ACCA P1 Governance, Risk and Ethics - 2010 - Study text - Emile Woolf Publishing
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Chapter 4: Board committees
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4.4 Composition of the nominations committee
Views may differ between countries about what the composition of the nominations
committee should be. The UK Combined Code makes the following
recommendations:
A majority of members of the nomination committee should be independent
non-executive directors. A minority of members may therefore be executive
directors.
The chairman of the committee should be either the board chairman or an
independent non-executive director. However, the board chairman should not
chair the nomination committee when it is dealing with the appointment of a
successor to the chairmanship.
The guidelines in the Singapore Code of Corporate Governance are slightly
different. This Code states that the nominations committee (NC) should consist of at
least three members, and the majority of members (including the committee
chairman) should be independent.
4.5 The nominations committee and appointment of a new chairman
The UK Combined Code recognises that the appointment of a new chairman for the
company requires particular care, to make sure that a suitable candidate is
identified who will be able to give the company an appropriate amount of his (or
her) time.
For the appointment of a chairman, the nomination committee should prepare a
job specification, including an assessment of the time commitment expected.
A chairman’s other significant commitments should be disclosed to the board
before appointment and these should be included in the annual report. Changes
to these commitments should be reported to the board as they arise, and
included in the next annual report.
No individual should be appointed to a second chairmanship of a FTSE 100
company. (It is assumed that one individual would not have the time to perform
the role of chairman in two such important companies.)
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The risk committee
Risk management as a corporate governance issue
The role of the board and board committees on risk
5 The risk committee
5.1 Risk management as a corporate governance issue
The board of directors is responsible for the performance of their company, and is
accountable to the shareholders. Responsibility for financial performance is not
simply a matter of trying to maximise profits. There is a need to manage the risks
that the company faces. Risks include:
the business risks and strategic risks that the company faces in its operations,
and also
risks of errors, fraud, losses through mistakes and breakdowns, and other
failings in systems and processes.
Responsibility of the board for risk management and risk control
The board of directors is responsible for safeguarding the assets of the company and
protecting the value of the shareholders’ investment.
The board has a duty to make sure that systems, procedures and checks are in
place to prevent losses through errors, omissions, fraud and dishonesty. Control
measures to prevent or detect such losses are internal controls. The board has the
ultimate responsibility for the effectiveness of the internal control system.
The board is responsible for protecting the company and its resources from the
risks of adverse external events, such as damage to assets from fire or flooding,
losses through theft, disruption caused by natural disasters or terrorist attacks,
and so on.
The board is also responsible for developing the strategy for the company. All
business strategies involve some business risk (or strategic risk) – for example, a risk
that customers will not buy enough of the company’s products or services, or that
competitors will be more successful, or that costs will be higher than anticipated
and profits lower. In developing strategy, the board should consider both the
expected returns and the business risk, and assess whether a particular strategy is
justified (whether the expected returns justify the risk).
Risk management as a task for management
Although the board has responsibility for risk management and internal control,
management has the operational responsibility for planning and implementing risk
management and control systems. Managing risk is a day-to-day requirement.
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Risk management and internal control should therefore be:
planned and implemented by management, and
monitored by the board, to ensure that effective systems of risk management
and control are in place.
The Cadbury Committee, which produced the Cadbury Report on corporate
governance in the UK in 1992, described risk management as ‘the process by which
executive management, under board supervision, identifies the risk arising from
business … and establishes the priorities for control and particular objectives.’
The Cadbury Report also suggested that risk management should be:
systematic, and
embedded in the company’s procedures, rather than applied occasionally and by
means of external review.
The Cadbury Report recommended that there should be:
a sound system of financial control, and also
a broader system of risk management.
It also suggested that the board should be responsible to the shareholders for
making sure that appropriate systems of internal control and risk management are
in place. This recommendation was not implemented at the time. However, board
responsibility for the review of internal control and risk management was
eventually introduced into corporate governance ‘best practice’ in the UK with the
publication of the original Combined Code in 1998.
5.2 The role of the board and board committees on risk
Executive management is responsible for designing and implementing systems of
internal control and risk management, and management should be accountable to
the board of directors. The board in turn should be accountable to the shareholders.
The UK Combined Code suggests what the responsibilities of the board should be
within the overall system of risk management. The Code states that the board
should maintain a sound system of internal control to safeguard shareholders’
investment and the company’s assets.
In order to do this, the board should:
conduct a review, at least once a year, of the effectiveness of the company’s (or
group’s) system of internal controls, and
report to the shareholders that they have carried out a review.
This annual review by the board should cover:
all material controls, including financial, operational and compliance controls,
and
risk management systems.
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Responsibilities of the audit committee for financial controls
The UK Combined Code also states that a responsibility of the audit committee
should include the review of the company’s internal financial controls.
The audit committee is in a good position to carry out a review of these controls,
because of the discussions it has with the company’s external auditors and internal
auditors. For example, the external auditors produce a ‘management letter’ at the
end of the audit, making recommendations for improvements in financial controls.
The audit committee should discuss these recommendations with the auditors and
management, to establish whether the recommendations have been implemented
(and if not, why not).
Board responsibilities for the internal control system and risk management
However, the internal control system extends beyond financial controls. It includes
not only financial controls, but also operational controls and compliance controls. In
addition to internal control, there is also the system of risk management – how the
company identifies, analyses and deals with business and strategic risks,
environmental risks, and so on.
The UK Combined Code states that there should be a board responsibility to review
the company’s internal control and risk management systems. This responsibility
for review should be carried out by:
the audit committee, or
the full board, or
a risk committee consisting entirely of independent non-executive directors.
The Combined Code does not suggest how the board, the audit committee and the
risk committee (if there is one) should carry out their responsibilities for the review
of internal controls and risk management.
The need for a review of internal control and risk management by the board is also
recognised in the Singapore Code of Corporate Governance. Its guidelines are
similar to the provisions in the UK Code:
The audit committee should review the adequacy of the company’s internal
financial controls, operational and compliance controls, and also the risk
management policies and systems that have been established by management
(collectively, all internal controls).
The audit committee should ensure that a review of the effectiveness of the
internal controls is carried out at least annually. This review should be carried
out by the company’s internal auditors, public accountants or a combination of
internal auditors and public accountants. (If public accountants are used, and
these are the company’s external auditors, the audit committee must be satisfied
that the independence of the public accountants will not be compromised by any
other relationship they have with the company.
The board should include a comment on the adequacy of internal controls and
the risk management system in its annual report and accounts.
Internal control and risk management, and the responsibilities of the board and
management, are dealt with in more detail later in this text.
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CHAPTER
5
Directors’ remuneration
Contents
1 Principles of directors’ remuneration
2 Remuneration package structures
3 Performance-related incentive schemes
4 Other remuneration issues
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Principles of directors’ remuneration
Remuneration: executive and non-executive directors
Components of a remuneration package
The purpose of a remuneration package
1 Principles of directors’ remuneration
1.1 Remuneration: executive and non-executive directors
A previous chapter explained the importance of directors’ remuneration in
corporate governance and the role of the remuneration committee. This chapter
considers in more detail what the remuneration package of a director should be, and
the reasons for the different component elements of a remuneration package.
In some countries, for example the US, it is common for most senior executives to be
excluded from the board of directors. References in this chapter to ‘directors’
remuneration’ mean the remuneration of executive directors and other senior
managers. The term ‘directors’ pay’ will be used as a convenient general term.
Non-executive directors are paid an annual fee for their services. This is usually a
fixed amount, based on the estimated number of days that the director will spend
with the company during the year, for example attending board meetings and
meetings of board committees.
A general principle of corporate governance is that the non-executives probably
cannot be considered properly independent if they receive any additional
remuneration from the company other than a basic fee. Additional remuneration
could take the form of:
fees for additional consultancy services
membership of the company’s share incentive scheme
membership of the company’s pension scheme.
1.2 Components of a remuneration package
The remuneration package for an executive director is a part of the director’s
contract of service. Remuneration is reviewed regularly, typically each year. The
broad framework of a remuneration package is agreed through negotiation between
the individual director and the remuneration committee. The package is negotiated
when the director first joins the company, and might be re-structured at any
subsequent time.
The components of a remuneration package are commonly:
a basic salary
one or more annual cash bonuses, linked to the achievement of specific
performance targets
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free shares in the company or share options
pension rights or a contribution to a pension fund for the director.
A director will often receive additional benefits such as free medical insurance, a
company car, use of a company aeroplane or helicopter, and so on. Occasionally, a
director might be paid a ‘joining fee’ to persuade him to join the company.
1.3 The purpose of a remuneration package
A remuneration package should attract individuals to a company, and persuade
them to work for the company. The size of the remuneration package that is needed
to attract ‘top quality’ individuals depends largely on conditions in the labour
market. In other words, the amount that a company must offer its directors depends
on:
what other companies are paying, and
how many suitable candidates are available.
The UK Combined Code states that levels of remuneration should be sufficient to
retain and motivate directors of the quality required to run the company
successfully, but the company should avoid paying more than is necessary for this
purpose.
A second purpose of a remuneration package is to provide incentives for the
director. Directors should be rewarded with incentives, so that they are motivated
to achieve performance targets.
A generally-accepted view is that unless a director is rewarded for achieving
targets, he or she has no incentive to improve the company’s performance. (This
view is based on the conflict of interest between management and shareholders.)
It can also be argued that companies have to offer incentives to their directors
because other companies do so. Directors usually expect cash bonuses and
equity awards.
If suitable performance targets are selected, and the targets are made sufficiently
challenging, the rewards for directors will be made dependent on achieving
performance targets for the company that are in the best interests of the
shareholders.
Both the UK Combined Code and the Singapore Code on Corporate Governance
contain the identical principle that: ‘A significant proportion of executive directors’
remuneration should be structured so as to link rewards to corporate and individual
performance.’ The Singapore Code adds: ‘There should be appropriate and
meaningful measures for the purpose of assessing individual directors’
performance’, but does not go into further detail.
The specific purpose of cash bonuses, shares and share options will be considered in
more detail later. However, a major difficulty in practice is finding suitable
performance measures and performance targets as a basis for the payment of
incentives.
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Remuneration package structures
Finding a balance between the different components of remuneration
Basic salary
Short-term incentives: bonus
Long-term incentives: share plans
Pensions
The purpose of each component of a remuneration package
2 Remuneration package structures
2.1 Finding a balance between the different components of remuneration
When a remuneration committee designs a remuneration package for a director or
senior manager, it should consider:
each separate element in the package, and also
all the elements in the package as a whole.
There are two issues to consider: the total size of the package and how it should be
divided into its different components, between short-term and long-term incentives,
between cash and equity and between current pay and pension rights. For example,
a director may be paid an average basic salary, but may receive a generous pension
entitlement and an attractive long-term incentive scheme. Another director may
receive a low basic salary but a very attractive short-term cash bonus incentive
scheme.
The relative proportions can vary significantly between companies, although the
incentive element should be high.
2.2 Basic salary
The purpose of a basic salary is to give the director a guaranteed minimum amount
of pay. If a director does not receive a basic salary, he will depend entirely on
incentive payments. It could be argued that this would not be fair on the director,
and would put him or her under stress.
The size of basic salaries varies between companies, and depends to some extent on
the salaries paid to similar directors in comparable companies. However, salaries
are also dependant on the extent to which directors and senior executives have an
opportunity to boost their earnings through incentive schemes. A lower basic salary
might be acceptable to a director who expects to receive large cash bonuses or
equity awards.
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2.3 Short-term incentives: bonus
Many companies have an incentive scheme for its senior executives that offers
directors and other senior managers in the scheme an annual cash bonus for
meeting or exceeding target performance levels. The bonus scheme may be on a
sliding scale, with a bonus for meeting target and higher bonuses for exceeding
targets by a certain amount.
It is widely believed that the nature and potential size of annual bonuses can drive
the behaviour of senior executives. Executives will possibly be much more
concerned about short-term targets and annual cash bonuses than about longer-
term share incentives and bonuses.
There may be a cap on the maximum bonus that any individual may earn. For
example, an incentive scheme may provide for a bonus equal to 25% of basic salary
for meeting performance targets, with a maximum bonus of 50% of salary for
exceeding targets.
The bonus payments will be linked to one or more key performance indicators,
possibly using a balanced scorecard approach. The targets may include:
performance indicators for the business as a whole (such as a target for earnings
per share) and/or
personal targets for the individual executive. These might be financial targets,
but might also be non-financial targets.
For example a sales director might receive a cash bonus of 15% of his basic salary if
the company achieves its target profit for the year, and an additional 15% cash
bonus if annual sales increase by at least 5% above the previous year.
2.4 Long-term incentives: share plans
Long-term incentive schemes usually take the form of awards of either:
share options or
fully-paid shares in the company.
A company might have several different share schemes, and individuals may
participate in several or all of them. For example, there may be a share scheme or
share option scheme for all employees, and a separate (additional) equity reward
scheme for top executives.
Share options
A share option gives its holder the right, at a future date, to buy shares in the
company at a fixed price. For example, a director might be given 20,000 share
options, giving him the right to buy 20,000 new shares in the company at a fixed
‘exercise price’ of, say, £6.40 on or after a specified date in the future.
If the company’s share price increases, the director will be able to exercise the share
options and buy new shares in the company at a price below their current market
price. If he wishes to do so, he can sell his new shares, and make an immediate
profit.
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A company will appoint a committee to decide how many share options should be
granted to each individual. In the case of share option schemes for senior executives,
this might be a responsibility of the remuneration committee.
In the UK, the earliest time that share options can be exercised is three years
after they have been awarded. The option holder will make a profit if the share
price rises above the exercise price during that time. The individual therefore has
an incentive to want the share price to rise over the period. This is why share
options are a long-term incentive.
The exercise price for the share options should not be lower than the market
price of the shares at the time the share options were awarded. For example, if
the share price is £6.00, a company should not issue share options with an
exercise price of, say, £5.50. (In the US, several companies were accused in 2006
of back-dating share options for executives and awarding options at an exercise
price equal to the market price at an earlier date, when the share price was
lower.)
Under-water share options
A problem with share options as a long-term incentive for directors is that the share
price can go down as well as up. If the share price falls below the exercise price for a
directors’ share options, the share options are said to be ‘out-of-the-money’ or
‘under water’. Unless there is a reasonable chance that the share price will recover
strongly, the share options will therefore have no value. If they have no value, or
very little value, they cannot provide an incentive to the option holder.
Companies faced with this problem in the past have tried to maintain the incentive
for a director, after the share price has fallen, by:
cancelling the existing share options, and
awarding new share options to the executive, at a lower exercise price.
The executive will then be rewarded if the share price rises above its new, lower
level.
However, there are critics of this practice of cancelling share options that are under
water and replacing them with new options. They argue that share options are
awarded as a long-term incentive to executives, to link their personal interests more
closely to the interests of the shareholders. If the share price goes up, the executive
and the shareholders benefit. If the share price goes down, the executive and the
shareholders should suffer together. However, if share options are replaced when
they are under water, the executive benefits from a rise in the share price but does
not suffer when the share price falls. This means that the interests of the executive
and the shareholders are not the same – the executive is protected against bad
results.
The award of fully-paid shares
An alternative to share options is the award of fully-paid shares in the company.
This avoids much of the problem of a fall in the share price. Whereas share options
under water have no value at all, fully-paid shares retain some value, even when the