Conventional executive long term share incentive plans (LTIPs) used by listed companies have many perceived drawbacks which has led to an increasing number of companies switching to Restricted Shares. In this update, we look at what Restricted Shares are and what you need to consider in deciding whether a switch is right for your company. This update is relevant for both listed companies and for private companies that follow listed company remuneration practices.
What is wrong with conventional LTIPs?
A conventional LTIP involves an executive receiving an award of shares which vests, or pays out, only if performance conditions are achieved over a period in the future, typically three years. Most LTIPs now have an additional holding period of two years, so executives usually cannot sell their shares until five years from when they received an award. Many criticisms have been levelled at LTIPs over the years, mostly directed at their complexity, the delivery of windfall payments and the way they can motivate executives to make short-term decisions in order to increase the levels of vesting. Many of these criticisms relate to the difficulty of setting appropriate performance conditions that are usually only assessed three years after they were set.
How do Restricted Shares work?
At its simplest, a Restricted Shares award involves an executive receiving an award over a number of shares that vests at a future date if they remain employed. Restricted Shares largely remove performance conditions from the award thereby making them simpler and pay outs more certain. Restricted Share awards are relatively common in listed companies for employees below executive level because those employees are less able to influence the overall corporate performance of the company than senior executives.
Market practice
Certain investors, investor bodies and proxy voting agencies, including the influential UK Investment Association (IA), have set out a number of additional features they expect to see if they are to give their approval to a Restricted Shares plan. These include:
- given the increased certainty of vesting, the size of an award should be at least 50 per cent lower than the level of any LTIP award it replaces, and have a combined vesting and holding period of at least five years;
- the remuneration committee should have discretion to reduce the level of vesting to avoid payments for poor performance; this may be facilitated by having soft performance criteria which the remuneration committee must judge to have been met before it allows vesting;
- there must be a strategic rationale for introducing the plan, such as alignment with a new strategic direction or because the company has a cyclical business model – failure to achieve LTIP performance conditions in the past is not a sufficient reason to change to Restricted Shares; and
- a significant shareholding requirement for executives.
For FTSE listed companies, these features appear to have become essential for high levels of shareholder support, which has made the design of these plans less flexible than was expected when they were first promoted for UK listed companies in 2016.
A wide range of companies have found shareholder support for Restricted Shares so that nearly one in 10 FTSE 350 companies (excluding investment trusts) have now adopted Restricted Shares, with some of the notable adoptions in 2020 being made by BT, Burberry, Foxtons, Hammerson, Lloyds Banking Group and Whitbread. Each of these plans are slightly different in design, for example,
- some allow the Restricted Shares to vest in tranches from the third anniversary but are then subject to a holding period until the fifth anniversary;
- some have soft performance underpins which require the remuneration committee to consider business performance, individual performance and wider considerations in the round before deciding on the level of vesting, while others have hard quantitative financial underpins which determine vesting levels.
In order to obtain a high level of shareholder approval for a Restricted Shares plan a company needs to undertake extensive shareholder consultation before putting the plan to shareholders, and to be prepared to change the original proposal in the light of shareholder reactions at the consultation stage.
COVID-19 Pandemic Considerations
The economic disruption of the COVID-19 pandemic and the uncertainty it has created about future business performance has made it difficult for many remuneration committees to set meaningful performance targets for traditional LTIPs. It has also caused considerable uncertainty as to whether many existing LTIP awards will achieve their performance targets. Added to this, investor bodies, such as the IA, have been quite adamant that companies should not adjust the performance targets for existing LTIP awards.
Whilst this situation would appear to present a good opportunity for companies to introduce Restricted Shares, the caution about Restricted Shares already present amongst investors before the pandemic does not appear to have changed. The COVID-specific guidance on executive remuneration issued by the IA and several proxy voting agencies have re-iterated their position that Restricted Shares should not be adopted simply because it is difficult to set LTIP performance targets. Instead, there must be a strategic rationale for switching to Restricted Shares.
Adopting Restricted Shares in the pandemic
Typically, extensive consultation with shareholders and the proxy voting agencies is required before putting a Restricted Shares plan to shareholders. Most of those companies mentioned above that adopted Restricted Shares in 2020 would have commenced their consultation process in 2019, and so it is not surprising that they were adopted after the pandemic started. For those companies whose employees are suffering financially as a result of the pandemic, adopting a Restricted Shares plan during the pandemic is probably not appropriate. The IA and the major proxy advisory services have cautioned against making substantial changes to executive remuneration packages while the pandemic continues.
However, for those companies that have a good strategic rationale for introducing a Restricted Share plan, and have not been adversely affected by the pandemic, they might want to consider adopting Restricted Shares given that a substantial number of companies have paved the way and obtained general shareholder acceptance.