Executive pay is an ever present point of contention in the public eye. Long-term incentives are the most contentious of all forms of executive pay as they are the least understood and therefore the least transparent. The purpose of an executive share scheme is to link the fortunes and performance of the organisation with the fortunes and performance of the executive team. There are numerous ways for these schemes to be administered, such as issuing full shares, appreciation rights and share purchase schemes as detailed.
Types of share scheme mechanisms
- Full-value shares: there are 2 types; namely,
- Forfeitable/restricted shares
Shares are awarded upfront, but may not be sold (restricted/subject to forfeiture). They usually carry dividend rights that may pay out when declared or only when/if shares vest. The shares may or may not carry voting rights. Upon vesting, based upon being in-service and the level of performance conditions met, the restrictions are lifted on all/some of the shares with the balance being forfeited. The full value is taxed at marginal rate on the value at vesting so the executive often needs to sell 45% to pay the tax. The shares are taxed at CGT (Capital Gains Tax) after vesting if retained.
- Conditional shares:
A conditional award of shares on condition that stipulated performance and/or service conditions have been met upon vesting. There is no dividend or voting rights. Upon vesting, based upon being in-service and the level of performance conditions met, all/some of the shares will be awarded. The shares are taxed at marginal rate on the value at vesting so the executive often needs to sell 45% to pay the tax. The shares are taxed at CGT after vesting if retained.
- Growth shares: the most commonly used are Share appreciation rights (SARs):
SARs are awarded to participants where the value will represent the increase/appreciation in the value of the company’s shares between award and vesting date. Being only a right to a share, there are no dividend or voting rights. Upon vesting, based upon being in-service and the level of performance conditions met, all/some of the SARs will vest with shares to the value of the growth in value of the shares being awarded. The growth in value is taxed at marginal rates on the value at vesting so the executive often needs to sell 45% to pay the tax. The shares are taxed at CGT after vesting if retained.
- Share purchase schemes
Shares are purchased by the executive and usually held in a trust or special purpose vehicle on behalf of the executives and used as collateral for a loan granted to the executive by the company. Interest is charged on the loan at the official SARS interest rate or an interest rate determined by the company. Dividends are used to service the interest on the loan and the loan is settled using short-term incentive bonuses or when the shares are sold by the executive. If the loan is interest-free, fringe benefit tax is paid by the executive on the notional interest on the loan at the SARS official rate. These share schemes have been favoured strongly by Christo Wiese in companies like Brait, Steinhoff, Pepkor and Shoprite.
- Bespoke share schemes
Shoprite’s deferred share scheme is an example of a bespoke share scheme that was put in place for a special purpose. As part of an unbundling of companies in 2000, Christo Wiese, chairman of Shoprite, was offered 265 million deferred shares (a separate class of shares with no economic value but voting rights giving him a 32.3% voting right (to prevent a take-over). The shares were issued at the time at 1c each and are held by an investment vehicle Thibault Square Financial Services. Institutional investors are unhappy that these shares have no economic value (no dividends) but command voting rights over such a large portion of shares whilst ordinary investors had to pay the full share price for the same voting rights (but they do enjoy full economic rights on the shares). The current board proposal is to replace the 265 million deferred shares, giving voting rights over 32.3% of shares in issue, with 20 million Shoprite ordinary shares (valued at R3.5 billion), with full economic value thereby reducing voting rights to 17.8% of issued stock (calculated at a share price of R175). Issues that have been raised by the investors are that the replacement ratio of the deferred shares (with a nominal value) with the ordinary shares valued at R3.5 billion is too high and the replacement ratio is skewed in his favour. It is also likely that the transaction will be funded by the shareholders through dilution and that this will need to be approved by a special resolution.
But the fact is that this is not really a remuneration issue but rather a shareholder issue. It is very important to separate management issues (agents) from ownership issues (principal) – a well-researched theory called agency theory. This bespoke scheme has very little to do with remuneration governance but rather a shareholder control and listing issue. The shares that are the subject of this transaction were acquired due to his role as a founder and transactor and not remuneration or fees for services rendered. The deferred shares were never meant to be a remuneration award and there should be records to that effect. The amount Wiese wants is at a huge premium and from a remuneration perspective Christo Wiese has already been paid for all the value he added through his normal TGP, STI and LTI as chairman. The ordinary shareholders will have to decide whether this premium (and subsequent dilution) is worth the reduction in control.
As far as the implications for Remcos are concerned, this is probably a very unique case – it is not a Remco issue but rather a legal issue around the intention of the share award and what happens if the company does not buy Wiese out. This does not distract from the increasing demand by investors for executives to hold a minimum number of shares (MSR) with full voting and dividend rights and what that level should be. There is a growing trend for executives to not be allowed to sell any vested shares and have trading restrictions placed on them for at least five years after employment at the company. In addition, South African companies are starting to enforce minimum shareholding requirements of between 200% and 500% of annual pensionable remuneration.
Why do companies use different share scheme structures?
It all comes down to trying to link the executives’ performance (and therefore reward) to company performance whilst achieving governance as set out by the Companies Act and the King IV code. There is a strong sentiment amongst some companies and institutional or major shareholders that the executives must have “skin in the game”. This is when they favour the third type of mechanism; namely, share purchase schemes. The motivation and logic behind the promotion of this sort of scheme is that the executives should be in the same position as external shareholders who have to purchase shares in the open market with their own money – either saved cash or loan capital from the banks. This means that the executives’ fortunes are tied to the fortunes of the company (through the share price only) in exactly the same way as the external shareholder.
Christo Wiese is a great proponent of this share scheme mechanism and instituted it widely in companies that he controlled like Pepkor and Shoprite. He recently told a journalist; “For me, first prize is to have top executives exposed as much as possible to the fortunes of the company. It makes me relaxed that my management and my shareholders are on the same side of the fence. We swim together, we sink together.”
Many of these schemes were characterised by executives being offered loans to purchase shares within the company. This type of scheme is risky as the executive would have to pay back the loan regardless of whether the share price adds value or becomes worth less than the initial loan that was made.
This intention is admirable if the conditions under which the executive participated in the scheme were the same as the external shareholder but this is not so for the following reasons:
- The executive participates in the scheme as part of his/her conditions of employment and is not really in a position to reject participation in the scheme;
- External shareholders seldom use debt to purchase shares in the market and if so-inclined usually use derivative mechanisms which can be hedged;
- The success of the scheme rests solely on share price performance over which the executive does not have individual control;
- Furthermore, the company sometimes stands as collateral for the loan which defeats the object of the executive having “skin in the game” since the company pays back or writes off the loan when the scheme does not produce enough value for the executive to settle the loan. This is in essence what has angered Pepkor shareholders in the Christo Wiese debacle since the company stood collateral for the executive loans for R440 million.
So the old adage of “you can’t have your bread buttered on both sides” stands. If the executives’ fortunes need to be tied to the company’s fortunes then the company cannot give collateral for the loans as the losers are all the other shareholders when it is called up. If the company does not stand as collateral then the executives are exposed to the vagaries of the share price and are not in a position to settle the loan if the share price does not perform. These executives will end up being dis-incentivised and may even become financial defaulters – not something any company would want for their executives. And in reality, there could be labour law issues for an employer to sue an executive for recovery of a loan that it essentially forced the executive to take up.
Ultimately the pitfalls of share purchase plans are that employees often don’t have resources to purchase shares in the company they work for. In most circumstances, dividends do not cover the participants’ loan interest, let alone repaying the capital of the loan. Using ‘after-tax’ remuneration is inefficient from a tax perspective for the company and employee. The company standing surety for the loans is ultimately dilutive for existing shareholders. It is taxable as income (when exercised) and not in line with King IV codes.
So how can companies avoid these downfalls but still get the executive to have ‘skin in the game’ and also align with good governance?
What if we had an executive share scheme that was not based on share price gains (over which executives have limited influence) but rather on earnings (over which executives have significant influence)? In addition the executive shares only in earnings if there is growth in earnings above a “base” figure approved by the board and Remco. If there is no growth, they have no entitlement in terms of attributable earnings. If there is growth, they will share in such growth at a higher rate than their percentage shareholding – at an accelerated rate to reward the executive for their services rendered.
In order to achieve this, a new class of shares is issued which has no immediate entitlement to participate in the after-tax earnings attributable to the company but does have voting rights the same as an ordinary shareholder. Once the earnings per share equal the earnings per share of the ordinary shareholders, then the new class of shares rank for participation purposes as ordinary shares in economic terms.
What are the advantages of such a scheme structure?
Executives are incentivised to grow bottom-line earnings as opposed to derivatives of value add. This means that the share scheme is directly dependent on company performance and not share price performance, aligning pay for performance for the first time. This means the existing and new shareholder are able to monitor the value added directly in line with King IV. In addition, the scheme has relatively simple administration, tax and compliance.
All gains from the outset should be treated as capital. This means that the cash return on incentive to participants is greater due to shares being classified as Capital. In addition IFRS 2 Share Based Payments is not applicable to the scheme.
There is a low entry value and hence any debt incurred is readily and easily repaid by the executive. In addition, if there is good growth, the dividends paid can achieve this after three to five years. The deemed interest costs are minimised, and are normally covered by dividends anyway.
Chris Blair is the CEO of 21st Century, Bryden Morton is an executive director at 21st Century.
The views and opinions shared in this article belong to their author, cannot be construed as financial advice, and do not necessarily mirror the views and opinions of Moneyweb.