the degree of convergence between this report and the Working Group's recommendations."

Remuneration is the UK public's second largest concern about the behaviour of businesses after tax avoidance, according to recent IBE research. The report cites the rapid increase in executive pay awards over the past couple of decades, high pay for average performance and occasional examples of rewards for failure as some of the reasons behind this.

According to the report, although the idea of linking pay and performance is "hard to fault", the practical application is often ineffective. Companies have been required to include more information about how directors have been and will be paid, along with how this relates to company performance, in their annual reports since October 2013. However, the report said that "the overwhelming majority of reports simply involve a post hoc justification of what has been paid out", rather than indicating why pay was set at that level in the first place.

The UK directors' remuneration rules also require disclosure of the amount actually paid to directors over a company's reporting year, and the report notes that it can be difficult to place an actual value on share awards that have not yet vested, or become exercisable by the director. The IBE said that in many cases, remuneration committees may not necessarily know the monetary values of executive pay awards.

The report recommends that remuneration committees should start from a position of "scepticism" towards dilutive use of shares and should instead favour cash payments where possible, although some of this should then be used to buy shares in the market which would then be held for the long term. The remuneration committee should then use the annual remuneration report to better justify the awards, with "fairness and simplicity" used to guide that justification, according to the report.

Referring to the recommendation for directors to hold shares for the long term, Lynette Jacobs noted that this aligned with 'post-vesting holding periods' and increasing and lengthening shareholding requirements for directors now operated by most listed companies in accordance with changes made to the UK Corporate Governance Code (the Code) in September 2014.

"The Code advocates that remuneration committees consider requiring directors to hold shares for a further period after vesting or exercise, including for a period after leaving the company.  This is an extension of the 'career shares' concept pioneered a number of years ago by HSBC, requiring a part of share awards to be held until retirement," she said.

"Whilst it has the advantage of increasing a director's long-term interests with the company and provides an incentive to ensure strong succession planning, it may also deter the director from taking reasonable risks as he or she prepares to retire or move to another company. That said, a requirement to hold shares after leaving lessens the opportunity for a director to plan his or her departure so as to optimise his or her personal rewards to the detriment of the company's longer term outlook," Jacobs said.