Skyscrapers in City of London,( Lloyds of London, Tower 42, Aviva and the Gherkin)

After making bold campaign pledges on UK corporate reform, a consultation paper (PDF) released last week finds Theresa May’s government trying to balance its prior rhetoric against the practicalities of governance. The green paper, published by the Department for Business, Energy and Industrial Strategy (“BEIS”), follows months of public posturing over the direction of UK corporate governance and how best to address perceived “boardroom excess”, as well as improving standards of business behaviour following recent debacles at Sports Direct and British Home Stores.

The paper lays out the government’s case for change and seeks responses from investors, businesses, and the general public about how best to go about “restoring faith” in how UK companies are being run. In doing so, the paper sets out 14 questions for consultation, focusing on executive pay; strengthening the voices of stakeholders, such as employees and customers; corporate governance practices at large private issuers; and other governance issues. Interested parties are invited to respond by February 17, 2017.

Perhaps unsurprisingly, executive remuneration takes up as much of the report as the other three topics combined. This section covers issues ranging from engagement to remuneration committee composition, transparent disclosure, and the actual structure of incentives; however the headline question concerns shareholder voting.

Currently, UK-incorporated companies are required to seek binding approval of remuneration policies every three years, with the annual vote on the remuneration report remaining advisory. Upon becoming Prime Minister, Ms. May had stated that there should be binding annual votes on executive pay; however, she was light on the details of how it would work. Although fully binding votes are still on the table, the green paper also cites alternatives, reflecting an acceptance that making the remuneration report subject to a binding vote may have “practical difficulties”. Proposed alternatives include restricting binding votes to:

  • the variable pay elements of remuneration packages, for all companies;
  • only companies that received “significant minority opposition” to pay packages in the previous year; or
  • only companies that failed to receive majority approval of the previous year’s advisory vote.

The approach of targeting poor performers was met with a favourable response from the Confederation of British Industry (CBI), which stated that “introducing a targeted [rather than for all votes at all companies] binding vote regime would focus attention on the most concerning cases and give shareholders the teeth to truly have the final say on top executives’ pay.”

Beyond the voting structure, the consultation also looks at one of the key drivers of shareholder engagement and voting in recent years: transparency. In particular, increased investor focus on disclosure has led to an increase in the proportion of companies that fully set out bonus hurdles, from 36% in 2014 to 64% in 2016 (albeit with some companies providing this information retrospectively, when hurdles are no longer considered commercially sensitive). Now, the government is considering whether to make retrospective disclosure within a set timeframe mandatory, or to avoid legislation and instead strengthen the Financial Reporting Council’s guidance on the issue while encouraging other stakeholders to maintain pressure on companies.

The consultation’s other question relating to disclosure covers pay ratios. Despite frequent and vocal criticism from issuers and business groups regarding its usefulness, a ratio of CEO-to-median employee pay remains a popular talking point, and will soon become a requirement in the United States. The consultation acknowledges criticisms of the ratio, noting that it “would need to be designed in a way which genuinely improves the ability of shareholders to understand company pay policies and to take an informed view on pay outcomes”; nonetheless, it appears that the government is seriously considering making such ratios a reporting requirement. In addition, the consultation highlights recent guidance from the Investment Association that goes beyond the median employee to raise the possibility of also disclosing the pay ratio between the CEO and other executives. This type of disclosure would provide a clearer view of internal pay disparities at the top, which can help shareholders “understand the dynamics of the senior management team, whether any individuals are unduly dominant and succession planning issues.”

Reflecting the increasing importance of effective engagement, the consultation asks whether steps should be taken to encourage remuneration committees to consult with shareholders and employees before developing pay policies, and to improve their effectiveness in general. Few details are offered, however the BEIS has taken up one specific idea from the Executive Remuneration Working Group, which proposed that committee chairs should have at least 12 months experience on a remuneration committee before taking up the lead role.

The consultation also raises questions regarding the structure of executive incentives. Responding to investor pressure, in recent years the vast majority of UK issuers have increased the performance and/or holding period on long-term incentives (“LTIs”); reflecting this shift, the government is asking whether the legal minimum for LTIs should be increased from three to five years.

The section on LTIs is also notable for considering the use of non-performance based ‘restricted share’ awards as an alternative to the current performance-based model. While common in other markets, equity awards that are not subject to performance have historically been frowned upon by UK investors. Indeed, last year the Weir Group saw its proposed remuneration policy rejected by 72% of shareholders, largely due to the inclusion of non-performance based restricted share awards. The case for restricted awards is that they serve to simplify the pay structure, and are generally granted at a lower quantum to reflect a lower risk profile in the absence of performance criteria; however, given the result at Weir, it will be interesting to see if investors are willing to accept such deviations from established UK market practice.

Critics have been quick to voice their displeasure with what they perceive as backtracking by the Prime Minister on the topic of binding votes and, in relation to strengthening the voice of stakeholders, have raised similar concerns regarding the potential for worker representation on boards. In addressing the CBI a week before the release of the green paper, Ms. May ruled out forcing companies to appoint workers to such positions, which appeared to represent a change of stance from statements made during her Tory leadership campaign. In line with the current stance of the government, the green paper stopped short of recommending board-seats for workers, instead seeking consultation on the best approach towards “strengthening the voice of employees” while maintaining a unitary-board governance “system that we consider serves the UK well and we do not intend to change”. The potential options include the creation of stakeholder advisory panels, to which the board would be required to listen; designating particular non-executives as responsible for ensuring the voices of employees are heard; and strengthening the reporting requirements related to stakeholders engagement.

Perhaps more notable than any one idea put forward in the green paper is the range of sources it draws its ideas from. Citing groups such as the Investment Association’s Executive Remuneration Working Group and the Big Innovation Centre’s Purposeful Company task force, the paper’s scope reflects the extensive discussion that is already ongoing regarding governance and remuneration in the UK. Indeed many of the specific points it raises – increased engagement, transparent disclosure, extended holding on LTIs – have been hot-button issues for investor groups for several years now, in some cases leading to significant shifts in pay practices without legal or regulatory action. Regardless of whether the consultation yields any dramatic new legislation or reporting requirements, investors should expect the discussion to continue as UK plc heads into the 2017 AGM season.