Covid-19: key decisions for remuneration committees
Decisions taken will undoubtedly be subject to significant scrutiny to ensure that pay outcomes are adequately aligned with workforce, investor and wider stakeholder expectations. All this in the first year in which companies are having to report on how they take stakeholder considerations into account when making key decisions.
What to do about existing awards?
Remuneration committees will need to understand the effect that the current market turmoil caused by Covid-19 will have on performance conditions applicable to in-flight awards. Any effect on awards will depend on the nature of the applicable performance conditions. At one end of the spectrum, some performance conditions may remain unaffected whereas, at the other end, some awards will now lapse due to a failure to meet targets.
Allowing awards to vest
Where performance conditions are not impacted or only marginally impacted, remuneration committees will need to decide whether to let the existing awards vest in the ordinary course or whether to make adjustments to vesting outcomes. The 2018 Corporate Governance Code requires that “remuneration schemes and policies should enable the use of discretion to override formulaic outcomes” and most listed company plans now include such discretions. The current situation means committees must decide whether an adjustment is appropriate.
They will have to balance the need to, on one hand, retain and incentivise key executives and individuals required to steer the company through turbulent times ahead and, on the other hand, ensure that pay outcomes are aligned with workforce, investor and wider stakeholder experience which may be particularly difficult for those companies that have to implement widespread redundancies and/or pay reductions.
Exercising discretion to ensure vesting
At the other end of the spectrum are those awards where, as a result of the recent market turmoil, the performance conditions will no longer be met. Here, remuneration committees will need to consider the effect the lapse of such awards will have on the retention and continued incentivisation of key individuals. Again, the committee should consider what discretions they have under applicable bonus and share plans - for example to adjust performance conditions – and decide whether exercising such discretions is the appropriate action to take. A number of share plans will only allow adjustment of performance conditions where the adjusted performance conditions are no less challenging. In addition, discretion to adjust performance conditions for executive awards must also be provided for in the company’s approved remuneration policy. If there is insufficient discretion, remuneration committees should consider what other steps could be taken under the applicable plans and policies. Such steps might include the grant of one-off retention awards, additional annual bonuses or restricted share awards (i.e. awards subject only to continued employment).
Irrespective of what action remuneration committees take, they should expect scrutiny from investors, proxy advisers and the media. The use of any positive discretion to effect pay-outs is likely to be very contentious from a shareholder and PR perspective and robust explanation of any decision would be required. We understand that ISS and the Investment Association have indicated that their clients would not expect to see an adjustment of performance conditions when assessing existing awards and bonuses. In any event, consultation with key investors may be required and should be factored into the timetable.
What about new awards?
With more than 70% of FTSE 350 companies having experienced share price falls in excess of 30% from January to March 2020, remuneration committees will also be faced with dilemmas in respect of the grant of new share awards. A depressed share price means that awards based on a multiple of salary (which is the norm) will require more shares in order to deliver the same value. This raises a number of potential issues.
Dealing with dilution headroom issues
First, the need for more shares will reduce the company’s headroom under its share plan dilution limits so companies with little headroom may struggle to maintain grant levels when their share price falls. Market purchase shares are unlikely to be an attractive alternative as this would be costly and reduce much needed cash reserves during a potentially difficult period. Consequently, remuneration committees will need to decide whether to reduce awards, use existing cash to buy shares in the market on vesting or take advantage of the depressed share price and buy shares into an EBT so as to hedge the future obligation to deliver shares.
Preventing windfall gains
The second issue relates to the fact that investors typically expect a “haircut” in award size where grants are made following a significant fall in share price. This is to prevent significant windfall gains to executives when the share price recovers. Shareholders will generally expect a reduction in award size where the share price has fallen “substantially” since the last award. A drop greater than 25% is typically viewed as substantial. A further measure which could be used by remuneration committees to ensure that executives do not receive windfall gains on vesting (e.g. where the share price has rebounded) is the discretion to adjust vesting outcomes mandated by the Corporate Governance Code. The Investment Association have advised that they expect remuneration committees to use this discretion to prevent windfall gains.
Another way to deal with the issue would be for remuneration committees to use a longer share price averaging period. Although ISS and the Investment Association have so far indicated they would take a flexible approach where the share price fall is solely related to Covid-19, many companies are already considering the use of longer averaging period (e.g. 12 months), to ensure awards are not made over an inflated number of shares. This could apply to executives only, or across the organisation.
Setting terms for new awards
When markets are in a state of flux, setting forward-looking performance conditions and targets for new awards can be particularly challenging for remuneration committees. Predictions on whether the impact of Covid-19 will be greater or lesser than expected could lead to unintended vesting outcomes once the markets have stabilised. Remuneration committees may therefore set new performance conditions and targets conservatively for this year or, more progressively, look to new incentive structures such as restricted share plans (i.e. awards subject only to continued employment). Alternatively, awards may be delayed or waived this year.
Other difficult remuneration decisions
On 18 March, the Pensions Investment Research Consultants (PIRC) wrote to 4,000 listed companies calling on them to suspend all payments to executives (other than basic salary) until the end of the financial year. The rationale was that suspending variable pay for executives would send a positive message of shared sacrifice to the rest of the workforce.
Although the impact of Covid-19 will vary by company and sector, PIRC’s letter can be seen as a call to remuneration committees to take active steps in respect of executive pay to ensure alignment with remuneration measures taken for the wider workforce such as temporary pay and headcount reductions and furloughing employees.
Our Covid-19 employment FAQs considers some of the key employment issues. In relation to reducing or forfeiting pay, there are a number of legal issues which remuneration committees will need to consider before taking such steps, principally whether the relevant plan rules or award agreements give them the necessary contractual powers and discretions.
In the absence of the necessary powers, remuneration committees could seek consent from the relevant executives and senior employees. Some companies and executives in affected sectors have already taken steps to address the troubled circumstances. Examples include:
- temporary pay cut or waiver (Virgin Atlantic CEO and executive leadership, InterContinental Hotels Group Board and Executive Committee, Heathrow Airport’s CEO, Ryanair CEO);
- temporary reduction in non-executive director fees (Dunelm, McCarthy & Stone);
- cancellation of bonus (BBVA, Rentokil Initial, most major UK banks);
- postponement of annual LTIP awards (Rentokil Initial); and
- reduction in annual LTIP awards (Vesuvius).
The extent to which such actions and measures become more widespread remains to be seen.
Furloughing and all-employee share plans
As a response to Covid-19, the government announced the “Coronavirus job retention scheme” (CJRS) on 20 March 2020. The aim of the CJRS is to provide support to UK employers to enable them to continue paying up to 80% of their employees’ salary (up to £2,500 per employee per month) for those employees that have been “furloughed” during the coronavirus outbreak. Furloughed employees include those that are laid off (i.e. placed on unpaid leave whether under a lay-off right in their contract or otherwise) as a result of the impact of coronavirus on the employer’s business and which, absent the CJRS, would have received no salary during this temporary lay-off.
Companies that operate any of the four HMRC tax-qualified plans (i.e. EMI, SAYE, SIP or CSOP plans) should consider the possible effects of furloughing employees who participate in these plans. We have set out some thoughts on possible issues in respect of each of the four plans below. We understand that HMRC is due to produce a new employment related securities bulletin explaining how Covid-19 affects each tax-qualified plan.
In order to be eligible to participate in an EMI scheme, the tax rules require employees to confirm that they satisfy the “working time requirement” (namely that they work 25 hours per week or 75% of their working time, if less). Once an EMI option has been granted, the working time requirement continues to apply. This means that if an employee at any point fails to clock up the required time, it would be a disqualifying event for EMI purposes which would result in income tax and possibly employee’s and employer’s National Insurance contributions (NICs) becoming payable on the exercise of their option.
Employees being furloughed therefore creates a potential risk of the EMI options held by such employees being disqualified. It is not currently clear how HMRC intends to deal with this problem. However, we understand this issue has been raised with them and it is hoped that a concession for employees with EMI options who are put on Covid-19 related furlough will be made available. We will continue to monitor the situation and report further in our next update.
Separately, depending upon the particular terms which apply to the EMI option, it is also possible that an employee being furloughed could result in the lapse of their EMI option under the relevant rules of the EMI scheme. Employers operating EMI schemes should check their rules and option agreements when considering furloughing employees.
Sharesave plans (SAYE)
Employees participating in SAYE plans may find that they have more choices available to them than under some of the other tax-qualified plans in the event they are furloughed given the structure of SAYE plans. For example they could:
- carry on saving through their SAYE scheme as normal;
- cancel their contract in order to release savings to date; or
- take a “savings holiday” for up to 12 months without causing their participation in the plan to lapse (although they cannot make up deferred payments and so the option maturity date would be deferred accordingly).
Cancelling the savings contract or taking a payment holiday could relieve some financial pressure for affected employees. The choices above might also be considered by employees whose SAYE options are underwater which may be a more prevalent issue at the moment.
Share incentive plans (SIPs)
For SIPs, the annual limit for partnership shares is £1,800 worth of shares (or 10% of salary, if lower). Salaries for employees who are furloughed will obviously be affected through the furlough period. At this stage it is not clear how these statutory limits will be applied by HMRC in the current circumstances and we expect HMRC to address this in the upcoming bulletin.
For employees participating in a SIP, the following choices would be available to them:
- cease monthly contributions to purchase partnership shares and leave existing partnership and matching shares in the SIP;
- amend the amount they contribute to their partnership shares; or
- in more extreme cases, the company may decide that the SIP should be terminated (although employees would keep their existing shares).
Where employees are being furloughed, the relevant company may want to reconsider the SIP limits going forward to ensure it has a handle on the costs of operating the scheme.
Company share option plans (CSOPs)
The increased number of redundancies resulting from the Covid-19 crisis will result in many leaver provisions being triggered in various types of share schemes. In all cases, the terms of the share option plans should be consulted. However, it is worth noting that the tax rules governing CSOP plans were changed a couple of years ago such that exercising CSOP options in connection with a redundancy does not result in any income tax or NIC becoming payable, even if the option has been held for less than three years. Similar provisions apply for SAYE and SIP plans.