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South Africa: Directors’ Duties (5 of 8) – Remuneration, long-term and short-term incentives

13 May 2024
– 11 Minute Read

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Overview

  • Most companies have moved away from a system of only paying fixed remuneration and have increasingly introduced variable and discretionary pay in the form of cash-based or share-based long-term and short-term incentives. There are strict requirements pertaining to employee share incentive schemes for companies listed on the JSE.
  • Proposed amendments in the Companies Amendment Bill, 2023, will require (a) the remuneration policies of listed and state-owned entities to be approved by shareholders, and (b) companies to report on the remuneration of all employees.
  • There are also existing income differential and discrimination disclosure requirements for designated employers under the Employment Equity Act, which also has equal pay for work of equal value provisions. Remuneration policies generally confer a number of discretions that need to be exercised by the board.

This is the fifth article in a series of articles on the duties of directors in relation to employment, employment law and employee benefits.

In the first article we identified six themes where the King IV Code on Corporate Governance (King IV) requires boards of directors to have knowledge of employment law and employment generally. Two of those themes are the obligation of the board to determine the company’s remuneration philosophy and to adopt a remuneration policy, and the duty to assess the performance of the CEO. As the assessment of CEO performance is also applicable in assessing variable pay awards, we will deal with the two themes together.

Most directors would be of the view that very few legal issues arise from their duties in relation to remuneration.  However, besides working in an environment of increasing regulation of remuneration, a surprising number of disputes can and do arise. As an example, in the past few weeks there has been publicity regarding a senior executive instituting a discrimination claim against Tsogo Sun based on the fact that her exit payments were not the same as those paid to other departing executives.

From a legal and regulatory perspective there are strict requirements pertaining to employee share incentive schemes for companies listed on the JSE. As share schemes often involve the dilution of shareholder value by the issue of shares, there is a need for stringent regulatory oversight.

King IV also recommends several approaches to governing executive remuneration which have been adopted and are enforced by the JSE. The Companies Amendment Bill, 2023 (Bill) proposes amending the Companies Act to require that the remuneration policies of listed and state-owned entities be approved by a majority vote of shareholders, failing which they may not be implemented. The proposed amendments would also preclude non-executive directors from continuing to serve on remuneration committees if the shareholders do not approve the remuneration report (which includes the remuneration policy and implementation report) by ordinary resolution on two consecutive occasions, and the directors would also have to stand for re-election to the board.

Currently the requirement is for remuneration policies and implementation reports to be put to a non-binding advisory vote by shareholders and there is no legal impact on the adoption of the remuneration policy or implementation report.

The Bill also proposes to require listed and state-owned companies to report on various aspects of the pay gap between the highest and lowest paid employees in the company, as well as the average and median total remuneration of all employees. There are also existing income differential and discrimination disclosure requirements for designated employers that need to be filed annually with employment equity reports under the Employment Equity Act (EEA). Furthermore, the EEA has equal pay for work of equal value provisions that provide that if the basis for not paying employees doing work of the same, similar, or equal value is directly or indirectly based on a listed discriminatory ground or an arbitrary ground, this can give rise to a legal claim.

Remuneration policies also usually confer a number of discretions that need to be exercised by the board or its remuneration committee in relation to, among other things, how the policy is implemented and administered.  The exercise of these discretions can be challenged by employees as being unfair conduct relating to the provision of benefits where the discretion is not exercised fairly or reasonably.

Finally, remuneration increasingly poses a reputational risk to boards and companies. There has been considerable public criticism of remuneration policies and practices that appear to deliver excessive rewards to executives while offering few benefits for other stakeholders. There has been increasing shareholder resistance to and activism around approving policies and voting in favour of remuneration policies and implementation reports that purport to offer excessive pay or do not hold executives sufficiently accountable by linking their incentive awards to the company’s performance, or by making provision for excessive termination payments.

Remuneration serves the aims of attracting, retaining, motivating, and engaging employees. The board, in determining the company’s remuneration philosophy, would seek to achieve these aims by adopting a remuneration policy detailing the company’s position on and approach to discrete elements of remuneration and workplace benefits.

Attraction and retention are accomplished by ensuring that the company is paying remuneration that is competitive in the market in which it operates. This is normally achieved through market benchmarking exercises and the use of salary surveys.

Motivation and engagement is normally achieved through variable pay which would include both long-term incentives (LTIs) and short-term incentives (STIs). LTIs also act as a retention mechanism since awards only vest once an employee has remained in the employ of the company for a defined period. Variable pay is intended to match reward to performance, be it personal or company performance, or a mix of both. The remuneration policy usually encompasses a consideration of all the above factors.

Turning then to the different kinds of variable pay, STI awards are designed to reward performance over the short-term, measured over the course of a financial year.  For senior employees they are increasingly based on the performance of the company as defined by a number of performance conditions.

Employees are given performance targets and measures that set out the areas of prescribed performance and the metrics and weightings that will be used to determine the extent to which the employee has performed. The only involvement of the board would usually be in defining the CEO’s performance targets and measures and then assessing the performance of the CEO against those criteria. As this is usually an objective exercise, there is little room for dispute.

The development of LTI schemes, their implementation, and operation are all normally in the purview of the board or its remuneration committee, particularly as most plans either involve the issue of shares or link the underlying value of awards to the company’s share or equity value.

If the company is listed, then there are also listing and regulatory requirements for employee share schemes that need to be identified and adhered to.

Once established, LTI schemes normally confer a number of discretions on the board or its remuneration committee. The first discretion is usually the allocation of awards to eligible employees. If the allocation is a percentage of fixed pay, then there is no discretion. If it is intended to drive and reward performance and is based on performance, then the board would need to satisfy itself that the prescribed performance can be objectively measured before it approves the allocation of awards.

The second discretion usually pertains to the setting of performance criteria. Most LTI schemes now provide for awards that will only vest upon the achievement of various performance targets over the duration of the vesting period. The setting of criteria has to be objectively sound and achievable, but at the same time, drive company performance in a manner that enhances shareholder value. Once established, the board will have limited discretion in measuring performance if the criteria are objectively determinable.

All LTI schemes should have both good leaver and bad leaver provisions. Bad leavers forfeit unvested awards and, in some cases, vested awards that have not been exercised or delivered. Good leavers would ordinarily be entitled to have a portion of their awards vest on an accelerated time pro-rated basis.

A mutually agreed termination of employment is not usually covered under either a good leaver or bad leaver event and often a discretion is afforded to the board to determine whether an employee’s award should vest in full or in part.

Mutual separations usually occur in the context of employers wanting to terminate the employment of the employee, where either there is a risk that there is insufficient evidence available to warrant the institution of disciplinary [or incapacity] proceedings, or it is likely to result in a protracted and expensive dispute. In these circumstances, the executive needs to be offered an inducement to enter into a mutual separation agreement. Permitting awards that would ordinarily be forfeited on resignation or dismissal to vest, often serves as that inducement.

The board may be required to exercise a discretion in these circumstances and will need to carefully weigh up the rationale for paying the inducement against the consequences of a failure to reach agreement with the employee concerned, and shareholder reactions to excessive or unwarranted termination payments.

There may be other discretions that will need to be exercised under an LTI scheme in relation to changes of control or transfers of a business or portion thereof as a going concern. In each instance, the discretion needs to be rationally and reasonably exercised. The failure to exercise a discretion reasonably and rationally could result in an unfair labour practice dispute.

Finally, most employers have now introduced Malus and Clawback clauses into their LTI schemes. These clauses confer a discretion on the board or its remuneration committee to require the forfeiture of unvested awards (Malus) or the repayment of an award once it has vested and been settled to an executive (Clawback).

These clauses usually apply in circumstances where there have been misstatements in the financials or mistakes in the measure of performance criteria on which the awards were made or allowed to vest, or where there has been employee misconduct that was not known to the employer at the time that the award was made or vested. In these circumstances the employee must be allowed to make representations before the board or remuneration committee exercises any discretion. Again, the discretion needs to be exercised rationally and reasonably.

There are also legal limitations pertaining to the application of Clawback. There is a prohibition in the Basic Conditions of Employment Act from requiring the repayment of remuneration already paid to an employee unless there has been an error in the calculation of the remuneration.  This means that Clawback clauses need to be drafted in a way that permits claims for repayment of awards that were made erroneously. 

So, awards that were made based on financial results that have to be restated or performance criteria that have subsequently proved to be wrong would be subject to Clawback.  In this sense, Clawback is remedial, to correct an error. Clawback cannot be applied in a punitive manner to punish an employee for misconduct discovered after the award has vested and been settled.

The board is required to assess the performance of the CEO in determining any variable pay award. There is also a general requirement in King IV to do so regardless of whether it pertains to pay or not. If there is a variable pay component to pay, then the process to be followed can serve both purposes. However insofar as the variable pay process may be confined to specific performance targets and measures there should also be a broader measurement of CEO performance to cover all the areas of delegated responsibility.

As previously indicated, a board member can discharge their obligation to act with care and skill by relying on those to whom authority has been delegated. But delegation does not mean abdication and there would still be an obligation to monitor how the delegated authority is being discharged. This would be included in any assessment of CEO performance.

Employees can refer disputes regarding how the board has exercised a discretion in relation to any one of the powers that are conferred on the board in regard to variable, discretionary pay to the Commission for Conciliation, Mediation and Arbitration (CCMA).

A CCMA commissioner is not confined to only assessing whether the board has acted rationally and reasonably but is entitled to substitute their own discretion for that of the board.  As variable pay can involve many millions of Rands, the CCMA is not ideally suited to determining matters that require the kind of expertise available to a board in remuneration governance.

For this reason, many LTI schemes often contain alternative dispute resolution clauses that require disputes regarding the scheme to be referred to independent arbitration. This arbitration could be conducted by an accountant if it involves a financial issue, by a lawyer if it is a legal issue, or by a remuneration expert.

In conclusion, the issue of remuneration poses legal and reputational risks. Consideration needs to be given to the remuneration philosophy of the company and the policies that implement and support this. Wherever discretions are conferred on the board, those discretions need to be exercised in a way that is both rational and reasonable.

A board should only consider relevant criteria and discount irrelevant criteria. Even then, it is possible that the board’s decision can be substituted by that of a commissioner at the CCMA. For this reason, careful consideration needs to be given to the drafting of alternative dispute resolution clauses in LTI schemes.

All articles in the series: