«Brian G M Main University of Edinburgh School of Management March 2002 1 ABSTRACT The ABI Guidelines for Share-Based Incentive Schemes. Setting the ...»
The ABI Guidelines for Share-Based Incentive Schemes.
Setting the hurdle too high?
Brian G M Main
University of Edinburgh School of Management
The ABI Guidelines for Share-Based Incentive Schemes. Setting the hurdle too
Brian G M Main1, University of Edinburgh School of Management.
This paper examines, from the perspective of the pay-performance connection, the guideline principles recently issued by the Association of British Insurers (ABI) in connection with the operation of share-based incentive schemes. The four main dimensions to these guidelines concern: (i) phasing of issue by use of regular awards; (ii) setting of performance criteria (hurdles) against a peer group or bench-mark; (iii) restricting any re-testing of satisfaction of such performance criteria; and (iv) instituting a sliding scale of reward contingent on the performance out-turn against criteria. Emphasis is also placed on the accounting recognition challenge of reporting to shareholders the expected value of such rewards. Results are derived from a simulation over a 14 year period of the implementation of such guidelines in a sample of companies traded on the London Stock Exchange. Empirical results suggest that the pay-performance connection is not always made stronger by setting the hurdle ever higher, and that higher hurdles are best tempered by generosity in terms of re-testing and re-issue of options. The saving of expense on such packages may be bought at the expense of a weakened pay-performance connection at board level.
1 The author would like to thank Paul Draper and Guy Jubb for helpful comments and advice in the preparation of this paper. Remaining errors are my own.
1. Introduction Since the passage of the Finance Act 1984, Executive Share Options (ESOs) have become an increasingly important component of executive remuneration. In addition to the tax advantages initially available by satisfying some relatively mild conditions, this means of remuneration continues to hold out the possibility of achieving a clear link between the executive’s pay and company performance. From the initial outbreak of enthusiasm for this means of executive remuneration, the prospect of equity dilution through over zealous use of such schemes prompted institutional shareholders to take an interest. In particular, the Association of British Insurers (ABI) has, through the promulgation and dissemination of various codes of practice2, emerged as the lead organisation in the regulation of these share-based incentive schemes.
The most recent set of consolidated ABI guidelines was issued in March 2001 and comes after a prolonged process of external scrutiny of top executive pay practices and procedures. A process which through theCadbury (1992), Greenbury (1995), and Hampel (1998) reports can best be described as self-regulation3, although the recent proposal for the reform of company law in this area4 represents a rare government intervention. One consequence of these various reports, and the Greenbury Report in particular, was to move companies away from ESOs towards more complex Long Term Incentive Plans (Ltips)5. Nevertheless, ESOs remain empirically important and continue to provide a standard against which other incentive pay schemes may be judged.
The new ABI (2001) guidelines mark a fairly radical departure from what has gone before. The detail of the development of these guidelines and the way in which they provide guidance to boards and remuneration committees is provided below but, in essence, the novelty comprises a move away from using the ‘four-times-emoluments’ guide as to a ceiling for option issue towards encouraging a ‘phasing’ of ESO issue in a regular manner in preference to having a somewhat lumpy issue once every three or four years. Markedly more emphasis is now placed on setting challenging performance criteria (or ‘hurdles’) before the ESOs vest, and performance is to be on a relative basis, using peer groups or performance bench marks. One version of a challenging performance criterion mentioned but not specifically required in the ABI guidelines, and certainly commonly touted in the business press, is the issue of executive share options with a strike price that is at a ‘premium’ to the market price. This alternative will also be examined below.
2 See, for example, Association of British Insurers (1987, 1991, 1993, 1994, 1995 and 1999).
3 Blundell and Robinson (1999) provide an extensive discussion on the prevalence and potential of such arrangements in the economy.
4 The main proposal being that shareholders should be allowed to vote on the report of the remuneration committee. See the original discussion paper DTI (1999).
5 For an examination of the impact of this move to Ltips, see Buck, Bruce, Main and Udueni (2001).
In addition, remuneration committees are discouraged from permitting a second or further chance to meet the performance conditions (‘re-testing’) if they are not fully satisfied at the first opportunity6. Finally, the reward for the attainment of targets is encouraged to be on a sliding scale ( where the reward or proportion of options vesting increases with the level of performance once a certain threshold is surpassed). In all of this, it should be stressed that the actual ABI guidelines nowhere prescribe the behaviour of remuneration committees. Recommendations only are given7, exceptions are permitted, and remuneration committees and boards are free to depart from these guidelines.
Emphasis is also placed on reporting to shareholders the expected value of such rewards.
This suggests a move away from the current practice of neither reporting8 nor recognising the cost of servicing ESOs, a move which is wholly consistent with recent government proposals to bring reporting of executive pay more in line with the SEC (1993) regulations that apply in the USA. This challenge does, of course, highlight the difficulty of assessing the impact of the ABI guidelines on the pay-performance linkage confronting the executives being remunerated under such schemes9. There are sufficiently many inter-related conditions suggested by the new ABI guidelines that the question of evaluating their performance on the pay-performance rlationship looks intractable in terms of a theoretical approach. We are, therefore, forced to adopt a more empirical method of estimation whereby various combinations of the guidelines are simulated on data from a given set of companies.
This paper adopts an empirical approach to the study of the issues raised here, by conducting several simulations of the implementation of these guidelines in a sample of companies traded over a 14 year period on the London Stock Exchange. The method involves adopting various particular specifications of the guidelines and by applying them in each company to a representative chief executive at the start of 1984 and computing the reward that this person would earn under each specification as the 1984-1997 period unfolds. The fortunes of such representative executives in a sample of some 244 companies traded on the London Stock Market over the period is then used to produce an average picture. For each of the hypothetical company chief executives, the pay performance correlation is analysed to produced a summary measure of how each configuration of the guidelines fares.
In the following section of the paper, some background information is provided concerning the development of the ABI guidelines over the years. This is then followed by a section which explains how the empirical data are constructed. The next section 6 Options typically vest after three years and the performance period is usually the most recent three or fouryear period.
7 This is seen, for example, in paragraph 2.1 of the Guidelines which states ‘Remuneration committees are expected to have regard to these Guidelines in developing and implementing share incentive schemes.’ 8 In fact, UITF (
10) of the Accounting Standards Board (1994) does require basic option-related information to be reported in a footnote to the accounts.
9 For earlier work examining the pay-performance relationship brought about by executive share options, see Main, Bruce and Buck (1996) and Yermak (1995). And for a discussion of UK policy in this area, see Main (1999).
2. Background to the ABI guidelines In an attempt to foster the adoption of a more explicit culture of performance related pay in the board room10, the government of the day introduced the concept of ‘approved share option schemes’ under the Finance Act 1984. Until this point, any gains from ESOs were treated as income and taxed accordingly (up to a rather punitive top rate of 83% in early 1979). Although the top rate of income tax was reduced to 60% in 1979, the prospect held out by the Finance Act 1984 was that ESOs operating under certain restrictions could have their gains taxed as capital gains (which then faced a more attractive 30% tax rate). The principal restriction imposed by the Inland Revenue, in order to limit the tax expenditure implications of this concession, was that the face value (the exercise price times the number of shares under option) of options issued under such schemes should be limited to four times the annual emoluments of the relevant executive11.
With the vast majority of ESOs being serviced through shares by subscription (newly issued shares) rather than by acquisition (open market purchase), and with shares by subscription being neither recognised nor reported in the earnings statement, Institutional shareholders were alarmed at the prospect of equity dilution12. In drawing up a set of guidelines, the ABI seems to have reached for the existing Inland Revenue Code. The ABI guidelines were almost universally adopted13, to the extent that it almost became a rule or an entitlement that all executives at board room level would be issued with options to the value of four times emoluments. The fact that such a uniform distribution of ESOs is unlikely to represent an efficient outcome in terms of providing individual executives with the appropriate incentive - a situation that is likely to vary from company to company and, indeed, executive to executive - was highlighted by Main (1994).
Admittedly, revised ABI guidelines subsequently included provision for so-called ‘super options’ at eight times emoluments but the performance conditions14 were sufficiently steep to deter most companies from using them.
10 Performance related pay can be viewed as part of the contractual approach to corporate governance (see Shleifer and Vishny (1998) and Baker, Jensen, and Murphy (1988) for a more detailed review and discussion).
11 There were also Inland revenue conditions requiring a minimum three year vesting period and a maximum 10-year life. Annual emoluments are roughly base pay plus bonus with an allowance for the cash equivalent of benefits in kind.
12 One impact of the Greenbury and Hampel reports has been a reversal of this pattern and an increased propensity to use market purchases of share to meet vesting of awards under Ltips and ESOs.
13 Main (1993) provides a description of the organisational arrangements for pay setting in the board room.
14 These demanded a minimum vesting period of five years and growth in earnings per share that placed the company in the upper quartile of the FTSE-100 performance.
5 Although the intention of the ABI was always that their guidelines should be used by boards and remuneration committees to guide their remuneration policy, a succession of revisions (concerning issues such as the entitlement to reissue options within a ten year period if a previous tranche had been exercised) resulted in these very ABI guidelines effectively being used as the ‘rules’ by boards and remuneration committees. This in spite of the fact that any tax advantage gained by adhering to the original Inland Revenue conditions for approval had to a large extent swept away with the Finance Act 1988 which not only reduced the top rate of income tax to 40% but harmonised the tax payer’s capital gains tax with their marginal income tax rate15. Only with the Greenbury Report (1995) did the ABI guidelines lose their pre-eminence, and then only due to a movement by companies toward Ltips and away from ESOs. The latest ABI (2001) guidelines can be seen as an attempt to include all share-based executive incentive schemes16, but it also represents a marked departure from its previous implicit one-size-fits-all approach.
Companies are now free to issue options at some proportion of an executive’s base pay and to do so on an annual basis. In return, however, perhaps stung by the widespread past criticisms of what are widely (but often incorrectly17) perceived to have been unnecessarily generous ESOs, the ABI has included some strong encouragement toward the inclusion of demanding performance criteria. These criteria are required to be relative to a peer group of companies or to some benchmark performance standard.
The salient aspects of the new guidelines are as follows:
(i) condones the move away from the traditional option scheme with its four times
emoluments limit towards phased grants - on an annual or some other regular basis:
(ii) the use of challenging performance criteria relative to an appropriately defined peer group or other relevant benchmark, with total shareholder return being acceptable as the primary criterion where it is supported by a defined secondary financial criterion, e.g.
earnings per share. Performance criteria should demand median level performance but with a sliding scale towards superior performance: (‘RELPERF’).
(iii) a single predetermined performance measurement period is encouraged and the ability to ‘retest’ performance over successive periods if performance originally falls short is discouraged: (no ‘RETESTING’).
(iv) while the issuing of options with a strike price at a premium to the prevailing market price is not accepted as a substitute for performance conditions, i.e. performance hurdles, it is mentioned: ‘PREMIUM’.
15 The residual tax benefit lay in avoiding any tax until the underlying shares themselves were sold (as opposed to the options being exercise) and the tax shield provided by the annual capital gains tax allowance
- something most senior executives are likely to have exhausted in any case).