Brexit – implications for employee share plans

Fri 24 Jun 2016

Amongst the divided opinions it seems one thing can be agreed, that is the need to overcome fears, defeat indecision and avoid a hiatus limbo of non-productivity.

As we are assured, nothing changes immediately, however we think it prudent to consider what this historic decision might mean in the context of employee share plans.

In the first instance we would suggest that the need for effective retention, attraction and incentivisation of key skilled staff has never been so important. Providing those who grow productivity, agree sales with new markets, innovate and successfully navigate the uncertain commercial landscape with a reward that aligns with that performance and also supports ROI for the investors.

Of course there are those who will suffer in the short term – bank stocks and construction industry shares and other quoted securities have suffered a huge drop in value but equity should always be viewed as a longer term proposition. Share prices can go up and down and international share plans are always exposed to foreign exchange fluctuations, but current volatility is exceptional and brings its own challenges. What is needed now is a drive for resilience, creativity, efficiency, outperformance and bravery but with strong risk-management too. This is the reward framework that share plans best support.

Employee share plans are subject to a multitude of laws and this has increasingly encompassed EU regulations. In the corporate governance arena, executive pay has been under particular scrutiny by EU regulators to ensure that there should be no rewards for failure, especially in the financial services sector.

So, what are the key considerations to look at now that the UK is to negotiate a departure from the EU?

State aid – Perhaps now we can have more domestic control of our EMI legislation?

State Aid is one of the most important considerations for the majority of entrepreneurial businesses with or considering an Enterprise Management Incentive (EMI) plan. Why is that? The UK is subject to the state aid regime regarding competition law, governed by the Treaty on the Functioning of the European Union (TFEU). The TFEU regulates “aid” granted by an EU member state which, broadly, distorts or threatens to distort competition by favouring certain undertakings over others.

EMI is the most popular share plan arrangement in the UK and confers very generous tax reliefs (which are regarded as aid) to small and medium enterprises (less than 250 employees and less than £30m gross assets). Certain trading activities are precluded when determining eligibility for EMI. EMI is therefore selective in terms of the businesses who benefit (in addition to being discretionary in terms of participant awards). As a result, whilst the UK is in the EU any change that the UK government wishes to make to the EMI legislation first requires consideration and approval from the European Commission (such approval had to be sought each time the government wanted to increase the individual participant reward limit.)

The EMI regime relies on continued approval from the European Commission and it was such EU regulation that imposed a 250 employee limit.  EU State approval for EMI expires in April 2018, at which point the UK would have needed to negotiate an extension. This now seems less of a concern and perhaps Brexit will mean the UK government will be able to extend and further enhance such incentives to further attract high growth entrepreneurial business and skilled talent to the UK? This would seem to be welcome news.

Malus and clawback – A feature most relevant for quoted companies and those with institutional investors looking for good corporate governance behaviour

The introduction of malus and clawback provisions have been required more and more by shareholder groups due to concern that executive equity awards were not sufficiently risk-managed and poor board performance did not adequately curtail pay. The institutional investor and regulatory aim has been to cap bonuses and defer compensation to link pay to longer-term performance (increasingly with calls for a 3 year equity vesting period followed by a 2 year holding period – so a 5 year reward term in total where shares are awarded to executives under discretionary equity plans).

Financial services is the sector that has been hit hardest in this regard. The Financial Conduct Authority (FCA) unsuccessfully challenged the bonus cap through the Court of Justice of the European Union (ECJ). With the UK now leaving the EU the cap could, in theory, be scrapped. That might now be necessary as a sop to appease the banks. We’ll have to wait and see what the Chancellor does about that in due course.

European regulation only requires financial services companies to introduce malus and clawback, in the UK but the UK Corporate Governance Code provides that all UK listed companies (not just those in the financial services sector) must adopt malus and clawback rules, or explain to shareholders why they do not consider them to be appropriate. Given that these concepts have now become entrenched in most remuneration policies and represent best practice for corporate governance we would hope to see such provisions included in Long Term Incentive Plans (LTIPS) and executive remuneration plans post Brexit.

Securities laws – Will you now need a prospectus to offer shares to employees?

The most basic of share plan concepts, the grant of options and awards, is subject to EU prospectus rules. This frequently comes as a surprise to entrepreneurial businesses who are just taking their first tentative steps to operate cross-border.

There is a single legal regime throughout the EU for this which provides a set of exclusions and exemptions to enable plans to be operated across the EU without the tortuous and expensive requirement to produce a prospectus. In the UK there is currently an automatic exemption for any share offers in the UK to UK employees under the auspices of an employee share scheme but the matter is more complex where equity awards are to be made internationally.

Companies based outside the EU cannot necessarily take advantage of all the EU prospectus exemptions. As such, UK companies with employees across the EU may now find themselves subject to more onerous requirements than their EU competitors. This could make it harder and more costly for them to extend their share plan arrangements more widely. Again, we will have to see what can be negotiated but we expect to be providing more detailed advice in this area in the future.

Conversely, there is also the question of whether, outside the EU, the UK will become a problematic territory for overseas companies to extend their share plans into. Certainly there is a risk of a non-UK parent (eg US headquartered issuing entity) finding the process more onerous and expensive and choosing not to extend its global share plans to UK-based employees. This would be very disappointing and we must hope that the Chancellor is alert to this risk and steps up to create a supportive framework post departure from the EU.

Age discrimination – The generation matters

The Brexit voter age related poll results by @YouGov made interesting reading and evidenced a clear divide between younger (remain) and older (leave) voters. The Equality Act 2010 (EqA 2010) implemented the age aspects of the Equal Treatment Framework Directive (2000/78/EC) (the Framework Directive), prohibiting (amongst other things) direct and indirect age discrimination and this is something that is a consideration with share plan design to ensure a company is not discriminating by reference to age. In particular, in considering any qualifying period of employment, it is important to ensure the requirement does not unduly restrict the ability of certain age groups from being able to participate, unless objectively justified. Similarly, in determining whether an employee leaves by reason of “retirement” (and therefore is a good leaver), the interpretation of that rule should be assessed in a consistent manner, without reference to age.

If, in the case of a dispute, an employee plan participant claimant argues that the EqA 2010 is incompatible with the Directive, the tribunal or a higher court could decide to refer the matter to the ECJ for clarification.

Whilst it is unlikely that the basic principles around age discrimination will change following Brexit, without reference to the ECJ, UK courts will have more freedom to make independent determinations on points of interpretation. In addition there will obviously be an opportunity to review the EqA 2010 as it stands today, with the possibility that some changes will follow irrespective of whether there is any conflict with the Framework Directive.

‘Be careful what you wish for’ is the adage that now springs to mind when looking at the votes delivered by the grey pound demographic.

Share dealing rules – Will MAR be short-lived?

Companies listed on the London Stock Exchange are subject to strict rules and standards, principally through the Model Code that regulate when their directors and other senior managers are permitted to deal in shares and the clearance process that must be followed. In respect of share plans, this includes the grant and exercise of options and any subsequent sale of shares.

These rules are already subject to change with effect from 3 July 2016 as a result of the UK’s implementation of the Market Abuse Regulation (MAR). Under current proposals, the EU-driven changes potentially bring more uncertainty into how the requirements can be satisfied, doing away with the Model Code altogether. Perhaps now UK companies will continue with their current practices but any enforced EU changes may be short-lived with the UK reverting back to current rules and practice as soon as it is legitimately possible.

Disclosure of directors’ remuneration – How transparent will this now need to be?

Since 2013, UK listed companies have produced a remuneration policy that is approved by shareholders and an implementation report (describing how the policy has been applied) to be subject to a shareholder advisory vote. European regulation has previously not followed such a rigorous approach, although EU-wide “say on pay” rules are expected to be introduced later in 2016, through the European Shareholder Rights Directive. This would require similar voting requirements as provided under UK law, although some elements might not be as stringent.

Given the domestic drive for better corporate governance and transparency, as far as directors’ accountability on remuneration is concerned we would anticipate this will remain broadly level as between the EU and the UK post Brexit.

Market volatility

Nervous financial markets can lead to abnormal share price volatility and this too can impact share plans for quoted companies. Volatility is one of the variables considered when calculating the accounts reporting P&L charge under IFRS 2 for share option awards (so may also impact private companies looking to quoted company peer comparators for this purpose). The greater concern perhaps lies however in relation to LTIP performance metrics and share allocations under all-employee plans Save As You Earn (SAYE) and Share Incentive Plan (SIP). With SIP a lower share price may lead to more shares being allocated to employees in respect of Partnership Share purchases and corresponding Matching Share awards. A closer eye may need to be kept on dilution limits as a result.

December and March are often key times for new equity awards and vestings so we shall see to what extent the markets recover later in the year but there must currently be a fair number of share option awards just plunged underwater. Perhaps those with nil cost Restricted Stock Units (RSUs) vesting will fair best this year but few would be brave enough to make any firm prediction whilst markets are so sensitive.

Data protection – The legal fine print

The operation of share plans naturally involves a flow of employee personal data between employing entities and any third party plan administrator. Currently, such data can be freely exchanged within the EU. As data processors, in our role as employment related securities agent supporting companies with share plan annual compliance return filings in the UK, we are very mindful of this and currently have more stringent policies in place for transferring and receiving such data to/from outside the EU.

The European Commission would have to rule that a post-Brexit UK provides an adequate level of protection for the rights and freedoms of data subjects. Without this ruling, employee data could not be exported from the EU to the UK without finding another lawful way of doing so, such as obtaining express consent or through model clauses, which would involve additional administrative burden.

Conclusion

We may see, in a few years’ time, some very welcome changes to EMI. Meanwhile there is unlikely to be any immediate significant change in how companies approach the design and compliance of their share plans and remuneration arrangements.

Whilst there may be some operational and regulatory considerations to take into account, it would be expected that as part of the process of and discussions around withdrawing from the EU, the UK government will seek to ensure UK businesses are able to compete to attract and retain the best global talent.

For more information contact Liz Hunter of the Mazars Share Schemes team.