In his opinion, “a relentless ratcheting of terms and conditions has meant that the interests of directors and investors have grown steadily further apart… remuneration reporting has run wild and needs to be hacked back to its essentials”. And to prove he’s serious about this, his fund will vote against the re-election of any director on the remuneration committee who fails to respond to his concerns.
The case against
That’s strong stuff. So, what’s wrong with nil-cost options? The concept sounds easy enough. An 'option' in this context is the option to buy the employing company’s shares at a later date. The cost per share is the 'exercise price', which is set when the option is granted. If the share goes up in value, you 'exercise' your option and buy the shares; if the share goes down, you sit on your hands and hope the price recovers before the option lapses.
'Nil-cost' adds another twist. It’s exactly what it sounds like: when participants exercise their options, the shares won’t cost them anything. According to Mr Slater: “Share options should never be granted with exercise prices at less than market price. Receiving an option is already a huge privilege. [Nil-cost] options offer a return for no capital outlay… We pay market price for the shares we buy… If the price goes down our clients lose value. With nil-cost options there is no loss for the recipients: they can only make a profit come what may.” So, he concluded, they’re a one-way bet. A nil exercise price rigs the roulette wheel.
He has a point. When options began to be granted as part of pay packages (just for senior executives), the exercise price was set as the share price when they were granted. Discounted exercise prices were frowned upon. They still are.
Making life complicated
But there’s an exception: if the discount is 100 per cent (which turns options into nil-cost ones), then it becomes acceptable. Why is that?
The paradox is that a 100 per cent discount effectively turns the option into a share. And that’s a different beast altogether. When shares are awarded as part of pay, the recipients (normally executives) typically have to wait for a few years (often three) before they actually own them. They then have to pay income tax and National Insurance contributions (NIC) based on the market price of the shares on the date that they receive them (the 'vesting' date). They might sell sufficient shares to pay the tax; the remainder they could (in theory at least) sell if they wished to.
Then came the financial crisis, after which the view grew that senior executives should be required to hang on to their shares for longer. Holding periods were introduced. That caused a technical problem: executives had to pay the tax when they received the shares, but couldn’t sell them until two years, or more, later. Companies worked around this by allowing executives to sell sufficient shares to cover the tax bill, and by blocking sales on the remainder.
So, something that started off simple (pay in shares instead of cash) had become more complex because of extra governance. Reward consultants spotted an elegant way to simplify things: why not grant nil-cost options instead of shares? Options can be granted for long periods, typically up to 10 years. The same vesting period can apply of, say, three years. Executives can exercise their nil-cost options at this point, or let the options continue beyond any holding period (say, another two years). That’s five years gone by. They’re left with another five years, on any day of which they can exercise their option, receive the shares, sell them, pay the tax and keep the residual cash, all at the same time.
That puts Mr Slater’s concerns in a different light. His argument holds water if nil-cost options are granted as a gift. It’s flawed if they’re granted as part of the executive’s pay package, for then they do come at a cost. If the options weren’t granted, the executive would receive cash instead.
But he makes another point: senior executives are paid too much anyway. “It has become customary for executive directors to receive a handsome salary, the same again in cash bonus, and a similar amount in nil-cost options – year in, year out,” he said. Which is true, but with the qualification that normally the bonus and options depend on how well the executive and the company performs. The large amounts he cited typically represent the maximum that might be received.
Performance problems
But aren’t performance conditions often flawed? “Adjusted earnings per share are a debased coinage,” he said. “What matters to investors is the total return, and in particular the relative total return.” So, the performance condition he advocates starts by taking the share price when the options are granted, working out the growth by subtracting it from the share price at the end of the vesting period, and (assuming that dividends are reinvested) using that to determine by how much the company has outperformed its competitors. The outcome determines what proportion of shares will be released. A below-target outperformance results in a zero payout to the executive.
This method is often called “total shareholder return”, and investors like it for long-term rewards because it replicates how they would have fared if they’d invested at the same time as when the award was originally made. But there are alternative measures. Cash generation, for example, or return on capital employed. One size won’t fit all because different companies have different characteristics and challenges.
For the annual bonus, which depends on short-term performance, conditions might include progress against agreed KPIs (key performance indicators) and assessments of behaviour and leadership skills. Many investors welcome these, although they often complain that remuneration committees aren’t stringent enough.
Mr Slater’s argument seems to be that executives should just receive a cash salary, plus possibly a cash bonus that depends on the relative returns to shareholders – in other words, turn the bonus into a pseudo share award. Don’t link pay to personal leadership qualities, to behaviour or to environmental, social or governance (ESG) concerns. Keep pay simple and don’t pay directly in nil-cost options or shares. He seems to have forgotten that what matters is not just what executives achieve, but also how they achieve it.
IQE: how not to do it
As if to illustrate Mr Slater’s concerns, four days after the date of his letter, IQE (IQE), the semi-conductor technology specialist, came out with an announcement. This was on Christmas Eve, when media releases often get buried.
It sounded as though, six months after the event, IQE’s directors had just cottoned on to a massive vote (43 per cent) against the adoption of their 2019 long-term incentive plan (LTIP) at its June AGM. Since this LTIP (which is a long-term incentive share option plan) was similar to the previous one, its remuneration committee hadn’t bothered to consult major shareholders in advance of the meeting. True, they had known that Institutional Shareholder Services (ISS), an external watchdog, had advised shareholders to vote against the resolution. But even so, it seems that the vote took them by surprise.
ISS had spotted a risk that every investor needs to look out for: of significant chunks of value being siphoned into the pockets of senior executives. The way IQE does this is by granting nil-cost options every year, most of which go to its most senior people. Every time these nil-cost options are exercised, IQE creates new shares to transfer to the participant. This progressively dilutes the proportion of the company that’s owned by existing investors.
IQE says that over a rolling 10-year period, its potential dilution won’t exceed 15 per cent. But that’s not good enough. The limit that all quoted companies are expected to follow is 10 per cent.
What can IQE do? It says it has to offer options every year to attract and retain “highly sought-after candidates in critical roles throughout the entirety of the organisation”. But it can’t control the number of shares under the options it grants because they’re set at an agreed percentage of salary. If the share price is lower when they’re granted, executives receive more shares; and vice versa. Nor can it predict how many shares it will need to create over the next few years, because this depends on a performance condition: the growth of IQE’s earnings per share. And who knows what that will be? Consequently, the directors believed that “a reduction to the 10 per cent limit is not currently feasible”, but they hope to move to it over time.
To be honest, that’s feeble. First, IQE need not grant options as a percentage of salary. It could express them as an agreed number of shares. If the share price happens to have fallen during the year, so be it – under the old normal, past executives’ actions would have contributed to such falls. And secondly, it could treat nil-cost options like share awards. Prudent companies pay into an employee benefit trust when share awards are made. The trust buys company shares in the market and then releases them when the award vests. That comes with a cash cost, but it hedges the company against share price rises – and, of more importance, it avoids diluting the stakes of loyal shareholders.
Licensing rewards for failure
Mr Slater might not approve. In lobbying for executive pay to be mostly in cash, he risks executives being paid significant amounts no matter how badly they perform. Pay in shares or nil-cost options and, in a plunging market, executives experience the same pain as shareholders. But for IQE and Mr Slater that’s probably academic. IQE’s recent swing into loss and its lack of growth wouldn’t have fitted his investment criteria anyway.
