The Soul of Discretion…?

Now is a good time to take stock of the use of discretion in your share plans; Paul Randall and Tamsin Nicholds at law firm Hogan Lovells International LLP ask how these discretionary powers are operated and reported on and if they are truly beneficial.

Where might discretionary powers have been reserved?

Most share plans have good/bad leaver treatment specified in the governing rules. Certain leavers’ rights will vest, as of right. Others, even if deserving, will be categorised by default as bad leavers. For the latter, there is often a discretion reserved to the remuneration committee to allow vesting, to some degree or another, of awards which would otherwise lapse.

There will normally also be some discretion reserved around the application of performance targets. This might range from, at one extreme, the power to disapply performance targets altogether to, at the other extreme, the power to deny vesting despite the fact that the specified target has been achieved.

Finally, the remuneration committee will often have some discretion reserved to govern the proportion of awards that vest on a change of control or other significant corpo­rate event. This may go to the application of performance conditions over a truncated performance period, or the application of time apportionment, often both.

 

What does the inclusion of a discretionary power in a plan achieve?

It is fruitless to try to legislate for every eventuality in plan rules. Something will be missed, or circumstances will arise that de­mand some subtle variation. By including discretionary powers, the decision on a particular question can take full account of the relevant facts. For example, a “change of control by means of a takeover offer” may be a takeover or a merger of equals. It may be effected in various ways. Should the consequences be the same? Where it is difficult to specify in advance what makes the treatment different in similar situations, reserving a discretion to be exercised by the remuneration committee at the time of the event may be the answer.

In the case of leaver rules, there would normally be a fairly tightly defined set of circumstances in which awards vest, with the awards of “bad leavers”, i.e. all those who do not fall within the “as of right” categories of leaver, laps­ing immediately. Typically, a voluntary resignation would not be a good leaver circumstance. A residual discretion to determine that a bad leaver should be allowed to exercise/re­tain awards allows discretion to be exercised in favour of one who, for example, leaves service to care for a sick relative.

 

Are there limits?

The inclusion of discretion will not necessarily allow the re­muneration committee free rein. The words that describe the nature of the discretion will naturally serve to limit it, sometimes more than might be expected. For example, dis­cretion to determine what proportion of an award will vest implies that at least some proportion, rather than none, will vest. Clear words should be included if the intention is oth­erwise. The likelihood is that the terms of any discretion will be closely scrutinised by a court and would be construed strictly against the company.

In addition, discretion may be limited by the operation of law. Case law indicates that a person exercising discretion has:

  • A duty to exercise the discretion honestly and in good faith.
  • A duty not to exercise the discretion in an arbitrary, capricious or irrational way.
  • A duty not to breach the implied term of trust and confidence in the employment relationship. This highlights that the exercise by an employer of discretion in an employment context may be subject to a greater level of scrutiny that in a general commercial contract - and also that one employee should not be singled out and treated differently from others.

A person who stands to benefit from the exercise of discre­tion is rather like a member of the class of beneficiaries un­der a discretionary trust. Although there is no right to have the discretion exercised in his or her favour, there is at least an obligation on the holder of the discretion to consider its exercise, one way or the other.

In practice, this means that there ought to be some consid­eration of the operation of the discretion on each occasion. This could be burdensome in relation to leavers, for exam­ple, so the company may wish to lay down some broad principles as to the circumstances that would merit closer examination, so that the generality of bad leavers would have little cause for complaint at not being lifted out of a default lapse regime.

Share plans may expressly exclude liability for loss caused by the operation of a discretionary power. Properly drafted, these exclusion clauses should be effective, but bear in mind that the Consumer Rights Act 2015 may have altered the ability of an employer to rely on them. The position is unclear.

 

Why are discretions particularly relevant now?

The inclusion of discretions in plans and their use is worth considering now for several reasons.

Retirement

Following the Equality Act 2010, typical plan provisions which provided that an employee who left employment be­cause of retirement at or above a specified age would be a good leaver could no longer stand. Non-tax advantaged plans can now either provide that retirement is a good leav­er reason regardless of the age of the participant or remove retirement as a good leaver reason and rely on the use of discretion. In practice, the use of discretion here may add to the risk in operating the plan. Retirement is not easily defined but it may be preferable to tie the treatment to the employer’s general retirement policy or practice.

Market Abuse Regulation

The introduction of the MAR regime in July 2016 shone light on the question of whether employers could exercise discretion to allow share awards to vest while price-sensitive information was in existence. In general, the exercise of the types of discretion that we have referenced here are unlikely to fall within concerns of insider dealing, but it is worth bearing in mind that the issuer is potentially caught by the restriction on insider dealing.

Good governance

Quoted companies must produce remuneration reports. The remuneration report must include, in respect of direc­tors’ remuneration which appears in the “single figure” table, information where any discretion has been exercised as to how it has been exercised and how the level of the award was determined. Discretions operated in respect of employees below board level may not be reported on but they may be restricted by statements in the company’s re­muneration policy. Directors’ pay must fall within the remu­neration policy, therefore a discretion cannot be exercised to make an award outside of the terms of the policy (or discretion allowed by the policy) without risk of liability on the part of members of the remuneration committee.

Investors will be interested in the use of discretions to re­ward leavers who have arguably underperformed or to temper the strict application of performance targets. As to whether the use of discretions in the application of perfor­mance targets in plans is favoured by institutional investors, this generally depends on whether they are being exercised to increase or decrease pay! A use of discretion to increase remuneration should be supported by careful explanation and the GC100 suggest that prior dialogue with sharehold­ers may be appropriate. It is preferable to have established a track record of careful application of discretions.

The report by the Executive Remuneration Working Group (Final Report 26 July 2016 here) stated:

Discretion has been a source of increasing tension in recent years. Remuneration committees increasingly feel that they cannot use discretion, as it will not be supported by share­holders. Companies often feel that they are unable to use upward discretion, and that investors will only approve the use of downward discretion.

The need was stressed to build up a record of negative discretion where external circumstances have boosted the ability to achieve performance targets in order that inves­tors are more likely to be comfortable supporting upward discretion. Recommendation 8 says that:

The use of discretion should be clearly disclosed to investors with the remuneration committee articulating the impact the discretion has had on remuneration outcomes. Share­holders will expect committees to take a balanced view on the use of discretion.

Litigation risk

While it is probably not a determining factor, it should be noted that an employee seeking to bring a claim for a ma­terial loss is likely to prefer to make a claim for breach of contract (for an incorrectly exercised discretion) rather than a claim before the employment tribunal (where awards are capped, absent discrimination).

 

Are discretions the answer to preventing exces­sive rewards?

The Investment Association Guidelines here state that:

Discretion can help Remuneration Committees to ensure that the outcomes of executive pay schemes properly re­flect overall corporate performance and the experience of the shareholders in terms of value creation.

However, while investors might be happy with reduced vesting adjustment, the participants are unlikely to be. As mentioned above, reserving discretion in a plan does not hand the remuneration committee carte blanche to de­cide on vesting. In very clear-cut circumstances a reduction might be uncontroversial, but those circumstances may well be ones which could have been dealt with specifically at the outset. For example, a minimum share price could be in­cluded as a vesting condition. Although it is difficult to write specific adjustments to deal with the impact of transactions, the principle of whether inorganic growth will be rewarded might be set out.

Making incentives subject to an overarching discretion to prevent large rewards may be seen as investors having their cake and eating it. If awards are to be capped then that can be specified at the outset. If there are factors which are rel­evant to performance but cannot be set out in a mechanical adjustment then the fact that their impact on performance is going to be considered could be set out in advance, for example interest rate movements.

Reserving discretion in plans remains important so that the remuneration committee does possess the power to finesse the blunt tool of rules drafted in most cases more than three years before vesting and without a crystal ball, but discre­tion alone should not be relied on to achieve the “right” result for either investor or executive.

 

This article was previously published in the July 2017 edition of the Executive Compensation Briefing.


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