Module 5: Exec Share Plans

Question 1

What is the FRC’s UK Corporate Governance Code?

Answer 1

From 1 January 2019: Rem policies should promote long-term sustainable success; Exec rem should be aligned with company values/ purpose and be clearly linked to company’s long term strategy; LSE Premium Listed companies have to comply with the UK Corp. Governance Code.

Question 2

What are the IA’s principles on remuneration?

Answer 2

Long term incentives need to reward the creation of shareholder value over a period appropriate to the strategic objections of the company; Equity based long-term incentives are the most effective way to align the interests of participants and shareholders.

Question 3

Executive Plans: Who is eligible?

Answer 3

Usually all group employees are eligible but the actual participation is discretionary and usually determined by the RemCo (sometimes also needs board approval).

• Usually excludes: Non-employees, JV employees, self-employed contractors
• Also sometimes does not include Exec Directors (if company wants to avoid needing shareholder approval)

Question 4

Exec Plans: Why shouldn’t non-employees be granted awards?

Answer 4

• The purpose of share plans is often to align employees with shareholders so view is often that non-employees wouldn’t have the same incentive.
• Many of the share plan exemptions are based on employees only so non-employee participants could cause a problem
• Issues of financial assistance, Trust law and tax issues, Financial promotion rules, Market Abuse, Insider Dealing

Question 5

Exec Plans: Do companies have “absolute discretion” over their share plans?

Answer 5

No, there is case law and implied law that is clear that the discretion must not be capricious or discriminatory (age, race, sex, religion, etc). CASE: Watson v Watchfinder: “Absolute Discretion” is not absolute and you need to take note of relevant factors.

Question 6

Exec Plans: What was the takeaway of Braganza v BP?

Answer 6

Remco cannot make decisions on a whim or irrationally; need adequate evidence

Question 7

Exec Plans: What was the takeaway of Simpkin v Berkeley Group?

Answer 7

Need accurate record of decision making and reasoning for these decisions; This case involved inadequate info and poor meeting minutes.

Question 8

Exec Plans: When does an employee have the contractual right to an award?

Answer 8

• They are discretionary awards and it is important that the employee only has the right to the award at grant;
• Important when drafting an offer letter that the right is not given then (phrasing usually make recommendation to Remco for future award);
• You need to make sure that discretion is used EVERY year and is recorded so that someone cannot claim ‘custom and practice’ if they do not get an award one year

Question 9

Exec Plans: Can a participant sell or transfer their awards?

Answer 9

Rules normally say no, unless it is to a personal representative (PR) on death; there are many reasons for this: loss of incentive effect; shareholders wouldn’t view favorably; legal difficulties eg non-employees; global securities laws; and difficult to administer

Question 10

Exec Plans: What are the different ways of providing shares?

Answer 10

1. New Issue
2. Trust/ Market Purchase
3. Treasury

Question 11

What are the key characteristics of newly issued shares?

Answer 11

• Simple (but need to pay the nominal value if they are free shares)
• Opportunity cost as they would have likely made more if they were sold at market (but usually no actual cost to company)
• Subject to institutional shareholder limits (10% in 10 years, 5% in 10 years for discretionary plans)

Question 12

What are the key characteristics of trust/ market purchase shares?

Answer 12

• With a trust, the company is the settlor and the discretionary trust is created to benefit the group employees
• It is set up and funded by the company (either by gift or by loan)
• Market purchase shares are the ONLY shares that do not count towards dilution limits
• Trust can help pay the nominal value for free shares
  You can avoid the need to get shareholder approval if you just use market purchase shares
• Trust can help with the hedging and holding of shares

Question 13

What are the key characteristics of treasury shares?

Answer 13

• Regulated by the Company Act and also UK listing rules for some
• No need to pay nominal value because the shares already exist
• They however DO count towards dilution limits
• Shares are held in treasury and then transferred to the employee on vesting
• No requirement to pay nominal value

Question 14

What is net settlement?

Answer 14

Where you only pay out the shares (or cash) actually owed to the participant, less any tax or exercise price in the case for options; can pay out shares for the actual award and cash for the tax amount; it looks the same for the participant but means the company uses less shares

Question 15

When does a company need to get shareholder approval?

Answer 15

All premium listed companies which want to establish a new plan, except when the plan:

• does not allow for the issue of new shares or the transfer of treasury shares, and
• is not a long term incentive plan in which directors can participate

Question 16

What is a LTIP?

Answer 16

Defined in listing rules; there is a broad definition but there are three main characteristics:

1. has service/performance conditions over more than 1 financial year
2. will incur cost/liability
3. is not a deferred bonus plan (often don’t have performance conditions)

Question 17

Exec Plans: What are performance conditions and who requires them?

Answer 17

• A target that must be satisfied before an award vests; designed to incentivise employees (usually execs) to achieve a particular goal over the perf period
• Required by the Corporate Governance Code and IA guidelines
• Reflect shareholders wishes
• Standard is 3 year performance period (now usually have an additional 2 year holding period)

Question 18

What types of performance conditions are there?

Answer 18

Four Types:

• Absolute v Comparative
• Financial v Non-Financial

Going to be one of each of the above…

Absolute (ex EPS) looks at the company itself and whether it’s improving whereas Comparative (ex Relative TSR) looks at the company against its competitors

Financial factors include the companies share price, profitability, etc whereas non-financial conditions would look at customer satisfaction, health & safety, etc

Question 19

How do performance conditions work in practice?

Answer 19

They used to be “win or lose” but are now often done with a sliding scale or with rankings; might rank against a comparative group or on a scale with a min threshold
- This can cause problems when calculation is needed early (good leaver, takeover, etc) so it is important to consider and then record how you plan to measure things if something happens at an odd time.

Question 20

What are Financial Non-Market based performance conditions?

Answer 20

• Not based on the stock market but instead usually based on the company’s profit & loss account
• Formulas to determine
• Include EPS, EBITDA, ROCE, Earnings, Revenue

Question 21

What are Financial Market based performance conditions?

Answer 21

• The most common is TSR = share price change + dividends (there are diff ways to calculate the start and end prices) - can either be the first/last day or an average
• Share price is not common as shareholders don’t like that someone could benefit just by the market going up

Question 22

What performance conditions are usually used for an Annual Bonus Plan?

Answer 22

• Conditions are usually personal, internal and financial measures (not usually market conditions)
• Often based on EPS and personal targets
• Usually quite detailed and often not disclosed because of market-sensitive information

Question 23

What performance conditions are usually used for a LTIP?

Answer 23

Very common: TSR
Sometimes: EPS
Or: both of the above (can have multiple conditions)
There is usually a three year performance period although the IA would prefer 5 years

Question 24

What should you consider when determining the right performance condition for a company/ employee?

Answer 24

• Maturity of the company; example: TSR would not be appropriate for a start up company that is looking for growth but not paying dividends
• Level of employee: plc directors are more likely to be able to influence high level finance, whereas lower level employees may only influence smaller divisions

Question 25

Performance Conditions: What are the pros/cons of using revenue growth as a metric?

Answer 25

Pro: Simple Con: Open to manipulation

Question 26

Performance Conditions: What are the pros/cons of using EBITDA as a metric?

Answer 26

Pro: Well understood Con: Fails to capture capital investment

Question 27

Performance Conditions: What are the pros/cons of using EPS as a metric?

Answer 27

Pro: Widely recognised and accepted Con: Can discourage long term investment

Question 28

Performance Conditions: What are the pros/cons of using TSR as a metric?

Answer 28

Pro: Well alignment with shareholders Con: Hard for employees to understand/ influence

Question 29

Who is responsible for setting performance conditions? How are they set out?

Answer 29

The Rem Co is responsible for setting the conditions; they are usually communicated alongside the award certificate and must be carefully drafted as they are contractual; they may include provisions about how to calculate early (good leavers, takeovers, etc) and may include powers to waive or vary

Question 30

Exec Plans: What makes an award vest? What is the process on vesting?

Answer 30

Either by reaching a specified date or by satisfying a performance condition; the vesting process will be dictated in the plan rules or the award certificate; there is often a time frame (30 days) for satisfaction after vesting

Question 31

Exec Plans: When do participants actually get the shares? Where do the shares come from?

Answer 31

For free share awards: shortly after vesting For options: shortly after exercise The shares will usually come from the company or a Trust

Question 32

Exec Plans: What happens when someone's employment is terminated?

Answer 32

Generally awards will lapse unless someone is a good leaver (a lot of variation here) - need to read the plan rules to see what happens when someone leaves and what they include as 'good leaver' provisions. Usually include: death, sale of subsidiary, redundancy (things out of your control) - sometimes include retirement and ill health (not always!!)

Question 33

Exec Plans: How are good leavers treated?

Answer 33

It depends - there is much variation but the key features are vesting, subject to: - Time pro-rating: award can be adjusted based on the amount of time served (2/3 of award for 2/3 time) - Accelerated vesting: move vesting forward (not common now, except on death) - Performance conditions being satisfied - often tested as if they were there the whole time

Question 34

What does the UK Corporate Governance Code recommend for good leavers?

Answer 34

They want a time pro-rated award and to stick to the original vesting date with the performance conditions measured against the full performance period (rather than an accelerated vesting)

Question 35

Exec Plans: What did Nosworthy v Instincfid Partners Ltd show?

Answer 35

Need to draft bad leaver provisions carefully and ensure that these provisions are clear in case an employee disagrees

Question 36

How do companies usually treat leavers when they are in a Deferred Bonus Plan?

Answer 36

- Leaver provisions are often more generous as the company sees these awards as already being "earned"; often will only lapse for bad leavers/ misconduct - Often will have accelerated vesting but with pro-rating being applied - Company can decide though so could have the same leaver provisions as their other plans (some companies want consistency)

Question 37

What are malus and clawback?

Answer 37

Malus: applies before vesting; an award is forfeited or prevented from vesting Clawback: applies after vesting; employee must repay award

Question 38

What can trigger malus and clawback?

Answer 38

- Misstatement in the company's accounts - Serious financial problems - Individual misconduct - Misconduct by a division of the company Is often in the plan rules or may be in a separate document

Question 39

How can malus and clawback be applied in practice?

Answer 39

Malus: simpler to apply; usually like an extra performance condition Clawback: more difficult as participant received the shares and paid tax on them; Company may just ask for the net amount back or may come back for the whole amount (Martin case set a recent precedent); This is because employees may be able to claim the income tax back from HMRC (not the NICs) - Companies will often have flexible provisions to allow them to change their approach on the above

Question 40

What is post-vesting retention and why would a company want to put this policy in place?

Answer 40

Employee can't transfer or sell shares after vesting (often facilitated by a block on a nominee account) Why? Now the norm in the UK; outlined in the UK Corporate Governance code; the IA wants a holding period and would likely vote down if you didn't have one; helps enforcement of clawback

Question 41

What is change of control? How does the vesting work?

Answer 41

When a parent company's shares are acquired by a third party ("bidder") - Bidder will usually want 100% ownership/ not want any outstanding awards or options; Therefore EARLY VESTING is normal - Check rules to see what happens - more common to now see awards time pro-rated and subject to performance conditions (rather than full awards) - Roll over or exchange also possible so that they become awards over the new company - Lots of options for vesting (tax advantaged plans usually more strict) - can pay out in awards with immediate sale or can have a cash cancellation

Question 42

What are the key documents for exec plans?

Answer 42

Plan Rules - often very general Grant documents, including performance condition Explanatory booklet Vesting documents Important docs as they create valuable legal rights

Question 43

Exec plans: What is contained within the award certificate?

Answer 43

Contains individual details and performance condition Often executed as a deed (bc there's no consideration) Companies will often have a "global deed of grant' so they don't need to have one for each person May require signing and acceptance by the participants esp if there is anything potentially negative for them

Question 44

Exec Plans: What information is given to participants about the performance condition(s)?

Answer 44

Plan rules are usually very general, more detail given in the award certificate or detailed appendix Includes: details of the condition, any comparison group, length of perf period, various vesting levels for performance levels; how to measure if early leaver, how and when to waive/ vary

Question 45

Exec Plans: What information goes into an explanatory booklet?

Answer 45

Uncommon for executive plans; Explains plan in common English; gives examples; not a legal doc but ma have information on which participants rely

Question 46

Exec Plans: What is included in a vesting document?

Answer 46

Instruction (if employee has a choice) or communication about what happens on vest; often electronic; want to communicate value; will also explain what happens after vest (if there's a holding requirement/ if moving to a nominee) For free share awards: participants' directions about tax, sale of share, nominee arrangements, post-vest holding For options: option exercise notice, plus directions about tax, sale of shares, nominee arrangements, post-vest holding

Question 47

What is a conditional share plan?

Answer 47

Often called a PSP or a RSU (US terminology); a right to receive free shares in the future, on vesting - Vesting happens on a fixed date, or when a performance condition is met

Question 48

What is an unapproved option plan?

Answer 48

Not a CSOP; A right to buy shares in the future by exercising an option; Option exercise price may be market value or less; common that person is not be able to exercise until after vesting; exercise period usually 10 years from grant

Question 49

What is a nil cost option plan?

Answer 49

Same structure as unapproved options but the exercise price is nil (or nominal amount) so shares are free; exercise period may be 10 years but often less

Question 50

How common are option plans?

Answer 50

Have declined in popularity; see more free shares now Underwater options don't serve as an incentive More expensive to administer bc exercises can happen any time over a long period (free shares are more straightforward) However, options can be better for tax planning for some execs

Question 51

What is a restricted share plan (Restricted Stock)?

Answer 51

Not a RSU; Ownership is transferred upfront; therefore can usually vote and receive dividends; there is often tax payable upfront unless (broadly) forfeitable within 5 years or no election is made; If forfeited they need to have the shares back but tax is not repaid; uncommon in UK

Question 52

What is a deferred bonus plan?

Answer 52

Linked with annual cash bonus scheme, need to be clear about when the right to the shares is given (and therefore when the tax is payable); are the shares deferred pre or post tax?; leaver provisions are often more generous

Question 53

How would a match work with a deferred bonus plan?

Answer 53

Way to make a DBP more like a LTIP; Ratio of matching shares to bonus shares, often 1:1; performance condition on matching shares (effectively an LTIP); different leaver conditions for the bonus and matching shares; quite uncommon

Question 54

What is a phantom plan?

Answer 54

A right to receive cash equal to the value of a specified number of shares (phantom just means its settled in cash); phantom plans can take many different forms

Question 55

What is a phantom stock appreciation right (SAR) plan?

Answer 55

It is a phantom option plan- on exercise the participant gets cash equal to the share price minus the option price

Question 56

What are the pros/cons of using a phantom plan?

Answer 56

Pros: Simple, helps to avoid security law issues Cons: There is a direct cash cost (although hedging can help this); accounting treatment is complex; incentive effect may not be as good as with real shares

Question 57

What is a co-investment plan?

Answer 57

Similar to DBP with match but the funds don't have to come from a cash bonus The participant buys shares and then there is an award of matching shares, subject to retention of the investment shares Also often subject to a performance condition Designed to improve alignment with shareholders

Question 58

What are EMI options?

Answer 58

Enterprise Management Incentive Options - UK tax advantaged options; very limited in availability and certain industries cannot sue them; Companies with assets of less than 30mil pounds Option gain is free of income tax and NICs; participants may be granted options worth up to 250k pounds; with 3mil max for company Good for small companies that aren't cash rich and want to incentivise execs