Ellason lens on… assessing ‘windfall gains’

Mon 28, November

Time flies, as they say, and we are now fast approaching the third anniversary of the onset of the Covid-19 pandemic. In March 2020, global stock markets fell sharply as a result of the uncertainty and turmoil that the pandemic was predicted to bring. Few companies, if any, were spared from the initial market decline, albeit the speed of the subsequent recovery has differed greatly between sectors.

For many companies – particularly those with December year-ends – the market collapse in early 2020 coincided with the annual long-term incentive grant cycle. Faced with the dilemma of whether to reduce LTIP award levels (as would normally be expected by investors following material share price declines), the majority of companies chose instead to commit to reviewing vesting outcomes to ensure that there is no reward simply for ‘windfall gains’.

What is the issue?

Most FTSE companies define their long-term incentive opportunities as a % of salary, with the resulting number of shares awarded being a function of the share price at the date of grant. All other things being equal, a lower share price – such as that resulting from the pandemic – results in incentive awards being granted over a higher number of shares. This, it could be argued, rewards participants for a falling share price in the run up to the date of grant (with the reverse being true for a rising share price) and raises the possibility of outsized rewards in the event of a subsequent market recovery.

As an example, see the table below: a 30% lower share price at grant results in a participant receiving an award over 43% more shares, and therefore a vest date value which is 43% higher than for a similar company where no such fall in share price prior to grant had occurred. Here, a 30% lower share price reflects the average fall across the FTSE350 by mid-April 2020 following the onset of the pandemic.

How might companies assess whether executives have benefited from windfall gains?

Assessing and quantifying windfall gains is likely to be a judgment call rather than a purely formulaic exercise, and committees may wish to consider a wide range of quantitative and qualitative factors in making a decision in this area. Ideas for relevant reference points might include:

  • The total single figure of remuneration for each Executive Director in the year of vesting: how does the ‘headline’ remuneration figure compare to outcomes over the last 5-10 years, and does this feel appropriate in the context of underlying performance over the period?;
  • The proportion of long-term incentive value accounted for by share price appreciation: under remuneration reporting regulations, companies are required to quantify and disclose the impact of share price appreciation in relation to the LTI value recorded in the single-figure table. If the proportion of LTI value made up by share price growth is particularly high (in either absolute terms or with reference to historical norms), this may be indicative of windfall gains;
  • The shape of the company’s recovery following the pandemic lows: has there been a strong correlation between the company’s share price performance and that of the broader market following key events during the pandemic (the announcement of restrictions being lifted or the development of a successful vaccine, for example)? Such high correlation might be indicative of sectoral or macro influences rather than management actions on the share price;
  • Absolute total shareholder return levels as compared to historical FTSE and sector norms: how has share price performance over the three years since grant compared to broader market returns over the longer-term? Ellason’s analysis (see chart below) indicates that an upper decile (90th percentile) 3-year share price growth has been around 29% per annum; however, does a 1-in-10 event necessarily indicate a windfall gain, or should we consider a higher threshold (e.g. the 95th percentile 3-year share price growth would be 37% per annum, or 44% per annum since the onset of the pandemic);
  • Other financial and non-financial indicators: what has been the broader context since grant? Has underlying financial performance been strong over the period? What has been the experience of shareholders, employees, customers and other stakeholders over the period? Has the remuneration committee received strong support for its remuneration decisions in recent AGM seasons?

No single reference point is likely to tell the whole story, and so constructing a detailed narrative around the committee’s decision-making process will be important in explaining any adjustments (or lack thereof) both internally and externally.

What should the Remuneration Committee do if it concludes there has been a windfall gain?

Having identified – and quantified – a windfall gain, the committee has a number of alternatives around how to adjust for the gain. Timing is an important issue to consider here, since the methodology used to value vested long-term incentives in the Directors’ Remuneration Report often produces very different results to that which an executive ultimately realises from an award (e.g. because of mandatory holding periods and/or changes in share price between year-end and the vesting date).

Most simply, the committee could decide to apply a reduction to the number of shares vesting from an incentive, with the balance lapsing entirely and immediately at vesting. Variations to this approach could see an executive committing to give up the additional proceeds to charitable causes or broader employee initiatives, although this may require careful planning from a disclosure and taxation perspective.

Alternatively, committees could choose to defer the windfall gain, or to make this subject to further service or performance conditions. One approach might see such amounts retained by an executive but made subject to a mandatory holding period (possibly until retirement), thereby providing further long-term alignment between the impacted LTI participant and investors.

What is the investor view?

Most shareholders were understanding of companies not making an ex-ante reduction to their long-term incentive award sizes and instead committing to review this at the point of vesting. For example, in its 2020 ‘Shareholder expectations’ guidance, the Investment Association noted that its members accepted ‘that there does not need to be an adjustment to [LTIP] grant size’ where ‘the share price fall is solely related to COVID 19 market movements’. There was, however, a strong steer that companies should commit in their reports to reviewing the ultimate vesting outcomes from these awards to ensure that executives would not benefit from a market rebound. Subsequent shareholder guidance elaborated on expectations for active disclosure around the types of factors that the committee would take into account in quantifying any windfall gains, which many did in their 2020 (and subsequent) Remuneration Reports.

Fast-forward to today, and Ellason’s recent conversations with investors have suggested that this remains an area of particular focus moving into the 2023 AGM season. Many shareholders we have spoken to are planning to scrutinise both the vesting results and explanations provided by companies in approving long term incentive outcomes from the 2020 grants, and look set to vote against those where this issue of windfall gains is considered not to have been adequately addressed. Investors have also been keen to note that the flexibility offered in this area during the pandemic is not their preferred position going forward, and that companies will be expected to consider up-front reductions to long-term incentive award levels where there has been a material fall in share price in the run-up to grant (as may well be the case for many companies in early 2023, given recent market turmoil).

Please do not hesitate to contact any of the Ellason team should you wish to discuss this issue further.