UK: The Directors´ Remuneration Report Regulations 2002

In June 2002, Patricia Hewitt, the Secretary of State for Trade and Industry, said that:

"top class pay for the best performers is something we support. But there can be little doubt that some company directors have received lavish pay awards in circumstances where they aren’t deserved.

We share the view of many shareholders and employees that this is unacceptable and has to change, and it’s important that shareholders should be able to express their views about remuneration packages".

The result is the new Regulations on disclosure of directors’ remuneration which came into force on 1 August 2002.

Prior to the new Regulations coming into effect, disclosure of directors’ remuneration has been based on a mixture of provisions in the UKLA Listing Rules (paragraph 12.43A), the Combined Code and Schedule 6 Companies Act 1985.

The Directors’ Remuneration Report Regulations 2002 (which have amended the Companies Act 1985) have now put the disclosure of directors’ remuneration onto a statutory footing and require all UK companies which are listed in the UK (but not AIM-listed companies) or any other EU state, or on the New York Stock Exchange or NASDAQ, to:

• include a detailed report on directors’ remuneration in the annual report; and
• put a resolution on the report to shareholders at each annual general meeting.

The Regulations apply to financial years ending on or after 31 December 2002. This means that a company whose current financial year ends on or after that date will have to produce a remuneration report satisfying the new requirements as part of its next annual report and accounts and put the necessary resolution to shareholders at the next AGM. Directors who sit on remuneration committees and company secretaries will need to familiarise themselves with the detail of the Regulations now and think about how information on remuneration will need to be collated and presented in order to satisfy the new disclosure requirements.

The Listing Rules already require a lot of detail about directors’ remuneration to be included in an annual remuneration report. What the Regulations do is put this on a new statutory footing, add new procedures that need to be followed, add to the level of disclosure particularly in relation to policy and add a requirement to put the report to the vote.

• The requirement for listed companies to prepare a directors’ remuneration report is now a statutory requirement under the new Section 234B of the Companies Act, rather than only a Listing Rules requirement. Failure by a company to comply with this requirement is a criminal offence making all directors liable to a fine.
• The report must be approved by the board and signed on its behalf by a director or the company secretary. A signed copy must be delivered to the Registrar of Companies. It will be an offence to put the report to a shareholder meeting, or to circulate, publish or file the report, if it has not been properly signed, and all circulated copies must state the name of the person who signed it.
• A copy of the report must be sent to every member of the company, every holder of the company’s debentures and every person who is entitled to receive notice of general meetings.
• Listed companies are now required to put the directors’ remuneration report to a shareholder vote, following a long and vocal campaign by various institutional shareholder bodies and other corporate governance activists. Previously, the Combined Code only required a company to consider whether the remuneration report should be voted on (although, interestingly, nearly 40% of the FTSE 100 already puts its remuneration policy or the entire remuneration report to a vote). The requirement is found in a new Section 241A of the Companies Act. However, the resolution to approve the remuneration report is an oddity in that it has no legal effect – the Regulations say that putting the remuneration report to a vote in accordance with Section 241A does not of itself make any director’s remuneration conditional on the outcome of that vote. If a company’s shareholders do not approve the remuneration report, that does not mean that past or future payments to directors are rendered unlawful. Similarly, even if shareholders refuse to approve the report, the company would not be in breach of the Act if it ignored the outcome of the vote and implemented its defeated remuneration policy anyway. In practice, of course, few listed companies would want to flout shareholder opinion like that and it is likely to be treated as a vote of no confidence in the remuneration committee, if not the board.
• A new Schedule 7A to the Companies Act sets out the detailed information to be included in the remuneration report. Some of this reflects the information that has been required in remuneration reports under the Listing Rules for some years now. The UK Listing Authority has not released any detailed proposals for changes to the Listing Rules, but it has said that in principle its intention is to amend the Listing Rules so that they do not duplicate the requirements that are now found in the Companies Act. However, until such changes are made, companies need to have regard to the new Schedule 7A, the Listing Rules and the Combined Code (and in some areas the Listing Rules go further than the new Schedule 7A).
• There is a new personal requirement on directors to give notice to the company of anything the company needs to know in order to comply with the detailed content requirements of Schedule 7A. Again, failure to comply will be an offence punishable by a fine. This applies not only to current directors but also to anyone who was a director at any time in the preceding five years.

Below we focus on some of the new requirements for disclosure and look at what companies should now be doing so that they will be able to produce the necessary information for the new style remuneration reports.

The detail of what needs to go into the remuneration report is set out in Parts 2 and 3 of the new Schedule 7A.

Part 2 of Schedule 7A sets out key disclosure requirements on policy and performance, many of which are new:

• The members of the remuneration committee, the names of any persons who materially assisted the remuneration committee on matters relating to directors’ remuneration and, if any of those who assisted were not themselves directors of the company, information on the nature of any other services they provided during the year. (The Combined Code required the members of the remuneration committee to be listed in the remuneration report, but the requirements on persons who assisted the committee are new.)
• A statement of the company’s policy on directors’ remuneration for the forthcoming and subsequent financial years. (The Listing Rules required a statement of the company’s policy on executive directors’ remuneration, but the reference to "forthcoming and subsequent financial years" makes it clearer that the statement should be forward-looking.) Unlike the Listing Rules requirement, it is not limited to executive directors’ remuneration, so companies are now required to disclose their policy on non-executive directors’ remuneration.

• The policy statement must include, for each director, a detailed explanation of the performance conditions applicable to his or her entitlements to share awards (whether an award granted under a shareholder-approved option scheme or long term incentive scheme or an award granted under a deferred bonus scheme set up without shareholder approval). The detailed explanation must show why the performance conditions were chosen; a summary of the methods used to assess performance (and why such methods where chosen); details of any performance conditions involving comparison with external factors together with details of any comparator group; an explanation of any significant amendment proposed to be made to any entitlement of a director to a share award (actual amendments to share awards will now require disclosure as audited information); and where an entitlement to a share award is not subject to performance conditions, an explanation as to why this is so. In relation to each director’s remuneration, the policy statement must explain "the relative importance of those elements which are, and those which are not, related to performance".
• The policy statement must also include information on the company’s policy on length of contracts with directors, and notice periods and termination payments under those contracts. (This requirement to state the policy is new, although the Companies Act already required disclosure of the aggregate amount of compensation paid to directors for loss of office and the Listing Rules require details of any service contract with a notice period in excess of one year or with provisions for pre-determined compensation on termination which exceeds one year’s salary and benefits in kind, and the reasons for such notice period.) Non-executive directors’ appointment letters as well as executive directors’ service contracts will be caught by this new requirement, so listed companies should now disclose their policy on the length of non-executive appointments and whether they can be terminated by notice. (Institutional investors have in the past expressed concerns about companies being able to terminate by notice because they regard it as weakening the non-executive director’s position.)

• There is a new requirement for a performance graph illustrating actual shareholder return on a holding of the company’s listed shares over the last five years compared with the notional shareholder return over the same period on a basket of shares "of the same kind and number as those by reference to which a broad equity market index is calculated".
• Details of directors’ service contracts and/or contracts for services, and, in the case of non-executive directors, letters of appointment. This must include date, unexpired term and notice periods; any provision for compensation on early termination; and details of any other provisions in the contract which shareholders need to know about in order to estimate the liability of the company on early termination. Any "significant award" made to a former director must also be explained. This would include any compensation package for loss of office and details of whether (and why) any discretion was exercised in favour of a director to enable that director to exercise options or receive other share awards.

Part 3 of the Schedule requires very detailed information to be set out regarding the actual amounts received in the financial year by way of salary and fees, bonuses, expenses and other non-cash benefits and any compensation for loss of office or other termination payment; information on each director’s share options and interests under long term incentive schemes; and information on each director’s entitlements under pension schemes. These are similar to the existing Listing Rules requirements but are more detailed in some respects, such as the disclosure requirements on performance criteria and conditions for share option and long-term incentive schemes. There are also additional requirements on excess retirement benefits, compensation for past directors and sums paid to third parties for directors’ services, largely derived from the existing requirements of Schedule 6 to the Companies Act (which has also been amended).

The auditors are required to report to shareholders on this part of the remuneration report and state whether in their opinion it has been properly prepared in accordance with the Act; so the position is similar to that under the Listing Rules where the auditors’ report had to cover the disclosures on individual director’s remuneration packages, share options, long-term incentive schemes and pension schemes. The auditors are also required to provide a statement giving details of any non-compliance with the Act.

For those listed companies that send out a summary financial statement, the Companies (Summary Financial Statements) Regulations 1995 have been amended by the Companies (Summary Financial Statements) Amendment Regulations 2002 to set out those elements of the remuneration report which are to be included in the summary financial statement. The minimum level of disclosure required in the summary financial statement is the aggregated amount of directors’ remuneration, the statement of the Company’s policy on directors’ remuneration and the performance graph.

Set out below are the key steps that companies should be taking now to make themselves prepared for the new regime:

• Keep a record of the membership of the remuneration committee and, if there are any changes to its make-up during the financial year, be able to identify who was on the committee at the time when any particular matter relating to remuneration was considered.
• Keep a record of any person who provides advice or services to the remuneration committee in its consideration of any matter relating to remuneration. The consultation paper suggested that this is mainly intended to catch external remuneration consultants but it could also include, for example, one of the other directors or an employee of the company (such as a member of the Human Resources team). If that person is not a director, the nature of any other services they provide to the company also needs to be disclosed.
• Carry out the necessary analysis of the performance conditions under the company’s share option and long-term incentive schemes. This requires not just a description of the performance conditions themselves but also an analysis of the methods that are used to assess whether the performance conditions are met and an explanation of why those methods were chosen.
• Think about how to meet the very broad and open-ended requirement which requires an explanation, in respect of each director’s terms and conditions relating to remuneration, of the relative importance of those elements which are, and those which are not, related to performance.
• Draft a statement of the board’s policy on the duration of contracts with directors (both executive and non-executive), and notice periods and termination payments under such contracts. If the board has not yet adopted a formal policy on these matters, it should be preparing to do so now.
• Consult with the company’s brokers on preparing the required performance graph.
• Pull together the information relating to directors’ service contracts and contracts for services. Bear in mind that this applies to non-executive directors’ engagement letters as well as to executive directors. In particular, careful thought needs to be given to the requirement to supply "such details of other provisions in the contract as are necessary to enable members of the company to estimate the liability of the company in the event of early termination". This is quite an onerous requirement and listed companies may need to take specific legal advice on what disclosures to make. This section of the report also needs to explain any compensation payments made to past directors during the financial year.
• Review the detailed disclosure requirements in Part 3, Schedule 7A, bearing in mind that they apply where relevant to non-executive as well as executive directors.
• Talk now to auditors to establish what information they will require to be able to audit the report.

© Herbert Smith 2002

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