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KEY POINTS
- Is replacing cash bonuses with share incentives a good idea?
- The effectiveness of share incentives in a recession.
- Can 'underwater' share options be a disincentive?
- Could this be the time to improve and extend EMI schemes?
On Monday of last week, 13 October, in an unprecedented move that was subsequently copied by their counterparts across Europe and perhaps much more significantly the United States of America, the British Treasury semi-nationalised some of the country's biggest banks in order to prevent their imminent collapse and the panic that would have followed.
With the vocal support of Chancellor of the Exchequer Alistair Darling and his predecessor, Prime Minister Gordon Brown, the Treasury announced the conditions that they were imposing in return for their £37 billion 'bail-out package', the main element of which saw UK plc turning venture capitalist by taking substantial shareholdings in three of the country's highest profile businesses.
This did not make good reading for the senior executives of the Royal Bank of Scotland, Lloyds TSB or HBOS. Gordon Brown announced that one of the Government's measures was designed to achieve the result of 'bringing an end to rewards for failure' by eliminating all cash bonuses at these institutions. The Treasury statement referred to an agreement with the banks relating to:
'remuneration of senior executives — both for 2008 (when the Government expects no cash bonuses to be paid to board members) and for remuneration policy going forward (where incentive schemes will be reviewed and linked to long-term value creation, taking account of risk; and restricting the potential for 'rewards for failure')'.
This is great for headlines (and hardly bad news for the author of a newly-published book on share incentive schemes!) but, in the longer term, could have profound implications both for companies involved and the British economy.
As John Humphrys on the BBC's Today programme rather too cheerfully talks about 'more mayhem on the markets' with stock exchanges around the world plunging further into freefall, the implications of this announcement could in some cases be rather unexpected.
In that the reasoning behind the decision was at least initially rather rushed, it is useful to recollect in something closer to tranquillity how this measure might affect not only the 'fat cat' bankers that the media loves to criticise, but also directors and employees far further down the food chain.
Financial competitiveness
It seems fair to assume that the powers that be were primarily concerned to eliminate bonuses for the likes of departing RBS chief executive, Sir Fred Goodwin, who topped up a by no means modest salary with a cash windfall of £2.86 million.
The sop of 'incentive schemes' will have been seen very much as a cheap alternative, although in fact, it might well prove to be a very powerful motivator in the right circumstances.
In tough times as company performance fell away, such bonuses would diminish or disappear. The risk for organisations that put a moratorium on bonuses is that they could lose their best people to competitors who do not.
There must be some possibility that Sir Fred could be laughing all the way to the bank (presumably not RBS) as other organisations compete for his undoubted talents.
Wherever he ends up is likely to offer incentive-backed cash bonuses in addition to opportunities to benefit from corporate performance in the form of share incentives such as long-term incentive plans (LTIPs) or possibly share options.
Get rich quick
With world financial markets in turmoil and stocks like HBOS losing 90% of their value in the last year, very few people would wish to predict what might happen to share prices over the next day, week, month or number of years. In reality, if the past is anything to go by, in the longer term, markets and individual stocks will recover and probably ascend to record-breaking levels.
The consequence will be that lucky individuals who receive bonuses by way of share incentives could get far richer than those who get cash. Depending upon the levels of bonuses, there has to be a strong possibility that, when stocks eventually bottom out, the most successful companies could see a tenfold increase in share value from the darkest days.
It is likely that some stocks that have fallen as a result of recent market movements rather than company performance could double in value over a few weeks. If that were to happen, then brokers and remuneration committees (or the non-executive directors that UK plc is to put on bank boards) might well have egg on their faces.
Share incentives in recession
If past experience is anything to go by, many companies will find the next year or two very hard, as people stop spending. Already, the property market has come to a virtual standstill with many estate agents struggling to sell even one property a week.
This will quickly trickle down through the economy and must inevitably lead to redundancies, financial difficulties and closures.
In such a climate, many organisations will be unable to offer competitive pay rises. Following the Chancellor's example, one route that many might choose to follow is to give employees an opportunity to share in the company's future success through share options or other more sophisticated arrangements involving company stock.
Where increases in pay have an immediate cash flow effect, the institution of a stock option arrangement, quite possibly with Government sponsorship through one of the HMRC approved schemes, can be implemented economically and cost nothing to run.
If the company eventually becomes successful, then the lucky employees will be able to share in the benefits. If it does not, then at least it might have been given an opportunity to survive in the hardest of times.
Underwater options
At the moment, the typical share option is likely to be worthless. The underlying principle is that executives get rewarded as their company's share price moves upwards. They receive the opportunity to acquire shares at a fixed value and are able to benefit when this is exceeded.
In the right circumstances, for example taking advantage of the benefits of the HMRC-approved enterprise management incentives (EMI) arrangements, there are also valuable tax breaks.
However, in an environment where almost all share prices are plunging, unless options were granted long ago or a company is in a rarefied sector, those options will be underwater, i.e. the exercise or strike price will be higher than the market value and as such they will cease to have the intended effect of retaining the key employees that businesses so badly need in times of crisis.
Re-pricing options
The obvious solution is to grant new options with an exercise price that is close to today's market value. There could well be a number of impediments for those wishing to follow this route.
If the Government is one of your major investors and has just had to bail out your business, they will probably not look kindly on requests to follow this course of action. Similarly, companies quoted on the London Stock Exchange or AIM are usually obliged to follow strict guidelines laid down by the Association of British Insurers.
In May 2004, one of those insurers — the Co-Operative Insurance Society — set out a list of the 'seven deadly sins of options schemes', the first of which was 're-pricing of share options'. This echoed the ABI's guideline which stated that 'repricing (sic) or surrender and re-grant of awards or "underwater" share options is not appropriate'.
One wonders whether they might be inclined to waive this requirement at some point in the near future, at least in selected cases.
In recent weeks, it has become apparent that a number of companies have sought advice from brokers as to whether it might be possible to re-price options in order to maximise the performance of executives and other key employees. To date, the reactions have been mixed with some companies told that this might be deemed acceptable, although the likelihood is that the majority of those have not had significant institutional investment.
Enterprise management incentives
Even for smaller companies, re-pricing is often difficult. The rules for enterprise management incentive schemes are generally very flexible, but could cause problems in this area. There is an overall limit of £120,000 per individual employee. This is based on the market value at the date of option grant and in many cases, will have been pushed to the limit.
Where this is the case, no new options can be granted until the later of the time that existing options have been exercised and three years from the date of grant. Therefore, if employees are at the limit, it is not possible to cancel recent options and replace them with new EMI options at a much lower strike price.
In fact, there might be at least a little bit of leeway since the limit up to 5 April this year was only £100,000 and therefore many option holders will have at least the opportunity to get £20,000 worth of new options. In the current climate, one fears that that £20,000 could buy more shares than the original £100,000!
The next steps?
Gordon Brown has described these as extraordinary times and they call for extraordinary measures at all levels. The Government, institutions and individual companies will need to consider what actions they can take in order to shore up business on both macro and micro levels.
While discouraging bonuses makes for fantastic soundbites, in reality, if companies are losing money and their share price is plummeting, it is unlikely that bonuses would be paid out, though there can be a time lag. It would also be very harsh if directors of those few companies that really are successful in the current climate had to miss out on richly deserved rewards.
Share incentives may take some time to bear fruit but in these straitened times, where it might not be possible to offer pay rises and there is a distinct possibility that companies could be restructuring and reducing staffing levels, they might just be the difference between surviving and going to the wall.
If instead of offering a pay rise that would increase an overdraft to its limit, an employer could present a package based on share incentives, it is likely that most employees would be receptive. That has certainly been the pattern in past recessions.
The Government is trying to do its bit and institutional investors in publicly quoted companies, such as the Association of British Insurers, could also help by reconsidering their guidelines at a time when the 'credit crunch' would appear to have given way to global recession.
Restructuring EMIs
Where options could be offered under an EMI, the tax incentives represent an additional bonus. Therefore, a far-seeing Government might now be considering changes to the EMI rules in the impending Pre-Budget Report.
These could be three-fold. First, they might consider extending the arrangements to all companies or at least to far more than those that currently qualify. Secondly, at least as a short-term measure, the rule that prevents the cancellation and re-granting of options might be abandoned.
Finally, even though the limits have only recently been increased, they are still inadequate for many of the larger organisations that already qualify, let alone others that might benefit.
Conclusion
In recent weeks, the British Government has taken some bold and almost unprecedented measures in an effort to rescue an ailing economy in the face of financial meltdown.
Time will tell as to whether the world is moving into full-blown recession but if it is, then Gordon Brown and Alistair Darling will have to continue to think up novel ways of keeping UK plc afloat and in the fullness of time, on course for recovery.
They have already demonstrated their commitment to employee share incentives as a more appropriate solution than cash bonuses. It would be very good to see them taking further bold tax initiatives to ensure that those plans have the desired effect.
Philip Fisher heads the employment tax and rewards team at PKF (UK) LLP and is the author of Employee Share Schemes, the second edition of which is published by CCH today. He can be contacted at Philip.Fisher@uk.pkf.com.
