On 11 June, the Government released a draft statutory instrument (The Companies (Miscellaneous Reporting) Regulations 2018 (the Regulations)) and accompanying FAQs (the FAQs), which, subject only to Parliamentary approval, will require additional disclosures to be made in the Annual Reports of Listed PLCs1 for financial years beginning on or after 1 January 2019. In the main, these changes will be implemented via amendments to the Large & Medium-sized Companies and Groups (Accounts & Reports) Regulations 2008.

These new reporting requirements are part of the Government's wider package of corporate governance reforms announced in August 2017 (for further information on the wider package of reforms, click here, for further information on the UK Corporate Governance Code developments, click here, and for further information on the reforms affecting large private companies and unlisted PLCs, click here).

Summary of the Additional Disclosures Required in the Annual Report

Subject to meeting the relevant thresholds described below, Listed PLCs1 will be required to make additional disclosures regarding: (i) the ratio of the CEO's pay (the single total figure of remuneration) to the median (50th), 25th and 75th percentile full-time equivalent (FTE) remuneration of their UK employees; (ii) the impact of the future share price on executive pay; (iii) how the directors have had regard to the matters in section 172(1) of the Companies Act 2006 (S172(1)); (iv) how the directors have engaged with employees; and (v) how the directors have had regard to the need to foster the company's business relationships with suppliers, customers and others.

Comment

While it is unsurprising that the new Regulations and the qualifying thresholds that they include are complex, the CEO pay ratio reporting requirements, in particular, with their three options for calculating the data, are likely to prove particularly challenging for HR and payroll teams who have just got to grips with the gender pay gap reporting requirements. There are undoubtedly going to be further questions as market practice develops in this area, particularly as, unlike the gender pay gap data, there is no consensus as to what a "good" CEO pay ratio is, or what stakeholders should be looking for over time in these disclosures. The Government has stated that it is not going to specify the "correct ratio" for a specific company. It will be important for companies to carefully consider the explanation provided, both externally and internally, to put the ratio into context and also to explain the potentially significant variations from year to year. These changes will be largely driven by inevitable fluctuations in CEO pay due to the performance related nature of much of their remuneration. For example, companies will need to consider the impact of the LTIP vesting schedule.

The Regulations, along with the other associated reforms including the proposed revised UK Corporate Governance Code (the Code), will also present challenges in the sense that they will require mandatory additional information to be included in the Annual Report when companies are already under pressure to "cut the clutter" and reduce overall length. Notably, in the Remuneration section of the newly drafted Wates Corporate Governance Principles for Large Private Companies (for further information, click here), there is a reference to a company's gender pay gap reporting and a considered assessment of a company's response to it, which is currently missing from the proposed revised Code and might well make it into the final version expected to be published in mid-July.

Further Detail on the Additional Disclosure Requirements

CEO pay ratio

All Listed PLCs1 that have over 250 UK employees (for parent companies, look at the number within the group) must publish, in tabular form in the Remuneration Report, the ratio of the CEO's pay (the latest single total figure of remuneration (STFR)) to the median (50th), 25th and 75th percentile full-time equivalent (FTE) remuneration of their UK employees. The disclosure will build incrementally in the table to eventually cover a 10 year period.

Underneath the ratios table, companies must provide further supporting information, including an explanation of:

  • the methodology chosen for calculating the ratios;
  • the reasons for changes in the ratios from year to year, including whether a change is attributable to a change in: (i) the remuneration of the CEO, or the pay of the company's UK employees taken as a whole; and / or (ii) the company's employment models (including whether there is an increase in employees employed outside of the UK, and any increase in the proportion of the company's workforce that is not employed by the company under direct contracts of service);
  • any trend in the median pay ratio over the number of years covered in the table; and
  • for the median ratio, whether, and if so how, the ratio accords with the company's wider pay, reward and progression policies.

The Government estimates that these requirements will affect approximately 450 Listed PLCs.1

Methodology

Notably, the Government had previously stated that the new Regulations were going to require companies to report their ratio of CEO pay compared to the mean average pay of their UK employees on the basis that this would have involved a lower regulatory burden. On reflection, the Government has opted for median and quartile-based pay ratios on the basis that a mean figure would not have revealed any significant new information (as employee pay is largely already collected and reported on in the accounts and totals could be divided by the STFR) and mean figures can be skewed significantly upwards by very high pay at the top of the pay scales, particularly where the company has a smaller number of employees.

Acknowledging the additional regulatory burden on companies, the Government has tried to reduce the impact by offering companies three options for calculating the ratios, as follows:

  • Option A - a company calculates the total FTE remuneration of each UK employee of the company (and its group) for the relevant financial year, ranks all of those employees on the basis of their total FTE remuneration from low to high, and then identifies the employees at the 25th, 50th (median) and 75th percentile points of this ranking.
  • Option B - a company uses the most recent hourly rate gender pay gap data for all UK employees to identify three UK employees as the best equivalents of the 25th, 50th (median) and 75th percentile employees described under Option A, and then makes adjustments, using reasonable estimates, where necessary, to ensure the best equivalents are reasonably representative, and then describes their methodology in the Remuneration Report.
  • Option C - a company uses other existing pay data (i.e. other than gender pay gap data), where this is not less up to date than the gender pay gap data, to identify three UK employees as the best equivalents of the 25th, 50th (median) and 75th percentile employees described under Option A, and then makes adjustments, using reasonable estimates, where necessary, to ensure the best equivalents are reasonably representative, and then describes their methodology in the Remuneration Report.

While the intention to make this "easier" for companies to comply with is to be welcomed, the result is an extremely complicated set of Regulations and FAQs to explain how this all works, and it does mean that a cross comparison between peer companies is unlikely to be meaningful. The Government argues that this does not undermine the primary aim of the policy, which it states is to ensure companies explain to their shareholders and wider stakeholders why the ratio is appropriate, rather than to allow a cross comparison of ratios across companies. It will be interesting to see if this lack of comparability of peer company numbers and the lengthy descriptions of each company's exact methodology are acknowledged in practice. Our sense is that if the media coverage of the CEO pay ratio is anywhere near as extensive as the coverage of the gender pay gap figures, this message could easily be lost. In the US (which has its own CEO pay ratio reporting requirements which also allow companies certain flexibility in how they report), for example, Bloomberg has launched an online tracker of US CEO pay ratios which, unsurprisingly, focuses on the headline figures and not the methodology used for each company.

Describing year on year changes, trends in the median ratio and whether, and if so how, the median ratio accords with the company's wider pay, reward and progression policies

The Regulations require detailed explanations to be given of the reason for changes to the ratios year on year, but do not prescribe the length of such explanations. The FAQs indicate that they are unlikely to need to be more than a few paragraphs unless there have been significant changes to the ratio. This explanation will require some careful drafting every year as the ratios are inevitably going to fluctuate due to CEO pay being heavily based on a company's performance and associated bonus awards, as compared to average employee pay which remains relatively constant. However, unlike the gender pay gap data, where there is broad agreement that the pay gap should be as low as possible, it is difficult to pinpoint what investors and other stakeholders will be looking for in these explanations. It is also not obvious that a reduction in the ratio will always be seen as a positive thing for the workforce. For example, part of the rationale for these disclosure requirements is to address concerns raised by respondents to the consultation that making the ratio look at the pay of UK employees only (by contrast to the US requirements which look at worldwide employees) may incentivise companies to offshore or outsource low-paid staff. Although this reporting requirement should reveal if the employment model is changed, there are likely to be multiple reasons for fluctuations of the ratio year on year and there is nothing to actually prevent companies offshoring or outsourcing employees, leaving a question mark as to how effective a deterrent this disclosure requirement is likely to be. Drafting the trends in median ratios and whether and, if so, how the median ratio accords with the company's wider pay, reward and progression policies is likely to be equally challenging for the same reasons. This disclosure is inevitably likely to cross refer to the other new disclosures in the Annual Report described below, particularly regarding employee engagement and compliance with S172(1), and to be influenced by the proposed revised Code.

Impact of the future share price on executive pay

All Listed PLCs1 to provide:

  • where executive remuneration outcomes are linked to performance periods or other executive incentive periods of more than one year (for example LTIPs, retention plans or share options), an illustration, in their next new Remuneration Policy, of the impact of share price appreciation of 50% during the relevant performance period;
  • in their Remuneration Report:
    • additional disclosures under the STFR table, being (i) an estimate of the STFR that may be attributable to share price appreciation; and (ii) whether, and if so how, discretion has been exercised as a result of share price appreciation or depreciation; and
    • a summary, in the Remuneration Committee Chair's statement, of any discretion that has been exercised on executive remuneration outcomes reported in the relevant year.

It is notable that, in this drafting, the Government has acknowledged that the exercise of a discretion may result in a pay award being adjusted upwards (as well as downwards) in a situation where share price depreciation means that an executive's pay does not reflect his or her strong performance, though the exercise of this type of discretion is likely to be relatively rare.

Statement regarding how directors have complied with their duty to have regard to matters in S172(1)

All large2 companies will be required to include a separately identifiable statement in their Strategic Report describing how directors have had regard to the matters set out in S172(1) when performing their duties under S172.

The contents, level of detail and length of the statement will be different for every company, but should be consistent with the size and complexity of the business. The Government indicates in its FAQs that companies will probably want to include information on some, or all, of the following:

  • the issues, factors and stakeholders the directors consider relevant in complying with S172(1) and how they have formed that opinion;
  • the main methods the directors have used to engage with stakeholders and understand the issues to which they must have regard; and
  • the effect of the above on the company's decisions and strategies over the year.

The Government acknowledges that there may be overlap between the disclosure required in the Directors' Report on employee engagement and customer and supplier relationships (described below), and what the company intends to disclose in its S172(1) statement in the Strategic Report. They have confirmed that, in these cases, companies can solely make a disclosure in the Strategic Report (as long as they make it clear in the Directors' Report which information has been included in the Strategic Report). Although the rules may seem duplicative, the rationale for the additional requirements in the Directors' Report is twofold: (i) to ensure that there is disclosure in the Annual Report about engagement with employees, customers and suppliers even where directors do not consider the information to be of strategic importance to the business; and (ii) to allow companies to provide more information than may be warranted in the Strategic Report, in the Directors' Report, for example by providing more detail on their employee engagement mechanisms. Companies should also consider the impact of the proposed revised Code when drafting this disclosure.

Updated FRC Guidance on the Strategic Report is due to be published in July 2018 and the FRC has agreed to include guidance on how companies should prepare a S172(1) statement.

Employee engagement

All companies that have more than 250 UK employees (for parent companies, look at the number within the group) will be required to explain in the Directors' Report how the directors have engaged with employees and had regard to employees' interests, and the effect of that regard, including on the principal decisions taken during the financial year. The Government estimates that around 12,400 UK companies have more than 250 employees, but are not able to estimate how many of these have more than 250 UK employees and will therefore be impacted by this rule change. Notably, this amendment will be implemented via a wholesale replacement of the existing rules on employee involvement disclosure set out in Part 4 ("Employee Involvement") of Schedule 7 ("Matters to be dealt with in a Directors' Report") of the Large & Medium-sized Companies and Groups (Accounts & Reports) Regulations 2008. Any companies already complying with that Part 4 will need to look at the amended rules carefully and consider whether they need to comply in each financial year (see "Qualifying Thresholds" below).

Fostering the company's business relationships with suppliers, customers and others

All large2 companies will be required to summarise in the Directors' Report how the directors have had regard to the need to foster business relationships with suppliers, customers and others, and the effect of that regard, including on the principal decisions taken during the financial year.

Qualifying thresholds

Each of the reforms set out in the Regulations has its own unique set of qualifying thresholds, in most cases referred to as the "qualifying conditions". Although the headline qualifying thresholds are described above, it will be necessary for companies to look at each of the Regulations in turn and work out whether or not they need to comply each year. In particular, for companies whose size may fluctuate from year to year above and below the relevant thresholds, it is worth noting that the Regulations contain "smoothing provisions" which provide for a two year time lag before a company drops out of, or is covered again, by the requirements.

Sanctions for Non-Compliance with the Disclosure Requirements

If either (or both) of the Strategic Report and the Directors' Report do not contain any of the required information discussed above, each director of the company may be criminally liable and subject to a fine where they either knew it did not contain the required information, or were reckless as to whether or not it contained the information, and failed to take reasonable steps to secure compliance.

Parent Companies with UK Incorporated Subsidiaries

The corporate governance reforms described above are part of a package of reforms being introduced by the Government, some of which apply to private companies and unlisted PLCs. Notably, many of the reforms (such as the new requirement for very large private companies and unlisted PLCs to make a corporate governance statement in their Directors' Report) apply even where the relevant company is a wholly owned subsidiary of a parent company that is: (i) complying with the Code; and (ii) preparing a consolidated group Directors' Report. A Listed PLC which has UK incorporated subsidiaries in its group should familiarise itself with the corporate governance reforms affecting private companies and unlisted PLCs to ensure a consistency of application across the group.

Next Steps

  • The Regulations are subject only to approval by Parliament. The Government expects them to be passed before 1 January 2019 as they will apply to financial years beginning on or after that date. In the meantime, the FRC expects to publish its updated Guidance on the Strategic Report in July 2018.
  • The amended Code is due to be published in mid-July 2018 and is expected to apply to financial years beginning on or after 1 January 2019.
  • The first Annual Reports required to comply with the new Regulations and the new Code are expected to be published in 2020.
     

Action For Listed PLCs1 to Take Now

  • For companies that will be required to disclose their CEO pay ratio:
    • start to look at the data, if any, that is already available about employee pay across the company and the wider group (where applicable) and consider how this might best be used for calculating the CEO pay ratio;
    • involve Payroll and HR early on in any discussions about how best to compile and use existing data, and draft associated disclosures;
    • consider calculating data for previous years voluntarily so that patterns can be identified and the first year's disclosure can be more informed and / or signpost likely future fluctuations; and
    • consider whether to provide any additional messaging both externally and internally at the time that the CEO pay ratio and other new disclosures are published. For example, many companies reporting on their gender pay gap in April took the opportunity separately to report the results to their employees and, in doing so, added additional disclosure not required by the rules.
  • Update the Remuneration Committee on the changes and consider these in the context of the wider corporate governance reforms, including the proposed revised Code.
  • Consider the employee and wider stakeholder engagement mechanisms the company has in place now, if any, and whether they should be introduced, improved or expanded (also keeping the proposed revised Code in mind).
  • Work out which members of the business need to be involved in drafting and / or reviewing the relevant engagement mechanisms, strategies, policies and procedures described above (HR, Legal, Compliance etc) and the new disclosures in the Annual Report.
  • Where the company is a parent company with UK incorporated subsidiaries in its group, consider which group companies need to comply with what requirements and how best to ensure a co-ordinated approach to compliance and drafting of the required disclosures.

[1] A Listed PLC, otherwise referred to as a "quoted company", is a UK incorporated PLC with equity shares listed on the FCA's Official List, or on NASDAQ, the NYSE, or a recognised stock exchange in the EEA. It does not include AIM listed companies.

[2] A large company is a company that meets two or more of the following criteria:

  • turnover of > £36 million;
  • balance sheet total of > £18 million; and
  • Number of employees > 250.

The Government estimates that changes affecting large companies will impact around 16,000 companies.

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