markets economy

Disadvantages of existing share incentive structures

‘In our view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.’

Warren Buffett- Berkshire Hathaway Chairman’s Letter 

No longer the right thing to do

In addition to poorly performing equity markets, new legislation, most notably Section 8C of our Income Tax Act, has added further drains on the effectiveness of current share incentive structures. All gains arising under employment-linked share incentives (whether purchase schemes or appreciation rights) are taxable as income. Taken with the recent increase in the marginal tax rate to 45%, companies are awarding greater tranches of shares to management to compensate for this increased ‘cost’. In effect, ordinary shareholders are paying the price. Whilst many share schemes serve to align management and shareholder interests, there is a worrying trend, highlighted in the media, of growing discontent. This article expands on some of the weaknesses of these ill-fated Long-Term Incentive (LTI) structures. As all schemes are essentially the same thing (see here), this insight explains why these structures are not appropriate for performance orientated companies.

Tax has made them all the same

Equity instruments acquired by virtue of employment are governed by Section 8C of the Income Tax Act. The effect is that if the equity instrument (i.e. the option or share purchase) generates a gain, the taxpayer is required to include such gain in their personal income for the tax year in which the instrument vests in their name. What this means is that any gains are effectively diluted by 45%! This damages their effectiveness as an incentive tool, and makes them a costly and inefficient mechanism, for the companies involved. Essentially, all of the gains accruing to employees from “restricted” equity instruments are now subject to income tax. If your executives are being incentivised to improve their business, then share-appreciation rights are not resulting in the right behaviour. Instead of working on the company, such schemes prompt the executive to work on the share price.

Executive benchmarking

Directors and remuneration committee in particular feel increasingly threatened as they are terrified of using innovative approaches to align management with shareholders for fear of being singled out by remuneration consultants and “activist” shareholders. Whilst boards cannot be removed if they receive a no vote on their remuneration policy, it is driving the industry towards a single framework that leaves little space for innovation or competition. The result. Companies have ended up with a one-size fits all policy to executive remuneration – and it doesn’t work! Remuneration practices needs to better align performance conditions with those of the ordinary shareholders by for example achieving minimum shareholder requirements (MSR) – where executives are actually shareholders themselves.

Derivative structures

There is a worrying prevalence of derivative structures being used as executive performance structures. Bank funded schemes are likely to be viewed unfavourably by shareholders as this is seen as another LTI on top of the existing structure – it does not align with shareholders. Bank funded schemes limit the downside risk to participants but place the company at risk – as the company often has to stand surety for any credit risk exposure. Derivative financial structure releases the participants from poor share price performance which could result in management taking unnecessary risks as they are ‘protected’ from the consequences. Consider the adverse press comment on the recent Brait executive “release” mechanism to understand the far-reaching damage caused by these derivative structures.

Loans and interest are sinking these ‘leaky ships’

Participants generally acquired shares via a “soft” loan, provided by the company.  However, the effectiveness of this scheme to participants has been progressively eroded through and high interest rates to the point that it is currently unattractive. Add to this, the disastrous performance of local equities on the JSE and many companies will be faced with the prospect of reversing these geared structures.

What about options, I hear you say?

Share option schemes are relatively simple.  The participant is granted the option to acquire shares in the future (say, in three to five years), at the current market price.  There is no risk to the participant, no extension of credit by the company and no deemed interest. However, any gains realised on the exercise of the options are treated as income for tax purposes, in the hands of the participants.  From a company perspective, there is a potential dilution cost in terms of earnings per share, which can be substantial, and although the benefits arising for employees are taxable as income, there is no tax-allowable expense for the company.

Conclusion

Alignment of executives with the company’s that they work is the primary goal of incentives. But, that is no longer possible when the structure implemented has not real likelihood of every accruing any value to the participant. The problem for shareholders up until now is that they have little power with which to interrogate many of the remuneration structures within their investee companies. While compensation is ultimately the decision of the remuneration committee, ordinary shareholders are no longer passive. Improvements in financial reporting and disclosure of executive remuneration also allows ordinary shareholders to better understand how management are being remunerated. In addition, the role that non-executive directors play within internal structures such Remuneration Committees has been brought into focus. Certain Asset Managers and individual ‘Activist’ shareholders are also starting to make a difference.