2020 was a devastating year for many companies, as the pandemic slashed revenues, particularly across travel, hospitality, entertainment, leisure, and non-food ‘bricks and mortar’ retail. In contrast, other sectors including on-line retail, home improvements and parts of the tech, medical supply and pharmaceuticals sectors have flourished. In this environment, management teams have faced unforeseeable and unprecedented challenges (and, in some cases, opportunities), and have been required to demonstrate resilience, adaptability and leadership.  

As Remuneration Committees meet to review the outcomes for 2020 bonuses and 2018-20 LTIPs, and to set the terms of new awards, many will be faced with difficult decisions to deliver outcomes and set targets that are perceived by executives, shareholders and other interested parties to be fair and reasonable. In this context, discretion can be an important tool for the Remuneration Committee, albeit one which should be used carefully and responsibly taking into account the considerations set out below.

What is a discretion?

When Remuneration Committees make determinations about executive pay outcomes, they will usually be making routine “judgments” rather than exercising “discretion”.  

The GC100 and Investor Group in their 2019 Directors’ Remuneration Reporting Guidance (the “GC100 Guidance”) discuss the distinction between judgment and discretion. They say: “In a number of areas, the remuneration committee is routinely asked to apply its judgment to what is appropriate within the bounds of the remuneration policy, or of a particular remuneration award or arrangement. This will not necessarily represent the exercise of “discretion” in the meaning of the Regulations [1].”

The July 2018 UK Corporate Governance Code (the “Code”) also helps differentiate between judgment and discretion. Provision 37 of the Code states “Remuneration schemes and policies should enable the use of discretion to override formulaic outcomes”. 

The GC100 Guidance and the Code suggest that discretion is a determination that is not “routine” and may enable the Remuneration Committee to reach an alternative conclusion to the outcome which would otherwise have been determined using the normal criteria. The distinction is important because there is a specific regulatory obligation to disclose and explain an exercise of discretion, whereas a routine exercise of judgment may not require an exceptional reference in the Remuneration Report.

The Regulations require that Remuneration Committee Chairs disclose in their annual statement in the Directors’ Remuneration Report (“DRR”), “…any discretion which has been exercised in the award of directors’ remuneration.” Additional disclosures relating to the exercise of discretion in respect of an award are required in the notes to the Single Total Figure Table. 

Circumstances in which discretion may be exercised

Circumstances in which it may be appropriate for the Remuneration Committee to exercise discretion could include the following:

• where, during the performance period, an exceptional event causes existing performance conditions to require amendment;
• determining the extent of any malus and clawback application to an award;
• where the Committee determines a need to override a formula-based or criteria-based incentive outcome; and
• where there is a need to apply a special treatment to one or more participants which is outside established practice; for example a discretion to treat a leaver or joiner differently from normal practice (although still within the bounds of the Directors’ Remuneration Policy (the “Policy”)).

Which factors will be relevant in exercising discretion?

The plan documentation and the Policy may provide a non-exhaustive list of permitted exercises of discretion. This can be helpful in building confidence regarding the parameters of the discretion, and important in ensuring the incentive value is not undermined. From a legal perspective, the Remuneration Committee must also be careful not to exercise discretion irrationally or capriciously and must respect the implied duty of trust and confidence to the participant. By giving examples of allowed uses of discretion, the Remuneration Committee is helping to manage these legal risks.

The effect of COVID-19 on the operation of discretion

Economic or other general circumstances such as the COVID pandemic usually do not provide grounds for the exercise of ‘upward’ discretion in favour of management to protect or insulate them from the effects. Shareholders usually expect executives to ‘take the rough with the smooth’ alongside other stakeholders. However, shareholders may expect the Committee to consider ‘downwards’ discretion in some circumstances, for example where the formula-based incentive outcomes are deemed too high in the context of overall company performance.

The Investment Association stated in its April and November 2020 guidance relating to the COVID-19 pandemic that members did not expect Remuneration Committees to adjust performance conditions for in-flight bonuses and LTIP awards.  

ISS indicated in its April 2020 guidance that it was not generally supportive of in-flight changes to long-term compensation plans since they cover multiple years and therefore it would look at in-flight changes on an individual basis “to determine if directors exercised appropriate discretion, and provided adequate explanation to shareholders of the rationale for changes”. Its approach to annual bonuses appeared to differ slightly; ISS acknowledged that Boards might wish to make changes to bonus metrics in light of the pandemic and encouraged companies to consult with shareholders in advance of such changes. In practice it can be difficult to consult with shareholders in relation to changes to targets during the performance period because of concerns over disclosure of price-sensitive information.

There have already been some examples of substantial shareholder dissent where discretion has been exercised due to the impact of the COVID-19 pandemic. For example, Hollywood Bowl received a 47.7% shareholder vote against its DRR, following a shortening of the performance period under the LTIP, to measure performance only for the period before the pandemic impacted results.    Although the Committee’s intention was to recognise strong performance by management up to the start of the pandemic, voting agencies and many shareholders opposed this change. 

In another example, NCC Group received a 48.47% shareholder vote against its DRR following an exercise of discretion by the Remuneration Committee.  This was to modify the bonus financial underpin in order to pay the element of the bonus linked to strategic, non-financial performance, although the financial hurdle for such payment was not met. The Remuneration Committee exercised discretion to assess the underpin on the basis of performance over the first three trading quarters only (their financial year end was May 2020). The Committee also took into account that the company had not received external financial support, nor furloughed or made staff redundant due to COVID-19.

Should you consult with shareholders before exercising discretion?

If the Remuneration Committee is considering exercising upwards discretion, it may wish to consult with major shareholders beforehand. In practice this can be very difficult if it risks a disclosure of price-sensitive information. Also, following the end of the performance period, there will be severe time constraints on consultation prior to determining pay outcomes and publishing the accounts.

Explaining the operation of discretion

It will be important for the Remuneration Committee to document its exercise of discretion and the factors it took into account in making its decision, to help meet statutory and Code requirements to disclose the use of discretion in the DRR. When reporting the use of discretion in the DRR it is best to avoid general statements, and instead to clearly explain to stakeholders why the use of discretion was necessary and how the remuneration outcome changed as a result.

Does the Remuneration Committee have the discretion it may need going forward?

When next reviewing Policies, you may wish to review the discretions available to the Committee, to determine the extent to which the Committee has the operational flexibility it might need going forward. 

How can A&M help

If you would like to discuss any of these issues or have any other enquiries please contact one of the Managing Directors, whose details are shown on the right hand side of this article. 

[1] The Large & Medium-sized Companies and Groups (Accounts & Reports) Regulations 2008 (as amended) (the “Regulations”)