Banking StandardsWritten evidence from Fidelity Worldwide Investment


A. Background

1. Fidelity Worldwide Investment (“FIL”) manages £102 billion of equity funds under management with approximately £16 billion invested in listed UK equities. Almost all of these funds are under active rather than passive management. We appreciate this opportunity to contribute to your deliberations on standards within the banking industry and have chosen to focus on the very specific issue of management incentivisation. This is an area in which we have extensive experience given our shareholdings in some 1,600 listed UK and European companies, and we would like to share the conclusions we have reached. We have not commented on the many other important areas of your brief as you will doubtless be receiving expert input from others whom are better positioned than us to contribute.

2. FIL has taken a prominent role in the debate about Directors’ remuneration in the United Kingdom. We contributed to the recent Executive Pay Consultation undertaken by the Department of Business, Innovation and Skills, and we have argued publicly in support of the introduction of a binding shareholder vote to govern Directors’ pay. Specifically, we recommended that all annual variable pay should be made subject to prior shareholder approval by a supermajority of the votes cast and with the Chairman of the Remuneration Committee being required to step down if the resolution failed to secure the requisite majority on two consecutive occasions. The decision to introduce a new rule requiring companies to submit a binding vote on pay policy for straight majority shareholder approval at least once every three years does not go as far as we had initially suggested, but we nonetheless welcome this important step towards giving shareholders a greater say on pay. The new regulations should improve the ultimate accountability of shareholders in determining remuneration and diminish the future likelihood of payment for failure.

3. It is widely recognised that misaligned incentives played a part in facilitating excessive risk taking within banks and were a contributory factor to the crisis which engulfed the banking sector in 2008. This situation had arisen over time as a consequence of a number of factors:

A lack of adequate oversight by Boards of Directors and Remuneration Committees.

An inflationary dynamic fuelled by a desire to achieve a second quartile reward profile.

A lack of meaningful input from shareholders.

The introduction of progressively more complex remuneration arrangements encouraged by a new profession of remuneration consultants.

4. These factors combined with the prevailing culture of risk tolerance to produce a situation in which both the quantum and structure of incentive awards were wholly disproportionate to the economic benefit being generated. The resultant cost to the tax payer, destruction of value for shareholders and damage to national well-being have made it essential that practices within banks are brought back into line with the needs of the wider economy.

B. The Importance of Longevity and Duration

1. Considerable work has already been carried out to analyse what went wrong in the financial system in 2008 and to devise measures to prevent a repetition. Management incentives are one of the areas which have been examined and several recommendations have already been made in this regard. However, practice on the ground has been slow to adapt and we would like to see companies make more widespread and faster changes in their approach to this critical area.

2. We would like to draw your attention to one of the conclusions of Sir David Walker in his 2009 review of corporate governance within banks in which he recommended that the LTIPs governing the variable remuneration of senior banking executives should have a minimum vesting period of at least five years for 50% or more of the award. More recently Professor Kay in his Review of UK Equity Markets and Long-Term Decision Making pursued the same theme and recommended that all long term incentive payments should only be made in the form of shares to be held at least until the executive has retired from the business.

3. We fully support the line of thinking expressed by Sir David Walker and Professor Kay and for our own part we have decided to focus on LTIP longevity and duration as key factors upon which Boards of Directors should concentrate. There is no easy way to promote a long-term philosophy within an organisation but, if this can be successfully achieved, the organisational culture will benefit and a whole spectrum of positive behaviour and values should result. By placing LTIP longevity and duration at the centre of our own governance voting guidelines we are giving Boards a clear message and this is also a framework which is straightforward to explain both to our clients and the wider public.

C. Practical Suggestions

1. We have recently changed our proxy voting guidelines such that there must be a minimum period of five years (up from three years) between the date of grant of an award and the sale of any shares. We are also encouraging companies to make at least a portion of these shares Career Shares with the stipulation that they must be held until termination of employment with the company or retirement. This mirrors our own internal approach to senior management incentivisation. An alternative to Career Shares might be to have five year+ vesting in conjunction with a further mandatory holding period, potentially in some circumstances extending beyond the departure of an individual from the company. When combined with a meaningful minimum shareholding requirement this would come close to replicating the effect of Career Shares.

2. A further advantage of management building up a sizeable long term holding in companies is that the dividend income arising from these shares should hopefully become an important part of overall remuneration. We regard dividends as an integral part of shareholders’ reward for investing in a business but, in the absence of a sizeable management shareholding, there is always the temptation for management to try and grow the business as an end in itself rather than balance growth with current rewards for existing investors. Sizeable management shareholdings address this problem.

3. Another benefit of long duration LTIP schemes is that they potentially enable a simplification of LTIP schemes more generally which is one of our other paramount objectives. Alignment between the interests of management and shareholders is achieved through the mandatory long-term marriage of their respective economic interests and there is less need to have detailed performance conditionality in determining the number of shares to be vested. Performance conditionality is a major source of complexity in existing LTIP schemes with shareholders having to make highly subjective judgements on whether the performance conditions are sufficiently stretching, and companies themselves are also very sensitive to revealing performance targets for commercial reasons.

4. We would also like to refer you to work which has been carried out by Pricewaterhouse Coopers which shows that recipients of shares under LTIPs place a high value on certainty with highly conditional awards being valued at a material discount. In the case of Career Shares or ex-ante performance vesting, once shares are awarded they really do belong to the recipient and hence it should be possible to achieve the same motivational effect with a lower quantum of shares. This could make a contribution to reining in the overall size of awards which is another area which needs attention.

5. Notwithstanding recent comments by the Bank of England and the FSA that they favour the use of bail-inable senior debt or other more subordinated forms of capital such as CoCos in remuneration arrangements, this is not a practice we would encourage. Debt carries less risk than equity and is less volatile in its value. By awarding management through debt instruments one is implicitly encouraging risk with the debt retaining value (and high coupon payments) even in circumstances where the equity may have been wiped out.

D. Progress to Date

1. There are some grounds for optimism that Boards are starting to recognise the importance of having a long-term framework for their incentive schemes. The HSBC LTIP scheme in particular adopts many of the ideas underlying Career Shares and they would doubtless argue that their approach to remuneration is reflective of their philosophy towards their underlying business as a whole. It is notable that HSBC were one of the banks which coped best with the challenges of 2008.

2. We are also aware of a proposal currently being considered by another clearing bank which incorporates ex-ante vesting with the quantum of shares being awarded being determined by the individual’s performance in the year prior to award. There would be no subsequent performance vesting with the alignment between shareholders and management being achieved solely through a demanding share ownership guideline and a long term retention requirement.

E. Conclusion

We believe that the structure of long term incentive programmes can have a major impact on the culture and performance of an organisation. There is much noise surrounding this topic and we believe that some leadership is required to direct the debate and to focus attention on those aspects of remuneration which have the potential to make a real difference in the long term. LTIP longevity and duration are key features which should be encouraged and which, if properly crafted, have the potential to foster a longer term culture in systemically important banks and organisations.

31 October 2012

Prepared 19th June 2013