UK: HOW SHOULD A COMPANY PAY ITS NON-EXECUTIVES? - Does a share-based system really impair impartiality?

Last Updated: 31 Aug 2010

Does a share-based system really impair impartiality?

The Government's decision, last month, to deny non-executive directors the right to join share option schemes has put a temporary cap on the recurring debate. The prohibition was driven partly by expedience - allaying public criticism of soaring boardroom salaries - and partly, apparently, by John Major's own increasing distaste at the same spectacle. Yet, as is often the case, the official reaction obscured a longer term issue that will doubtless resurface: exactly how - as opposed to how much - should independent directors be paid?

In its 1990 code of good practice, "The Roles of Duties of Directors", the Institution Shareholders' Committee declared clear opposition to an system of reward that linked non-executive pay to company performance: "In order not to impair their impartiality, non-executive directors should not, under normal circumstances, be offered participation in share option schemes, nor in performance-related or other incentivised remuneration schemes." Two years later the Cadbury Report took the same stance. Indeed, all the major UK investment advisory bodies have consistently opposed any link between non-executive remuneration and company performance.

Some remain unconvinced. "The idea that independent directors should not be paid any other means than a fixed fee needs to be seriously questioned," considers Peter Brown, chairman of Top Pay Research Group, the remuneration consultants. Brown proposes a system of performance-related pay for non-executives in which options, or opportunities for subsidised share purchase, are granted on a "fee-sacrifice" basis. Rather than taking a guaranteed fee, the non-executive would receive a minimum cash payment supplemented by a package share and option incentives.

What would the company gain from such a system? Advocates of share-tied compensation claim that personal financial commitment invariably leads to better corporate governance; that share ownership binds non-executives to the company and reminds them of their duties to investors. Brown also cites instances where he thinks alternatives to fees would work particularly well; in the small public company, for example, which can have difficulty in attracting the right non-executive at a fee warranted by its size.

At present such arguments seem to carry little weight. John Rogers, secretary of the investment committee of the National Association of Pension Funds (NAPF), sets out what appears to be the consensus view. "The non-executives is specifically there to represent the views of shareholders and monitor the activities of executive directors. If they were entitled to share options it would raise questions of independence. It's undoubtedly a big incentive for a director to stay with the company when he otherwise might leave." His concern is shared by Roger Regan, head of investment affairs at the Association of British Insurers: "To be truly independent the non-executive must be able to walk away from the company."

Difficulties also arise from the independent directors' role on audit and remuneration committees, says David Senior, ProShare's director of company services: "How can non-executives decide what is the best equity-based reward mechanism for executives if they are themselves beneficiaries of the same scheme?" There is also the issue of image. "If public confidence in the whole system of executives remuneration is to be restored then non-executives must be beyond reproach - and that, above all, means disinterested."

But while the status quo prevails here - with very good reason, in the eyes of most - the increasing use of performance related pay by large and often innovative US companies raises a distant spectre. Manpower, 3M, United Technologies and Travelers, for example, all give their outside directors some form of stock in lieu of part or all of their regular fees. Further down the scale, a recent Conference Board survey fees companies with a turnover of $100-500 million showed that 75% operate some form remuneration tied to share price performance. As the NAPF's Rogers observes: "It's usually true that what happens in the US sooner or later comes over here. Who's to say that one day we're not going to see this here to?"

In the meantime there's another option which British companies might do well to consider. They could encourage the independent director to apply his fees to the purchase of the company's shares. Not only would his own interests then be aligned with the shareholders', it would avoid taking cash out of the business, remove any slur on his motives and encourage that critical long term perspective. There, surely, is the best of all worlds.

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