CHAPTER 4

DIRECTORS' REMUNERATION

Directors' remuneration should be set by a remuneration committee consisting of independent non-

executive directors. Remuneration should be dependent on organisation and individual performance.
Accounts should disclose remuneration policy and (in detail) the packages of individual directors.

Purposes of directors' remuneration

Clearly adequate remuneration has to be paid to directors in order to attract and retain individuals of
sufficient calibre. Remuneration packages should be structured to ensure that individuals are motivated
to achieve performance levels that are in the company and shareholders' best interests as well as their
own personal interests.

Role and function of remuneration committee

The remuneration committee plays the key role in establishing remuneration arrangements. In order to
be effective, the committee needs to determine both the organisation's general policy on the
remuneration of executive directors and specific remuneration packages for each director.

The UK Corporate Governance Code suggests measures to ensure that the committee is independent,
including requiring the committee to be staffed by independent non-executive directors, ensuring that
executive directors do not set their own remuneration levels. Measures to ensure independence include
stating that the committee should have no personal interests other than as shareholders, no conflicts of
interest and no day-to-day involvement in running the business. Guidance from the Association of
British Insurers stresses the importance of remuneration committees bringing independent thought and
scrutiny to the development and review process, together with an understanding of the drivers of the
business that contribute to shareholder value. The Financial Stability Forum emphasises the importance
of committee members having sufficient risk measurement expertise. They must also have the ability to
make fair decisions about how remuneration should vary during periods of loss.

Remuneration policy

The Greenbury committee in the UK set out principles which are a good summary of what remuneration
policy should involve.

- Directors' remuneration should be set by independent members of the board.

- Any form of bonus should be related to measurable performance or enhanced shareholder value.

- There should be full transparency of directors' remuneration, including pension rights, in the

annual accounts.

Issues connected with remuneration policy may include the following.

- The pay scales applied to each director's package

- The proportion of the different types of reward within each package

- The period within which performance related elements become payable

- What proportion of rewards should be related to measurable performance or enhanced

shareholder value, and the balance between short- and long-term performance elements

- Transparency of directors' remuneration, including pension rights, in the annual accounts

Elements of remuneration packages

Packages will need to attract, retain and motivate directors of sufficient quality, while at the same time
taking shareholders' interests into account as well. However, assessing what the levels of executive
remuneration should be in an imperfect market for executive skills may prove problematic. The
remuneration committee needs to be mindful of the implications of all aspects of the package as well as
the individual contributions and additional work effort made by each director. Important factors to take
into account include:

- The market rate – the transfer value if a director was to move to a comparable position in another
company

- Legal, fiscal or regulatory constraints such as a compulsory multiple between the highest and lowest
paid in an organisation

- Previous performance in the job and the outcome of performance reviews

- Stakeholder opinion and ethical considerations

a) Basic salary

Basic salary will be in accordance with the terms of the directors' contract of employment, and is not
related to the performance of the company or the director. Instead it is determined by the experience,
performance and responsibilities of the director, and also what other companies might be prepared to
pay (the market rate).

b) Performance-related bonuses

Directors may be paid a cash bonus for good (generally accounting) performance. To guard against
excessive pay-outs, some companies impose limits on bonus plans as a fixed percentage of salary or pay.
Transaction bonuses tend to be much more controversial. Some chief executives get bonuses for
acquisitions, regardless of subsequent performance, possibly indeed further bonuses for spinning off
acquisitions that have not worked out.

Alternatively loyalty bonuses can be awarded merely to reward directors or employees for remaining
with the company. Loyalty bonuses have been criticised for not being linked to performance. Sometimes
they are granted for past loyalty without the director guaranteeing that they will remain with the
company.
There have been examples of directors leaving their company a short time after receiving a loyalty
bonus. The link between remuneration and company performance is particularly important. Recent UK
guidance has stressed the need for the performance-related elements of executive directors'
remuneration to be stretching and designed to align their interests with those of shareholders and
promote the long-term success of the company. Remuneration incentives should be compatible with
risk policies and systems. Governance guidance has also suggested that short-term bonuses should be
partially deferred, providing scope for companies to reclaim variable bonuses if subsequent results are
disappointing.

c) Shares

Directors may be awarded shares in the company with limits (a few years) on when they can be sold in
return for good performance.

d) Share options

Share options give directors the right to purchase shares at a specified exercise price over a specified
time period in the future. If the price of the shares rises so that it exceeds the exercise price by the time
the options can be exercised, the directors will be able to purchase shares at lower than their market
value.

Share options can be used to align management and shareholder interests, particularly options held for
a long time when value is dependent on long-term performance. The UK Corporate Governance Code
states that shares granted or other forms of remuneration should not vest or be exercisable in less than
three years. Directors should be encouraged to hold their shares for a further period after vesting or
exercise. Grants should be phased rather than being in one block. The performance criteria used for
share options are a matter of particular debate. Possible criteria include the company's performance
relative to a group of comparable companies. There are various tricks that can be used to reduce or
eliminate the risk to directors of not getting a reward through stock options. Possibilities include grants
that fail to discount for overall market gains, or are cushioned against loss of value through
compensatory bonuses or repricing. The UK Corporate Governance Code states that non-executive
directors should not normally be offered share options, as options may impact on their independence.

e) Benefits in kind

Benefits in kind could include transport (eg a car), health provisions, life assurance, holidays, expenses
and loans. The remuneration committee should consider the benefit to the director and the cost to the
company of the complete package. The committee should also consider how the directors' package
relates to the package for employees. Ideally perhaps the package offered to the directors should be an
extension of the package applied to the employees. Loans may be particularly problematic. Recent
corporate scandals have included a number of instances of abuses of loans, including a $408 million loan
to WorldCom Chief Executive Officer Bernie Ebbers. Using corporate assets to make loans when
directors can obtain loans from commercial organisations seems very doubtful, and a number of
jurisdictions prohibit loans to directors of listed companies.
f) Pensions

Many companies may pay pension contributions for directors and staff. In some cases, however, there
may be separate schemes available for directors at higher rates than for employees. The UK Corporate
Governance Code states that as a general rule only basic salary should be pensionable. The Code
emphasises that the remuneration committee should consider the pension consequences and
associated costs to the company of basic salary increases and any other changes in pensionable
remuneration, especially for directors close to retirement. The Walker report on UK financial institutions
responded to concerns raised about aspects of pension arrangements. It recommended that no
executive board member or senior executive who leaves early should be given an automatic right to
retire on a full pension – that is, through enhancement of the value of their pension fund.

Remuneration of non-executive directors

The International Corporate Governance Network (ICGN) issued guidance on the remuneration of non-
executive directors in 2010 and produced further draft guidance in 2012. The ICGN focuses on
recommending methods that preserve the independence of non-executive directors. It suggests that an
annual fee or retainer should be the preferred method of cash remuneration. Fees can vary according to
the responsibilities that non-executive directors have and the demands made on their time. Non-
executive directors who are members of board committees could be reasonably paid higher fees, with
chairs of board committees being given additional amounts. Alternatively the ICGN allows non-executive
directors to be paid in shares that vest in them immediately. These shares should come with
requirements about long-term ownership and holding attached, with directors holding the shares for a
specified period after they retire from the board. The ICGN believes that all non-executive directors
should hold an amount of equity in the company that is significant to them. This should help ensure that
their interests are aligned with shareholders. It would be best if these holdings were bought by the
directors out of their own pockets, but giving shares to them as part of their remuneration is an
acceptable alternative. The guidance prohibits transactions or arrangements that reduce the risks of
share ownership for non-executive directors. The guidance states, however, that non-executive
directors should not receive shares on a deferred basis, share options or performance-based
remuneration, as these might compromise their independence. Non-executive directors should also not
receive:

- Attendance fees in addition to their basic fees – attendance at meetings is a primary duty of non-
executive directors

- Severance fees

- Rights to participate in defined benefit retirement schemes, since non-executive directors are elected
representatives of shareholders and not employees.
Determining remuneration of non-executive directors

To avoid the situation where the remuneration committee is solely responsible for determining its own
remuneration, the UK Corporate Governance Code states that the board or the shareholders should
determine the remuneration of non-executive directors within the limits prescribed by the company's
constitution.

REVIEW QUESTIONS

In a recent case, it emerged that Frank Devo, a sales director at ABC Co, had been awarded a substantial
over inflation annual basic pay award with no apparent link to performance. When a major institutional
shareholder, OVO Investments, looked into the issue, it emerged that Mr Devo had a cross directorship
with Joe Ng, an executive director of DEF Co. Mr Ng was a non-executive director of ABC and chairman
of its remuneration committee. OVO Investments argued at the annual general meeting that there was
'a problem with the independence' of Mr Ng and further, that Mr Devo's remuneration package as a
sales director was considered to be poorly aligned to OVO's interests because it was too much weighted
by basic pay and contained inadequate levels of incentive.

OVO Investments proposed that the composition of Mr Devo's remuneration package be reconsidered
by the remuneration committee and that Mr Ng should not be present during the discussion. Another of
the larger institutional shareholders, Hanoi House, objected to this, proposing instead that Mr Ng and
Mr Devo both resign from their respective non-executive directorships as there was 'clear evidence of
malpractice'. OVO considered this too radical a step, as Mr Ng's input was, in its opinion, valuable on
ABC's board.

Required;

(a) Explain four roles of a remuneration committee.

(b) OVO Investments believed Mr Devo's remuneration package to be 'poorly aligned' to its interests.
With reference to the different components of a director's remuneration package, explain how Mr
Devo's remuneration might be more aligned to shareholders' interests at ABC Co.