Proper Share Scheme Adjustment

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In the past year average earnings rose 2.1% whilst top directors pay rose 14%. This was  due to windfall gains from Long Term Incentive Schemes( LTIPs) (Financial Times  17/11/13 article by Brian Groom), . LTIPs have been a growing and a most significant part of Directors total remuneration.

The chart comes courtesy of the Manifest/ MM&K Executive Director Total Remuneration Survey  September 2013 Update. The chart is based on estimates of the fair value of awarded LTIPs and Options, not the realized value which has tended  to be much higher, partly for reasons given in this paper.

LTIPs and Share options are the share incentive schemes being discussed here but it also includes some deferred bonuses where these take the form of a promised future share. It is my contention that the size of the incentives in these schemes is often being fiddled in a way that gives their holders more than was ever intended.

The incentive in most  such schemes is the promise of future shares in a company. The promise is conditional on meeting performance targets and in the case of share options, paying an option price. Schemes need adjusting to ensure the incentive is not changed by circumstance. That can happen in two ways, by changing the number of issued shares, and by changing the future value of the company.

The value of promised shares increases when the number of  issued shares are reduced by a share consolidation. This is because the promised shares’ share of the company ownership is greater. The opposite happens if the number  rises through a bonus allocation. To keep the promised share value the same, the number of promised shares must be adjusted in line with the changes to the issued shares.

The value of a company is diminished if money is taken out of it and given to shareholders. So too is any incentive based on a promised share of the future ownership. If this were not expected by the share scheme, the value of the incentive can only be maintained by a financial adjustment reflecting the capital return that had been given to shareholders.

The proper adjustment of share schemes following circumstances like these keeps the incentive the same, whatever the future share price. It is a neutral adjustment. The principle is simple. The adjustment is like for like.

Concerning Share Consolidations

This is not how share schemes are often adjusted. When capital is returned to shareholders it is usual to make  the adjustment by consolidating the shares in issue but not what is promised in share schemes. This  non neutral adjustment enhances the value of share schemes. Particularly common are share buybacks followed by share cancellation. They are no different although they may seem so (See Share Buybacks ).

Companies rarely admit to enhancing their share schemes, but say instead that:

  1. they have to consolidate their shares after giving shareholders a capital return, to maintain the value of their share schemes, and that
  2.  buybacks are as much a benefit to shareholders as they are to the share scheme holders.

Generally these companies could have made a like for like adjustment, but choose not to do so.

A recent example is the 76.7p per share capital return by Invensys Plc followed by a 4 for 5 share consolidation which shareholders agreed to on the 10/6/13. To end speculation it was announced on 11/7/13 that Schneider Electric SA had offered to buy Invensys at an indicative price of £5.05 per share.  Invensys directors said they would recommend. acceptance. They refused to say whether they knew this offer was likely when seeking shareholder acceptance of the share consolidation the month before. Because share schemes were not consolidated along with the shares, the value of the schemes (using a final price of £5.02) will have been enhanced by a factor of

(5 x 5.02) ÷ (4 x 5.02 + 5x .767) = 1.05

This is a 5% enhancement.  Changing what is actually promised in Invensys tax approved share schemes needs HMRC approval. Invensys claims, without giving any reason, that HMRC would withhold such approval had a proper neutral adjustment been proposed. for these schemes.  HMRC refuses to either confirm or deny, saying it is not their responsibility to comment.

5% additional shares gives  some scheme holders a modest extra £100,000. But one gain can compound another to make scheme enhancements much more significant.  Mitchells & Butler (M&B) 2003 share schemes provide such a case study ,with an estimated gain of between 34% and 44%.

Concerning Rights & Placing Offers

The proper adjustment following  a rights issue  or placing and open offer becomes a little more complicated. (See Rights & Placing Offer . At issue is whether shareholders are sold new shares on the cheap because the offer price is below the previous market price. If they are ‘on the cheap’ the company’s value is being diminished by the sales’ discount given to shareholders. On the other hand the offer price has to fall below the previous market price in order to sell more shares. So there is an element of judgment in assessing the true price discount.

 Current practice usually judges the discount by the way that the share price falls as shares go from cum-rights to ex-rights. For this purpose you use the very last cum-rights day price. To allow for the relative size of the rights issue, the adjustment is made using the Theoretical Ex-Rights Price (TERPs) formula.

The practice is not rigorously applied. In the case of the 5th June 2009 Lloyds Bank Placing and Compensatory Open offer (Price 38.43p) the cum-rights price of 100.3p was chosen from the day (19th May 2009) before the market knew there were any rights attaching to the shares. Choosing that price cannot measure what the market was willing to pay for a cum-rights share. If the last possible day (29th May 2009) had been used, the assumed cum-rights price would have been 68p. So it was assumed the shares were sold to shareholders at a discount of 61.9p off the market price instead of 29.6p which usual practice would have required.  

We can see the difference, the higher discount made in the following calculations using the TERPs formula, and taking note of the fact that for every 100 shares, shareholders were allowed to subscribe for 62.13 shares:

1. Adjustment Factor assuming  cum-rights price of 100p

100÷((100x100+62.13x38.43)÷(100+62.13)) = 1.31

2. Adjustment Factor assuming  cum-rights price of  68p

68÷((100x68+62.13x38.43)÷(100+62.13)) = 1.20

The difference is that Lloyds Bank scheme holders were given 11% more promised shares.

In a placing and open offer, shareholders get no compensation for not subscribing. A good reason for this is that the offer price is the market price for the shares. If so,  there is no discounted share sale to compensate for. But if that were true for non-subscribing shareholders, it also ought to be true for share schemes. Not so! In the past share schemes were adjusted. In 2004, Invensys reports enhancing their share schemes by 3.38% after a placing and open offer  (See Invensys 2004 Annual Report Page 21) . By contrast in 2009, the compensatory TERPs adjustment was not applied by Royal Bank of Scotland (RBS) following their 2009 placing and open offer. RBS said it would be unfair to promise scheme holders bonus shares when non-subscribing shareholders got nothing. This was RBS’s own decision. The Treasury refused to express any views on the adjustments the Lloyds Bank made to their share schemes following placing offers and rights issues despite the fact they make the rules and are a major shareholder. (See .)

Most rights and placing offers are underwritten by financial institutions who guarantee to buy up whatever cannot be sold at the rights/offer price. In bargaining with the company, the underwriter will be expecting that his underwriting fees will cover the cost of disposing of unsold shares - the difference between the expected market price and the rights/offer price. The bargain with the company  involves trading off a lower fee for a lower rights/offer price. It may also include the cost of measures to influence market prices to make the rights/offer seem more attractive.   

Authorities’ Reactions

HMG  (See ) and the International Accounting Standards Board (IFRIC committee) ( See IFRS 2-5 November 2006) do not deny the enhancing nature of the adjustments being made, but both have excused themselves from intervening. It is sometimes suggested that the share scheme rules approved by shareholders allow enhancing adjustments. The model rules provided by HMRC for tax approved share schemes  makes no such suggestion. It is left to auditors  to decide what adjustments are fair and reasonable (See section 6.8 of the specimen rules set out in HMRC’s Essum 47910).

HMG’s attitude is the most puzzling. They have the power to set the rules for HMRC tax approved share schemes and their declared aim  is that the adjustments are not enhancing (See Inland Revenue letter dated 25/3/2004 at ). Government so far has refused to set out any prescriptive rules and practice is often not following the policy. Government professes to see the need for pay transparency. Their failure to set out clear adjustment rules makes it easy for companies to claim that their enhancing adjustments must be alright since they have HMRC approval.

In answer to a letter, the Government claims that shareholders have been effective regulators of companies and that they have received little evidence that shareholders can’t themselves deal with the issues of share scheme adjustments. (See  )

For more details go to Authorities Reactions .