"CoCos and bail-inable bonds" how does this fit with transparency

The Financial Services Sector is getting prepared for the Capital Requirements Directive IV (CRD IV) which introduces new pay rules from 1st January 2014 and will impact bonuses paid in 2015 (in respect of the 2014 performance year). The area of this new Directive which is getting much focus is the Cap on Variable pay.

The banks are going to have to set appropriate ratios between fixed and variable pay, such that the variable portion granted each year must not exceed 100% of the fixed component. It is only with shareholder approval (of at least 66% of the shareholders,provided 50% of the shares are represented) that companies can increase the fixed:variable pay ratio up to a maximum of 1:2 (200% variable pay).

Fixed pay = payments or benefits without consideration of any performance criteria.

Variable pay = additional payments (or benefits) depending on performance and in excess of that required to fulfill the employee's job description. So this would include any bonus payable and the  long-term incentive plan (importantly valued at the date of grant). A discount rate of up to 25% can be applied to the variable pay, provided that it is paid in instruments which are deferred for 5 years or more.

Some creativity in this area is therefore expected, in the same way that EBTs/FURBS were used for Executives as a substitute for pensions provision when the Pensions Earnings Cap was introduced back in 1989 (was it really that long ago!), even though CRD IV does contain anti avoidance provisions.

So what are the likely solutions?

Increasing the fixed element of pay: there are lots of reasons why not to do this including increasing the fixed cost base of the financial institution, employment law implications as it is difficult to reduce fixed pay once implemented and of course public perception.

Introduce different types of variable pay: which have a low initial upfront value (at the time they are granted) but with greater potential upside. This would include co-ownership share structures (which already exist) whereby the employee only receives the gain on the value of the share which is subject to capital gains tax and an employee benefit trust holds the shares.

It will be interesting to see whether the financial services sector starts to (and is allowed to) use more complex alternative financial instruments as a substitute for the more traditional forms of variable pay - cash or stock incentive plans.

Some examples I heard of today and were new to my vocabulary were "CoCos" and "bail-inable bonds"! For those of you reading this blog who are not investment experts I have included a short definition below:

CoCos (or Contingent convertible bonds) are a form of debt securities that are coverted into equity upon a trigger event.

Bail-inable bonds are also a form of debt securities that are converted into shares upon a trigger event but they are also written down, potentially to zero, in order to "bail in" the bank.

My concern and reason for writing this, is how the potential creation of these new pay instruments sits against the UK Government reform on the reporting of directors pay and greater transparency on pay practices overall, but especially in the financial services sector where public and shareholder opinion is so high.

I will watch this space with continued interest over the next 12 months!

How do shareholders want you to reward your Executives?

With the AGM season almost upon us it will be interesting to see how many “no” votes companies get on their remuneration policies following last year’s casualties, such as Aviva and Barclays. Generally if 15% of shareholders vote against pay practices this would be seen as a problem, let alone the reputational damage this can have. So what should the Heads of Reward be advising their Remuneration committees to ensure the shareholders are voting with, and not against them?

·         Top down strategic approach: shareholders want to see a Corporation’s strategy and it’s KPIs influencing the reward of its top executives. They are looking for more than just financial measures in incentives and there is a definite trend away from using only EPS or TSR, to using a combination of financial and non-financial measures. As an example for our Executive STI (short-term incentive) we have introduced a balanced scorecard directly linked to the corporate strategy, made up of 60% financial and 40% non-financial metrics (including customer net promoter score) with an accelerator (or reduction) based on individual performance.

·         Performance metrics and a longer-term view: as well as a combination of financial and non-financial metrics in incentive plans, there is now an expectation that companies in both the financial and non-financial sectors should take a much longer term view to incorporate any tail risk. A three year time period for LTI (long- term incentives) is now viewed as not long-term enough and the concept of career shares vesting at the Executives retirement date are becoming popular amongst the financial institutions. Alternative solutions are to have a three year LTI performance period but then with a further 2 year deferral period before shares can be vested, or a deferral period on the STI payout as the financial sector already requires for those employees who are required to take risk in their roles.

·         Simplicity (and therefore transparency): ideally this would be one STI and one LTI program with companies being creative with their target setting and performance metrics to ensure they are driving the right behaviours. This idea of one LTI program is rapidly becoming the norm in the UK with the rapid removal of stock option plans in favour of performance shares. Share matching schemes are also less popular amongst shareholder groups not just due to the lack of transparency but “why should the Executives receive a discount on shares when the shareholders do not?”

·         Quantam: above inflation pay increases and above target bonus awards for Executives are no longer acceptable to shareholders who will only support exceptional rewards where corporate performance is strong. For 2013 there is an expectation that Executive base pay increases will average at 2.5% but there will be many instances of freezing Executive pay in under-performing businesses. The NAPF in particular are threatening to vote against companies awarding above inflation pay rises.

·         Clawbacks: although common practice for a while now in the banking world, other sectors are now incorporating clawback clauses in their STI plans to ensure Executives are made accountable for failure.

·         Rem Co Accountability: In the future shareholders will be looking to the Rem Co to justify their decisions, especially when they exercise any areas of discretion in pay practices. They will be required to disclose how performance metrics have been set in both STI and LTI programs and declare under what conditions maximum awards will be paid.

Shareholders are demonstrating “no tolerance” to high Executive payments which are out of line with the performance of the Company and they will continue to make their views known to those who are not demonstrating good pay for performance practices.