P1-05 Directors' Remuneration

Session 5
Directors' Remuneration
FOCUS
This session covers the following content from the ACCA Study Guide.
A. Governance and Responsibility

5. Directors' remuneration
a) Analyse and assess the general principles of remuneration.
i) purposes
ii) components
iii) links to strategy
iv) links to labour market conditions
b) Explain and assess the effect of various components of remuneration
packages on directors' behaviour.
i) basic salary
ii) performance related
iii) shares and share options
iv) loyalty bonuses
v) benefits in kind
vi) pension benefits
c) Explain and analyse the legal, ethical, competitive and regulatory issues
associated with directors' remuneration.
Session 5 Guidance
Note that this is another highly contentious issue, especially relating to banks and the
financial services industry.
Read through all of the sections, as they summarise best practice. Refer to the Code and
the LSE publication as necessary (s.1).
(continued on next page)

P1 Governance, Risk and Ethics Becker Professional Education | ACCA Study System
Ali khan - rajaali321@yahoo.com

VISUAL OVERVIEW
Objective: To assess the governance issues relating to the remuneration of directors.
COMPENSATION PRINCIPLES
• Background
• Corporate Governance Guidance
COMPENSATION PACKAGES OTHER ISSUES

• Components • Legal
• Basic Salary • Ethical
• Performance-Related Bonus • Competitive
• Transaction and Loyalty Bonus • Regulatory
• Share Options
• Shares
• Benefits-in-Kind
• Pensions
• Termination
NEDS
• Principles
• Guidelines
Session 5 Guidance
Consider the questions, "How much are executives worth?" and "How should
executives be paid?" (s.2), as well as the legal and regulatory environment that affects
compensation options (s.4).
Know best-practice guidelines for each type of compensation (s.2).
Understand the compensation principles specific to non-executive directors (s.3).
© 2014 DeVry/Becker Educational Development Corp. All rights reserved. 5-1

Session 5 • Directors' Remuneration P1 Governance, Risk and Ethics
1 Compensation Principles
1.1 Background
< Remuneration and compensation of directors is a hotly
debated topic. As the result of corporate governance
standards and legislation that requires ever-greater disclosure
in financial statements, it has become one of the more visible
areas of deliberation by boards of directors.
< The debate usually centres on four areas:
1. the overall level of directors' remuneration and
compensation;
2. the role of share options;
3. performance measures and linking remuneration with
performance; and
4. the role of the remuneration committee (see Session 4).
< Compensation plans should balance between:
= rewarding strong current performance and providing
incentives for the future; and
= avoiding payment for bad performance.
Getting the balance right will tend to attract and retain
high-performing individuals who lead the firm to success
and create shareholder value.
Getting the balance wrong may result in a failure
to attract or retain the "right" talent, employee
demotivation and executives aiming to achieve short-
term targets which impair corporate value.
< The London Stock Exchange/Robson Rhodes publication Corporate
Governance: A Practical Guide (www.londonstockexchange.com)
asks the following questions about directors' remuneration:
= Is the policy in line with guidance in the Code and relevant
institutional investors' organisations?
= Are institutional shareholders supportive of the
remuneration policy?
= Has executive directors' pay and performance been fairly
compared with that of an appropriate peer group?
= Are targets set (e.g. for bonuses) such that high rewards
are available only for outstanding performance?
= Does the remuneration committee thoroughly assess
whether targets have been met before making awards?
= Are any contract periods for executive directors in excess of
one year? If so, can they be justified?
= Are there arrangements to ensure that failure is not
rewarded when directors leave early because of poor
performance?
= Is there a high level of transparency in publicly explaining
how remuneration has been determined?
5-2 © 2014 DeVry/Becker Educational Development Corp. All rights reserved.

P1 Governance, Risk and Ethics Session 5 • Directors' Remuneration
1.2 Corporate Governance Guidance

1.2.1 The Code
< Levels of remuneration should be sufficient to attract, retain
and motivate directors of the quality required to run the
company successfully.
< A company should avoid paying more than is necessary for
this purpose.
< The remuneration committee members should judge where to
position their company relative to others.*
*Organisation boards have a natural tendency to "ratchet up"

remuneration levels to at least match the average compensation
in the industry. Firms outside the US should be particularly
mindful about comparing remuneration packages to US executive
compensation, which tends to run higher than outside the US.
Directors have always argued that they should be rewarded
according to the US model as they could, if necessary, resign and
find a well-compensated position in the US.
< A significant proportion of total remuneration should be

structured to link rewards to corporate and individual
performance.
< Performance-related elements should align directors' interests
with those of shareholders to give these directors keen
incentives to perform at the highest levels and to promote the
long-term success of the company.
< There should be a formal and transparent procedure for
developing policy on executive remuneration and setting
remuneration packages of individual directors.
< No director should be involved in deciding his or her own
remuneration.
< The chairman of the board should ensure that the company
informs its principal shareholders about remuneration in the
same way as for other matters.
< Shareholders should be invited to approve all new long-term
incentive schemes (as may be defined in relevant listing rules)
and significant changes to existing schemes.

Exhibit 1 SAY
AY ON PAY: BOARDS LISTEN WHEN
SHAREHOLDERS SPEAK
The following article was published 7 June 2012 by Bloomberg Businessweek.
www.businessweek.com/articles/2012-06-07/say-on-pay-boards-listen-when-shareholders-speak
Shareholders have now had two years to In some cases, shareholders remained
express their views on executive pay, and a unhappy. When presented last year with Kilroy
theme has emerged: They have no problem Realty (KRC) CEO John B. Kilroy Jr.'s pay
approving generous compensation packages, package, 51 percent of shareholders gave it
provided they're getting richer too. When a thumbs down. That sent the Los Angeles
a company's stock falls, they are not so company's six-man board—chaired by John B.
agreeable. Kilroy Sr.—scrambling to "make substantive
The Dodd-Frank financial reform law enacted in changes," according to Securities and
2010 calls for companies to submit executive Exchange Commission filings. Not substantive
compensation plans to nonbinding shareholder enough, perhaps. Kilroy's 2011 package, which
votes at least once every three years. This the company calculated at $6.4 million, was
year there have been some notable nays. rejected by 70 percent of the votes on May 17.
In April, Citigroup (C) shareholders refused "We made a lot of effort last year," says Chief
to endorse Chief Executive Officer Vikram Financial Officer Tyler Rose, "and the board will
Pandit's $14.8 million package after the stock continue to evaluate this issue."
fell 44.3 percent in 2011. In May they voted Towers Watson analyzed 1,438 companies that
four to one against the $5.8 million Chiquita conducted the nonbinding say-on-pay votes
Brands (CQB) awarded CEO Fernando Aguirre as of May 30 and found that companies whose
following a 41 percent decline in the stock shareholder returns were consistently in the
in 2011—even after the board said that the bottom quartile over five years were about
company's poor performance had cost Aguirre nine times more likely to fail their say-on-pay
his bonus. votes than neutral performers.
Overall, though, shareholders were remarkably Companies with hot stocks can pretty much do
obliging. As of June 4, corporations had what they want. Apple (AAPL) shareholders
brought 1,911 say-on-pay resolutions to overwhelmingly approved CEO Tim Cook's
a vote. Institutional Shareholder Services $378 million package, much of which is stock
(MSCI), which advises investors, recommended that vests over 10 years. To Doug Friske,
voting against 265 of them. Shareholders who leads Towers Watson's (TW) executive
rejected just 36, or less than 2 percent. compensation practice, such votes show the
Does that mean say on pay is a bust? Daniel Dodd-Frank rule working exactly as intended.
Ryterband, president of pay consultant "If a company is doing well," he says,
Frederic W. Cook, says the numbers underplay "shareholders have no problem with pay that
the drama taking place behind the scenes. In recognizes that."
his view, "say on pay has had a significant Eleanor Bloxham, a pioneer in designing pay
impact on the design and magnitude of pay programs who now advises boards as CEO
packages." Boards are nervous about how of the Value Alliance, says that placing such
proxy advisers such as ISS and Glass Lewis a high premium on stock performance can
will react to packages, so they're reaching out undermine a company's long-term success.
to shareholders and reducing pay that's not She points to studies by the Federal Reserve
tied to performance. and others that found loading up a CEO's pay
Almost all of the companies that faced package with stock incentives just encourages
embarrassing "no" votes last year have riskier behavior and a focus on the short term.
done away with practices that irked their "Boards should concentrate on rewards tied to
investors. Hewlett-Packard (HPQ) no things a manager can control, like profits," she
longer uses the formula that allowed CEO says. Trying to please people whose sole goal
Léo Apotheker to pocket $30 million for an is to profit from a share spike risks moving
11-month run during which the stock fell by boards back into favoring tools that encourage
almost half. Successor Meg Whitman has a leaders to talk up earnings and game the
salary of $1, with the bulk of her $16.5 million system. "These votes reward the perception
package tied to the company's share of performance instead of long-term goals."
performance. Nabors Industries' (NBR) former The bottom line: Boards are responding to
chief agreed in February to waive his $100 say on pay, even though shareholders have
million termination payment in the face of last rejected less than 2 percent of executive comp
year's no vote. packages this year.
—Diane Brady, 7 June 2012

1.2.2 The International Corporate Governance Network (ICGN)

< Remuneration has an important role in a firm's ability to
recruit and retain the executive talent it needs to ensure
success. It also has the potential to damage reputation and
affect employee morale and behaviour. Getting the balance
on time, especially for long-term deferred compensation, and
appropriate performance measures is critical.
< Well-designed remuneration programs have a demonstrable
positive effect on the long-term performance of the firm.
Conversely, poorly designed or poorly executed compensation
plans can have a serious negative effect on shareholder value.
< Best practice in remuneration begins with the formation of an
independent and effective process for deciding on executive
remuneration.
< The three underpinning principles are:
1. Transparency—investors can clearly understand the
program and see total pay.
2. Accountability—boards represent owners, in part by
obtaining shareholder approval of a remuneration report.
3. Performance based—programs are linked to relevant
measures of performance over an appropriate time.
< Design of a compensation plan should consider the possible
major elements (cash and short-term incentives, equity and
long-term incentives, post-employment benefits, etc) and be
constructed to fit the individual circumstances of each firm.
< Benchmarking or peer relative analysis should have minimal
influence in establishing compensation levels.*
< Remuneration plans should be:
= structured with an appropriate balance of short- and *Just because a CEO
long-term incentives which may vary according to market in Company A gets
conditions and the specific circumstances of the firm; and $1,000,000 a year does
= strongly linked to the firm's performance which reflects, and not mean that the CEO
is consistent with, value to long-term shareholders. of Company B should
get the same or more.
< Incentives may be provided to achieve both long- and short-
term goals; however, the performance drivers should not be
dual purpose and a balance should be struck with the need to
reward success over the long term.
< Each plan should be tailored to the firm's unique
circumstances as well as to the responsibilities of the position
held and the experience and expertise of the individual.

1.2.3 The Association of British Insurers (ABI)*

< Executive remuneration should be:
= set at levels which retain and motivate (based on
appropriate benchmarks, which should be used with caution *The ABI provides
to avoid "ratcheting up" with no corresponding improvement corporate governance
in performance); and advice to its members,
= linked to individual and corporate performance through who hold about 20% of
the UK stock market.
graduated targets, which align the interests of executives
with those of shareholders.
< The resulting arrangements should be clear and readily
understandable.*
*"Ratcheting up" is the process of raising pay to a benchmark at

a time when all firms in the industry are attempting to exceed the
benchmark in order to attract and retain talent.
Illustration 1 ABI Extract
The following extract from a letter sent in September 2008

to the members of the Association of British Insurers (ABI)
explains the relevance of the ABI's "Principles and Guidelines
on Executive Remuneration (Dec 2007)" to the current
economic situation.
"In addition, we would like to use this opportunity to draw
attention to the following points, which we consider to be
pertinent in the current economic climate.
• The remuneration policy should be fully explained and
justified, particularly when changes are proposed.
Members will carefully scrutinise remuneration uplifts,
particularly increases in salaries or annual bonus levels.
• Where a company has underperformed and seen a
significant fall in its share price, this should be considered
when determining the level of awards under share incentive
schemes. In such circumstances, it is not appropriate for
executives to receive awards of such a size that they are
perceived as rewards for failure.
• Shareholders are generally not in favour of additional
remuneration being paid in relation to succession or
retention, particularly where no performance conditions
are attached.
• In the context of the consultation process for share
incentive schemes, Remuneration Committees should
ensure that shareholders have adequate time to consider
the proposal and that their views are carefully considered.
Relevant information related to the consultation should be
clearly and fully disclosed."

2 Compensation Packages
2.1 Components
< There are many variations on the components and make up of
directors' compensation depending on industry norms, culture,
country and circumstances (e.g. government restrictions, The overall purposes
economic factors). of any reward are to
< The more common elements are: attract, retain and
motivate.
2.2 Basic Salary

< Received in accordance with the terms of a director's contract *Some commentators
of employment. It does not relate to the performance of the argue that basic
company or the individual (but there will be an argument for salary is for turning
not raising the basic salary if the director underperforms). up each day and doing
the administration.
< It reflects the basic contribution of the executive and Thus it should be
recognises the market value of a director generally. Usually as insubstantial as
it is set in relation to: possible compared to
= company size; the whole package.
= sector; Obviously, where
a director does
= experience; and
not receive any
= the level of basic salary in similar companies. performance-related
< As most governance codes suggest that performance-related element or options,
elements of remuneration should form a significant proportion basic salary will be a
far higher proportion
of the total compensation package, basic salary is unlikely to be
of the total package.
a significant proportion (e.g. will be less than 50%).*

2.3 Performance-Related Bonus

2.3.1 Background
< Performance-related elements have caused the most
controversy in recent years with some directors being awarded
a bonus even though their firms have underperformed (and
in some cases made substantial losses) or failed to meet or
exceed the sector average.
Example 1 Benefits of PRP

Explain the benefits of performance-related pay (PRP) in rewarding
directors.
Solution
< A balance between short- and long-term bonus schemes

should be found. The ICGN recommends a minimum bonus
period of one year (and not, for example, quarterly) and that
bonuses should be based on a percentage of basic salary (or
subject to a fixed "cap").
< A danger of bonus schemes is the directors' ability to
manipulate the target results on which bonuses are based
(e.g. revenue, profits). Achieving sales targets, in particular,
may result in questionable, unethical practices by directors
and employees.
Illustration 2 General Electric (GE)
A sales director in a US division of GE refused to complete a deal to sell

aircraft engines to an overseas airline because the CEO of that company
requested a consultancy fee. By doing so, the director failed to reach
his personal annual sales target. Jack Welch, the CEO of GE, not only
publicly praised the action of the director, but awarded him his bonus as
if the sale had been made.

2.3.2 Best-Practice Guidelines

< The remuneration committee should consider whether
directors are eligible for:
= Annual bonuses. If so, performance conditions should be *Traditional share
relevant, challenging and designed to enhance shareholder option schemes
value. should be weighed
= Benefits under long-term incentive schemes.* against other kinds of
long-term incentive
< Upper limits should be set and disclosed. There may be a case schemes.
for part payment in shares to be held for a significant period.
< In normal circumstances, shares granted or other forms of
deferred remuneration should not vest, and options should not
be exercisable, in fewer than three years.
< Directors should be encouraged to hold their shares for a
further period after vesting or exercise (subject to the need to
finance any purchase costs and associated tax liabilities).
< Proposals for new long-term incentive schemes should be
approved by shareholders and preferably replace existing
schemes. Total potential rewards should not be excessive.
< Payouts or grants under all incentive schemes should be
subject to "challenging performance criteria" reflecting the
firm's objectives.
< Challenging performance criteria should:
= relate to overall corporate performance;
= demonstrate that demanding levels of financial performance
have been achieved in the context of the firm's prospects
and the prevailing economic environment;
= be measured relative to an appropriate, defined peer group
or other relevant benchmark; and
= be disclosed and transparent.
< Criteria which reflect the firm's performance relative to
comparable companies (e.g. shareholder return) should be
considered.
< "Sliding scales" generally provide a better motivator for
improving corporate performance than a "single hurdle" by
encouraging exceptional performance.
< Rewards under executive share option plans (ESOPs) and
other long-term incentive schemes should normally be phased
over a set period.
< In general, only basic salary should be pensionable.
< Consequences of basic salary increases (e.g. on pension
costs) should be considered, especially for directors close to
retirement.

2.4 Transaction and Loyalty Bonus

2.4.1 Transaction Bonus
< There is a rising trend to award payment based on particular
transactions rather than on firm performance generated as a
result of the transaction.
< Such transactions or events include:
= successful acquisitions (often regardless of subsequent
performance);
= disposing of loss-making or underperforming elements;
= successful defence of a takeover bid; and
= successful listing of a company (e.g. at the most favourable
share price).
< Many consider such transactions to be within the normal
duties of directors and any bonus related to them should come
only through the normal performance-bonus scheme.
Example 2 Transaction-Based Bonus

No guidelines for transaction-based bonuses have yet been issued
by a corporate governance body.
Required:
Suggest what guidelines would be appropriate in dealing
with transaction-based bonuses.
Solution
2.4.2 Loyalty Bonus

< These are usually awarded for long-term service or staying
with a firm during a difficult time. Directors who stay with
a firm and "turn it around" (i.e. prevent it from going into
liquidation and then make it successful) often will be awarded *The need to retain a
a loyalty bonus.* director in the long-
term may be part of
< Guaranteed bonuses are becoming popular for employees
a strategic plan (e.g.
and directors (especially in the banking industry). A specified
to achieve a specific
percentage of salary is paid for staying in the service of the position in a particular
company for a given period (e.g. one year).* market). A loyalty
< The "golden hello", on joining a firm, is an incentive to bonus can be used
employees and directors to leave their current employment. to incentivise that
Loyalty requirements may include payment of the bonus director to remain in
only after a set period and requiring repayment should the the company.
employee leave within a further period. *Guaranteed bonuses
"handcuff" employees
< For directors, such awards are usually made in the company's
to stay in order to
shares with a condition that they cannot be sold until the end
receive the bonus.
of a vesting period (e.g. three years).

2.5 Share Options

2.5.1 Background
< As controversial as bonus schemes may have been, share
option schemes have been even more controversial because of
the ease of abuse on setting the option price, vesting rights and
the various methods directors have employed to enhance share
price in the short- to medium-term to gain maximum benefit.* *A share option gives
the holder the right
< Share options were the most common form of long-term (but not the obligation)
market orientated-incentive scheme. However, long-term to purchase an agreed
usually meant only three years (or less) with the director being number of shares, at
able to cash in without waiting for any further period to expire. an agreed price, on or
< Following a number of scandals, some of which involved after an agreed date
abuse of share options (e.g. Enron), there has been a general for an agreed period
from that date. The
tightening up of accounting and disclosure requirements for
date that the holder
share options (e.g. IFRS 2 Share-based Payment, requiring
accepts the contract
the cost and liability of share options to be recognised in is the grant date.
financial statements). This has resulted in a decline in the use Vesting conditions
of share options as a means of director compensation.* usually apply (e.g. a
percentage increase in
the share price). Such
conditions must be
met for the holder to
be entitled to exercise
*The collapse of stock markets in 2007/08 and, for many countries, the option.
recession, will have meant that the option price will far exceed the
market value at the date of vesting. Therefore, options currently
vesting are unlikely to be exercised. However, some directors
may well see an excellent long-term opportunity in options issued
currently based on actual market prices.

< Share-based incentives should align the interests of executive
directors with those of shareholders and link reward to
performance over the long term.
< ESOPs should not be offered at a discount (to the market price
at the grant date) except as permitted by the appropriate
provisions of the relevant listing rules.
< In normal circumstances, shares granted or other forms of
deferred remuneration should not vest, and options should not *Performance
be exercisable, in under three years. measures (e.g.
< Directors should be encouraged to hold their shares for a total shareholder
further period after vesting or exercise (subject to the need to return, earnings per
share (EPS) and
finance their acquisition and associated tax liabilities).
net profits) must be
< Grants under all incentive schemes, including new grants carefully defined by
under existing share option schemes, should be subject to the remuneration
challenging performance criteria. committee. It is far
< Consideration should be given to criteria which reflect the too easy to define and
set very low hurdles
company's performance relative to a group of comparable
for such measures.
companies in some key variables.*
< Grants under ESOPs and other long-term incentive schemes
should normally be phased rather than awarded in one large
block.

< All new share-based incentives, substantive changes to

existing schemes or changes in the general conditions of
operating schemes should be subject to prior approval by
shareholders by means of a separate and binding resolution.
< Their operation, rationale and cost should be fully explained so
that shareholders can make an informed judgment.
< Remuneration committees should regularly review share
incentive schemes to ensure their continued effectiveness,
compliance with the current best guidance and contribution to
shareholder value.
< Sliding scales are a useful way to ensure challenging
performance targets. They generally provide a better motivator
for improving corporate performance than a single hurdle.
< There will be no automatic waiving of performance conditions
either in the event of a change of control or where subsisting
options and awards are rolled over in a capital reconstruction
and/or the early termination of the participant's employment.
< Share or option awards should normally be granted only
within a 42-day period following the publication of the
company's results.
< Where individuals choose to terminate their employment before
the end of the service period, or in the event that employment
is terminated for any cause, any unvested options or conditional
share-based award should normally lapse.
< Commitments to issue new shares under all schemes must not
exceed 10% of the issued ordinary share capital in any rolling
10-year period. For executive (discretionary) schemes this
should not exceed 5%.
2.6 Shares
< The issue of shares instead of cash bonuses or share options is
becoming more popular.
< The guidance given by the Code and the ABI on share options
generally applies (as they refer to "long-term incentive
*The vast majority
schemes" as well as share options).
of directors consider
< Some share bonus schemes follow the principles of granting share options to be
and vesting over a rolling period (e.g. three years). Others remuneration and
award shares as part of the bonus (instead of 100% cash) cash them in at the
usually with a minimum period (e.g. three years) that the earliest opportunity.
shares must be held.* Share issue schemes
encourage directors
to hold their shares
after they vest and
incentivise them to
maintain a high level
of performance.

Illustration 3 Participation in
Performance
At a number of UK banks, the executive directors followed the lead
of the CEO and invested at least 50% (in some cases 100%) of their
cash bonus in the shares of the bank. Following the market crash
(2008), when many banks lost up to 80% of their share value and
have since required government bailouts, these directors suffered
significant financial losses.
In the ongoing (2009) investigations (e.g. the House of Commons
Finance Committee), these CEOs have been able to look the
investigating committee and bank shareholders "in the eye", and say
that they "put their money where their mouth was" and suffered just
as much as others.
However, as one member of the House of Commons committee
said, "you are all still in bloody denial" in accusing the CEOs of not
accepting that their "decisions, greed, poor governance and lemming
mentality" resulted in the near collapse of their banks.
2.7 Benefits-in-Kind
< Standard benefits-in-kind for senior employees and directors
normally would include a company car, pension scheme,
private health insurance and life insurance.
< Other benefits-in-kind may include company loans (although
these are illegal in most jurisdictions), use of company assets
(e.g. aircraft, helicopters, housing) club membership (e.g.
golf, tennis, football, gym, health centre) and similar benefits
for their spouse (e.g. car, health insurance, life insurance).* *Some of the more
abusive uses of
benefits-in-kind have
2.8 Pensions included use of a
company jet as a
2.8.1 Background private jet (e.g. for
< Pension schemes are often open to abuse, in that the scheme holidays or regular
for directors is usually a final salary scheme (higher costs trips by relatives), the
with the risk taken by the firm), while those provided for purchase of a racing
horse, the purchase
other employees would usually be fixed contribution schemes
of a baseball team
(lower cost and the risk of a pension shortfall is placed on the and the use of the
employee). company credit card
< Typically, a final salary scheme may be based on a set to pay for all private
percentage (e.g. 60%) of the average salary over a set expenditure (no refund
period (e.g. the last five years before retirement). There to the company).
is, therefore, an incentive for directors to weight their
remuneration towards salary in their last years before
retirement.
< In addition, directors may attempt to transfer company assets
into their pension scheme.

Illustration 4 WorldCom
During the year-long investigation into WorldCom's accounts, $9

billion in discrepancies were found.
The SEC levied charges against the corporation's CEO and several
executives. Among these, Scott Sullivan (WorldCom's chief financial
officer) was indicted on charges of securities fraud, and David Myers
(WorldCom's controller) pleaded guilty to committing securities fraud
and falsifying SEC filings.
In order to present a successful face to investors when company
profits began to wane, Sullivan, then CFO, made a series of
accounting adjustments. Over five financial quarters, Sullivan
masked $3.8 billion in WorldCom operation costs.
Another charge against WorldCom centres on the fact that the
corporation's CEO, Bernard Ebbers, illegally took $408 million in
personal loans from the corporation's funds.

< The remuneration committee should provide whatever
ancillary benefits would either be expected with the position
of executive director or which would increase loyalty and
motivation.
< In general, only basic salary should be pensionable.
< 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.
2.9 Termination
2.9.1 Background
< All governance codes make it clear that directors should not be
rewarded for failure. Therefore, when directors fail to achieve,
they should only be entitled to the minimum termination rights
under the law.
< Many directors' service contracts contain strict conditions on
what a director is entitled to on termination and under what
circumstances such entitlement may be lost.
< Restricting the length of a contract to one year minimises the
termination period to be paid to one year. Placing a notice
period of less than one year (e.g. six months) on the basis
of poor performance restricts the termination payment even
further.

< The remuneration committee should carefully consider what
compensation commitments (including pension contributions
and all other elements) their directors' terms of appointment
would entail in the event of early termination. The aim should
be to avoid rewarding poor performance. They should ensure
that contracts protect the company from being exposed to the
risk of payment in the event of failure.

< The committee should take a robust line on reducing

compensation to reflect departing directors' obligations to
mitigate loss.
< Notice or contract periods should be set at one year or less. If
it is necessary to offer longer notice or contract periods to new
directors recruited from outside, such periods should reduce to
one year or less after the initial period.
< The treatment of bonuses should be clear and a contractual link
established between variable pay and performance. Therefore,
in the event of early termination, there should be no automatic
entitlement to bonuses or share-based payments.
< When drawing up contracts, remuneration committees should
calculate the likely cost of any severance and determine
whether this is acceptable.
< Contracts should make clear that if a director is dismissed as a
result of a disciplinary procedure, a shorter notice period than
that given in the contract would apply.
< Contracts should not provide additional protection in the form of
compensation for severance as a result of change of control.*
< Pension entitlement on severance can represent a large
element of cost to shareholders. Remuneration committees *Such "golden
should identify, review and disclose in a report any parachutes" provide
arrangements that guarantee pensions with limited or no compensation in
abatement on severance or early retirement. These would not addition to any
be regarded as acceptable if included in new contracts. normal termination
< Remuneration committees should demonstrate that the route entitlement when
taken on severance represents the lowest overall cost to the directors lose their
jobs in a takeover.
company.
Illustration 5 Subordinated Debt
Under government pressure, UK banks that have taken government

loans and investment to survive following the subprime and credit
crunch crisis have used subordinated debt instead of cash or shares
to pay their staff bonuses (and will continue to have to do so until
they have repaid the government debt).
Only those parts of a bank that were in profit will receive any
bonus. The bonus also will be paid to other staff members who are
considered to be essential for the recovery of the bank and who
would otherwise create a serious risk should they leave.
The payments will be staggered over three years from 2010, with a
performance-related provision to claw back up to 100% of the award
over that period.
This approach allows staff members to still collect their bonuses (albeit
over three years) and will act as a motivating factor not to leave.

3 NEDs
3.1 Principles
1. The remuneration committee is usually made up of non-
executive directors (NEDs) and, therefore, should not set their
own compensation.
2. The alternative is for the main board, or a separate committee
of the board (made up of executive directors), to set the
annual salary of the NEDs.
3. As the NEDs should be independent, most governance codes
do not allow any other compensation apart from salary.
Example 3 NED Shares

Suggest the advantages and disadvantages of paying NEDs in shares.
Solution
3.2 Best-Practice Guidelines

< Levels of remuneration for NEDs should reflect the time
commitment and responsibilities of the role.
< Remuneration for NEDs needs to be sufficient to attract and
retain high-calibre candidates but no more than necessary for
this purpose.
< The board itself or the shareholders should determine the
remuneration of the NEDs within limits set in its constitution.
Where permitted, the board may, however, delegate this
responsibility to a committee, which might include the CEO.
< Remuneration for NEDs should not include share options.*
Shareholder approval should be sought in advance to grant
*Holding share options
shares as an exception, and any shares acquired by exercise can be a threat to
of the options should be held until at least one year after the independence.
NED leaves the board.

Illustration 6 FRC Guidance
The Financial Reporting Council's Guidance of Audit Committees (formally the Smith Report)
recommends that:
"In addition to the remuneration paid to all non-executive directors, each company should
consider the further remuneration that should be paid to members of the audit committee to
recompense them for the additional responsibilities of membership."
"Consideration should be given to the time members are required to give to audit committee
business, the skills they bring to bear and the onerous duties they take on, as well as the value of
their work to the company."
"The chairman's responsibilities and time demands will generally be heavier than the other
members of the audit committee and this should be reflected in his or her remuneration."
4 Other Issues
4.1 Legal
< Most of the legal requirements relating to directors'
remuneration will relate to the basic disclosure detail required
by law (e.g. the UK's Companies Act 2006). Further detailed
disclosures will be required by specific regulations (e.g. the
UK's 2002 Directors' Remuneration Report Regulations),
corporate governance codes and relevant listing rules.
< Directors have a legal right to receive compensation for
the duties they perform in accordance with the terms and
conditions of their service contract.
< Additional legal requirements may arise with a director's
employment and service agreement. Care must be taken
to ensure that there are no illegal actions required by the
director's service contract and that the contract does not
contradict any clauses in the company's constitution.
4.2 Ethical
< There is a traditional view that ethics and business do not mix.
As discussed later in Sessions 15 to 20, modern corporations
are increasingly demonstrating that they can combine
sensitivity to ethical issues with commercial success. The key
to this combination is seeing the effect on the commercial
environment of issues that companies are expected to
deal with. These ethical issues must be addressed by an
organisation's corporate governance system.
< There will always be an ethical argument about directors'
compensation where an organisation is considered to operate *The ethical
in an unethical area (e.g. animal testing, armaments) or in an arguments about
"what is a person
unethical way.
worth" is not
= Should directors earn high levels of compensation
just confined to
(performance bonuses, share options) in maximising directors. Footballers,
shareholder wealth when the business they are directing is performers, actors,
considered by many to be unethical? singers, DJs and
< The questions about the ethics of directors' compensation are even professional
mostly raised following high-profile corporate failures, especially accountants have
all been subject to
where the directors are perceived to have been earning
scrutiny.
excessive remuneration in relation to their performance.*

Illustration 7 Bank Bonuses
Shortly after receiving government bailouts to keep them afloat following the 2007/08 banking
crisis, many banks announced that they would still be paying out substantial bonuses to their
staff and directors for 2008, much to the fury of the general public.
Many press articles questioned the ethics of a banker earning millions for the banker's
contribution to society, compared to the much lower, fixed salary of a surgeon and the surgeon's
contribution to society.
4.3 Competitive
< It is essential that a company attract and retain the
appropriate directors to enable successful performance.
However, competition for the scarce resource of rare talent
may result in spiralling costs.
*The Code warns
< This usually has a cascading effect, in that players in against "ratcheting
the "second tier" will believe that they should follow the up" directors' pay
compensation trend of those top directors.* without any link to
< Compensation on main boards of global organisations often expected increases in
trend toward US levels as they hire international directors.* performance.
*Following proposals by the US and UK governments to limit the

bonuses of bank directors as a condition for taking public money,
many senior bankers cautioned against doing so as "the best talent
was needed by the banks to sort out the mess" and if they were not
paid well, they would not stay.
Many commentators replied that if this was the same "talent" that
got the banks into trouble in the first place, then it was a good thing
that they should go. In addition, given that most banks were in
trouble and would therefore have the same conditions applied to
them, where would the bankers who left go?
4.4 Regulatory
< The primary regulatory issues relating to directors'
remuneration are the numerous disclosure requirements in an
organisation's annual financial statements and the procedural
requirements at annual general meetings (AGM).
*This report combines
< Since 2003, UK companies have been required to produce and enhances
and submit to shareholders for approval (non-binding vote) a the disclosure
Director's Remuneration Report.* The contents of the report are requirements on
extensive and must contain detail on the following areas: directors' remuneration
= Consideration by the directors of matters relating to
in company law and
the Code.
directors' remuneration.
= Statement of the company's policy on directors'
remuneration.
= Performance graphs.
= Service contracts.
= Emoluments and compensation.
= Share options.
= Long-term incentive schemes.

= Pensions.
= Excess retirement benefits of directors and past directors.
= Compensation for past directors.
= Sums paid to third parties in respect of a director's services.
Vodafone's annual report (available at www.vodafone.com/content/

index/investors/investor_information/annual_report.html) includes
a good example of the detail required in this report. The examiner
will not expect you to reproduce the detailed content, but will expect
you to be able to broadly describe its use and give examples of the
typical content.
< Because of the legal nature of directors' service contracts and

compensation arrangements, the shareholders' vote on the
report is advisory only, but can send a powerful signal if
negative.
< Directors need to remember that shareholders vote on their
re-appointment (by rotation) and, if sufficient support is
raised, can pass a special resolution to have them removed.
Illustration 8 UBM's AGM, May 2005
UBM's annual remuneration report disclosed the payment of a special

£250,000 bonus to the company's chief executive, Lord Hollick, for ensuring
a successful handover to the new chief executive, David Levin. This
triggered a major rebellion, with 76% of shareholders voting against the
2004 remuneration report at the AGM.
UBM claimed it was contractually bound to pay the bonus whatever
shareholders said, and Lord Hollick appeared defiant, saying he had earned
the money. The shareholders protested that ensuring a smooth transition
was one of the "normal duties" of a chief executive and did not merit a
special award.
Peter Montagnon, head of investment affairs at the Association of British
Insurers (ABI), the voice of some of the UK's biggest institutional investors,
was quoted in the Financial Times of May 13, 2005, as saying: "The
company's owners have spoken. If Lord Hollick insists on keeping the
payment then he will be remembered for defying 76% of shareholders—
and not for his good performance as chief executive."
A few days later, Lord Hollick agreed to waive his right to receive the money.
< The Code requires that the board chairman should arrange
for the chairmen of the audit, remuneration and nomination
committees to be available to answer questions at the AGM
and for all directors to attend.

Illustration 9 Excessive Pay (1)

"European anger at 'social scourge' of excessive pay" (headline),
—Article by David Gow, Brussels, guardian.co.uk, 12 September 2008
The "social scourge" of excessive boardroom pay has prompted widespread debate
in the European Union as workers see their purchasing power eroded by rising
prices and low wage increases. European political leaders have demanded a legal
and fiscal clampdown.
Shareholders, especially retail investors, are pressing for greater corporate
disclosure of remuneration policy, including links to performance, and individual
directors' pay packages as well as votes on the issue at annual meetings.
The pay debate has been exacerbated by the credit crunch, which has exposed
undue risk-taking in the search for higher bonuses by highly paid investment
bankers and high-profile severance packages for failed executives, deepening the
sense of outrage in mainland Europe, which is culturally more egalitarian than the
US or Britain.
Even before Pat Russo, chief executive of serially loss-making IT firm Alcatel-Lucent,
quit in late July with a contractual pay-off of up to €6m (£4.8m), French president
Nicolas Sarkozy had produced draft laws to curb such "golden parachutes".
The Dutch government has introduced legislation for a 30% tax on bonuses of
more than €500,000 and a 15% increase in employer's fiscal contributions to
executive pensions, partly influenced by the multi-million pay-off for ABN Amro
chief Rijkman Groenink.
In Germany, where workers' pay rose only 4.3% between 2003 and 2007 as firms
laid off hundreds of thousands of employees, Social Democrats are demanding a
€1m ceiling on tax-deductible boardroom remuneration.
It is the widening gap between boardroom and shop floor remuneration in
a deteriorating economic environment that is fuelling the furor. The growing
evidence is that mainland European companies are following the lead of their
British counterparts by setting executive remuneration packages, including stock
options, at a level commensurate with global—not national—peers in an effort to
retain and incentivise directors.
Executive pay in the EU averages €5m a year. French chief executives are said to
be the highest paid with packages worth €6m after a reported 58% leap in 2007.
A recent survey by the German DSW investor lobby found that German executive
pay had risen 7.75% in 2007 to just below €3m, with Josef Ackermann of
Deutsche Bank the top earner with €14m, though Wendelin Wiedeking of unlisted
Porsche earned more than four times that.
It is this degree of corporate generosity that prompted Jean-Claude Juncker,
chairman of the EU's euro group, to label it a "social scourge".
Disclosure practices vary widely across the European Union despite a four-year-
old non-binding European commission recommendation to increase corporate
remuneration transparency on individual executive pay and remuneration policies
as a whole.
A European commission report last year found greater transparency had ensued
but responses had been patchy, with only a third of member states enabling even
an advisory shareholder vote on executive remuneration. In Germany, where
only 40% of the top 30 firms in the Dax have remuneration committees and most
annual reports detail just the package of the highest earner, even that stipulation
causes anger among directors.

Illustration 9 Excessive Pay (2)
A report (primarily aimed at banks) by the UK's High Pay

Commission in November 2011 concluded that "Executive pay
should be radically simplified to halt spiralling awards that are
'corrosive' to the economy and threaten to create the type of
inequalities last seen in the Victorian era."
The report notes that "pay packages have become increasingly
complex, damaging relations with shareholders and creating
confusion. The performance element should be a simple award of
shares at the discretion of the remuneration committee, held for
at least five years" and that "4 out of 5 people (in the UK) believe
executive pay is out of control".
Examples given to support the conclusion included:
= Barclays' Bank's top executive earned £4.36m in 2010—169 times
the earnings of an average British worker (£25,800). In 1980,
the multiple had been 13. Total earnings of the executive had
increased by 4,899% over a 30-year period.
= At BP, the chief executive earned 63 times the company's average,
while the 1980 multiple was 16.5. His % increase was 3006%.
= In 1979 the top 0.1% of earners took home 1.3% of national
income, but by 2007 this had grown to 6.5%. At the current rate
of increase the top 0.1% would take home 14% of income by
2035—equivalent to that last seen in Victorian Britain.

Summary
< The UK Code recommends that firms set remuneration levels sufficiently high to attract the
talent required to successfully run the company, but avoid paying more than is necessary.
Directors retain responsibility for positioning the firm with regard to remuneration. A significant
proportion should reward corporate and individual achievement (i.e. low salary with significant
performance-based pay).
< Directors should avoid setting their own remuneration.
< The ICGN, however, suggests that peer-relative analysis should have minimal influence in
establishing pay.
< The ABI indicates that benchmarks may be appropriate, but that firms should avoid
"ratcheting up".
< ESOPs should not offer shares at a discount to market price. Share availability should be
phased in over time. Sliding-scale performance targets generally result in greater motivation.
Early termination should result in loss of options. Committed shares should not exceed 10%
of the issued ordinary share capital in any rolling 10-year period.
< Benefits-in-kind (e.g. company car, pension scheme, private health insurance, life insurance,
club memberships, etc) should not be excessive.
< The remuneration committee should include only NEDs, who set annual bonuses based on
challenging goals with an eye towards enhancing shareholder value (i.e. not just short-term
based). Share awards to executives should vest only after three years. Rewards on longer-
term incentives should be phased in over time. Only basic salary should be pensionable.
< NEDs should be independent and compensated with salary only. The salary should reflect the
time commitment and responsibilities. Salary should be set by a separate board committee,
which may include the CEO.
< The UK Companies Act 2006 requires a certain detail of disclosure regarding board and
executive compensation. The 2002 Directors Remuneration Report Regulations require
additional levels of disclosure.

Session 5
EXAMPLE SOLUTIONS
Solution 1—Benefits of PRP

= In general terms, performance-related pay aligns directors’ and
shareholders’ interests by rewarding attainment of shareholder-
preferred results (e.g. meeting financial targets, share price levels or
even social responsibility goals).*
= These rewards, in turn, motivate directors, especially if they are *Increasing the
directly responsible for a cost or revenue/profit budget or centre. alignment with
shareholders interests
= The possibility of additional income for achieving organisation targets
should reduce agency
can assist in director recruitment and retention.
costs.
= Finally, performance-related pay aligns rewards against strategic
objectives, which increases the board’s control over strategic planning
and implementation.
Solution 2—Transaction-Based Bonus

The general approach should be that these awards are fully exposed to
the scrutiny and recommendation of the remuneration committee, the
same criteria as applied to performance-based bonuses are applied,
full disclosure is made to shareholders and, because of the special
(and perhaps controversial) nature of the awards, they are subject to
shareholder approval at the AGM.
Solution 3—NED Shares
Can align the interests of the NED with the long-term interests of
shareholders they represent.
Most NEDs would prefer to be paid primarily in cash.
If they are also an executive director of another company, any fee
they receive may, under their service contract, go directly to that
company. Shares may not be an acceptable alternative for either
company.
Any material build-up of shares held by NEDs places their
independence in jeopardy.

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Session 5

A. Governance and Responsibility

(continued on next page)

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COMPENSATION PACKAGES OTHER ISSUES

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1.2 Corporate Governance Guidance

*Organisation boards have a natural tendency to "ratchet up"

< A significant proportion of total remuneration should be

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1.2.2 The International Corporate Governance Network (ICGN)

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1.2.3 The Association of British Insurers (ABI)*

*"Ratcheting up" is the process of raising pay to a benchmark at

Illustration 1 ABI Extract

The following extract from a letter sent in September 2008

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2.2 Basic Salary

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2.3 Performance-Related Bonus

Example 1 Benefits of PRP

< A balance between short- and long-term bonus schemes

Illustration 2 General Electric (GE)

A sales director in a US division of GE refused to complete a deal to sell

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2.3.2 Best-Practice Guidelines

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2.4 Transaction and Loyalty Bonus

Example 2 Transaction-Based Bonus

2.4.2 Loyalty Bonus

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2.5 Share Options

2.5.2 Best-Practice Guidelines

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< All new share-based incentives, substantive changes to

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During the year-long investigation into WorldCom's accounts, $9

2.8.2 Best-Practice Guidelines

2.9.2 Best-Practice Guidelines

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< The committee should take a robust line on reducing

Illustration 5 Subordinated Debt

P1-05 Directors' Remuneration

P1-05 Directors' Remuneration

P1-05 Directors' Remuneration