In an innovative new approach to rewarding senior executives, Next Plc last year announced that its executive directors and certain other se...

In an innovative new approach to rewarding senior executives, Next Plc last year announced that its executive directors and certain other senior employees had each made a personal investment in a financial contract the success of which is based on the market price of Next shares in four years time. This article considers whether other companies may wish to consider similar arrangements.

For many years certain commentators have suggested that granting options to executives was like giving them a one way bet on the company’s share price - if the share price goes up the executive exercises the option and takes the increase, if the share price falls the executive walks away with no loss. As incentive scheme design has become increasingly complex, we have seen companies introducing all sorts of variations on the traditional option scheme in some cases trying to deal with some of the perceived weaknesses.

Changes to Option Plan Design
In addition to introducing a variety of alternative types of share incentive plans, companies have also changed the ways that they have used option plans. Some of the main changes have been as follows.

Performance Conditions
Executives could benefit from their options as a result of general share price increases rather than as a result of actual company performance. Hence, since the early 1990s an ever increasing percentage of UK listed companies have made the exercise of options subject to a performance condition. The most common performance condition for option plans being based on growth in earnings per share (EPS).

Source of Shares
As companies increased the use of share plans, many of them found that the limits on the number of shares that could be issued for the purposes of their share schemes imposed by the guidelines issued by the investor protection committees of bodies such as the Association of British Insurers (ABI) were proving problematic. In addition, although there was no accounting cost for granting options to subscribe for new shares many companies took the view that it was cheaper to buy shares in the market to satisfy options rather than to issue new shares. Hence, companies increasingly have established employee benefit trusts (EBTs) which have purchased shares in the market to satisfy options granted by the company (or the EBT itself). Some companies went a stage further and got the EBT to purchase an option from a bank to buy the underlying shares rather than the EBT actually holding the shares.

Investment by Executive
In the late 1990s we started to see companies introducing plans which required executives to make an up front investment as a condition for being granted an award. These schemes were typically introduced as an additional plan (i.e. on top of the ordinary option plan or performance share plan) and were potentially very rewarding for the participants. They were often referred to as Equity Participation Plans or Co-Investment Plans, and took a number of different forms. Examples of these included:
o Hays, which set up an Equity Participation Plan under which executives effectively paid for the grant of nil cost options
o Saatchi & Saatchi and Cordiant Communications Group which both set up Equity Participation Plans at the time of their split into two listed groups under which executives either effectively paid for the grant of nil cost options (as with the Hays plan) or they sacrificed salary in return for being granted market value options
o WPP Group which set up its Leadership Equity Acquisition Plan in 1999 under which executives could receive up to five free shares (depending upon performance) for every share acquired
o MFI Furniture Group which set up its Executive Co-Investment Plan in 2002 under which executives could receive up to two free shares and were granted market value options over a further two shares for every share acquired.

ITV has a similar plan, the Commitment Scheme, where participants can receive up to three free shares and are granted market value options over a further three shares for every share acquired.

The “Next” Approach
The approach adopted by Next appears to combine a number of the features previously seen in the plans outlined above and then adds a new twist in terms of the delivery mechanism. The following analysis is based on publicly available information.

Commercial Substance of Arrangements
Directors and certain senior executives (the “participants”) have effectively acquired instruments which, using normal share option terminology, could be described as premium priced, capped, cash settled options with the following terms:
o share price at grant - approximately £15
o exercise price of option is £20
o consideration payable on grant of £0.954
o option exercisable at the end of July 2008 at which time the option is cash settled and receives an amount of cash equal to the average share price of Next over the three months to 28 July 2008 less the exercise price (£20) but capped at £5 per option

With the exception of the Chief Executive, Simon Wolfson, for every £109 that the participants invested in the arrangements, the participant received a special bonus from the company of £50 (after tax and NIC) thus reducing the personal investment to £59. The acquisition price of just under £1 would appear to be based on the fair value of the option after taking account of the fact that any gain in excess of £5 per option is not receivable by the participant.

Legal Substance of Arrangements
The participants have had a bet with Cantor Fitzgerald on the following terms:
o the average share price of Next over the three months to 28 July 2008 will exceed £20 as a result of which the covered warrants issued by Goldman Sachs (which appear to have been written by Goldman Sachs specifically for this purpose as they have an exercise price of £20 per share and expire on 28 July 2008) will have some intrinsic value
o the cost of the bet is £0.954 per share subject to the bet of which (with the exception of the CEO) the company has provided approximately £0.52 per share
o the payout of the bet is limited to £5 per share subject to the bet
o Cantor Fitzgerald may well have hedged this bet by buying covered warrants in Next issued by Goldman Sachs.

According to the announcement made by Next, the company has no “present or future liability” in respect of these bets. Clearly there was a cost to Next of the Special Bonuses which amounted to £1.96 million (gross) in total.

Interesting Features
As explained above, a plan which requires investment by the participant and which has the potential for fairly substantial rewards is not of itself that unusual anymore even within listed companies. There are though certain features of this arrangement that are worthy of further consideration for companies considering implementing something along similar lines.

Cost of the Arrangements
The company has fixed its total costs for the arrangements at the outset (being limited to the special bonus being paid) both from a cash perspective and from an accounting perspective.
Instead of the company having a P&L charge under the new accounting rules that is spread over the life of the option, the company simply has a charge in the year that the special bonus is paid. However, if one ignores the personal investment element then the figures used above suggest that the P&L charge will be higher than it would otherwise be as every £100 of bonus costs the company (before tax) £112.80 yet only buys options with a value of £59 (i.e. bonus of £100 less income tax and NIC). In addition, the company will get an immediate corporation tax deduction on £112.80 rather than a potential corporation tax deduction on the gain in four years time. Of course, with real options the company would also have got a tax deduction on the personal investment element.

Taxation of Participants
At first glance, the company could have created an arrangement where the gain made by the participant is completely free of tax as winnings on bets are currently tax free. It remains to be seen though whether the Inland Revenue will be able to argue successfully that the participants have in fact received a “security” (within the meaning of section 420 Income Tax (Earnings and Pensions) Act 2003 (“ITEPA”) made “available by reason of employment” (within the meaning of section 421B ITEPA).

The bet will be a security if it is either a contract for differences or is a contract similar to a contract for differences. Section 420(4) ITEPA provides that a contract which is not a contract for differences is a contract similar to a contract for differences if “the purpose or the pretended purpose” of it “is to secure a profit or avoid a loss by reference to fluctuations in the value or price of property ….”. Given that such a bet would normally be treated as a contract for differences under paragraph 21 schedule 2 Financial Services and Markets Act 2000 and the wording there is almost identical to that in section 420(4) ITEPA it appears likely that the Inland Revenue would consider it to be a security for these purposes.
Bearing in mind that any individual could, presumably, take out a similar bet with Cantor Fitzgerald, it must be arguable that even if the bet is a security it was not made available by Next. One to watch.

Need for Shareholder Approval
Next have not sought shareholder approval for these arrangements presumably on the basis that the arrangements are not a long-term incentive scheme as defined by the UK Listing Rules.
A long-term incentive scheme is defined as being
“any arrangement (other than a retirement benefit plan, a deferred bonus plan or any other arrangement specified by paragraph 12.43A(c)(ii) as an element of a remuneration package) which may involve the receipt of any asset including cash or any security by a director or employee of the group:
(a) which includes one or more conditions in respect of service and/or performance to be satisfied over more than one financial year; and
(b) pursuant to which the group may incur (other than in relation to the establishment and administration of the arrangement) either cost or a liability, whether actual or contingent”.
To fall outside of this definition, Next will presumably have taken the view that either the bet is not part of the arrangement under which the special bonus was paid or that if it is part of that arrangement, that as the costs are incurred only in one financial year the second leg of the definition is not satisfied.

Other Regulatory Issues
Section 323 Companies Act 1985 makes it illegal for a director to buy a call (or put) option over existing shares in a listed company. This is why companies that use purchased shares held by an EBT always grant the option under deed rather than for even nominal consideration. Interestingly, the Companies Act does not appear to make it illegal to buy a contract for differences (where there is no right to call for the shares but simply a right to call for the cash). The Next arrangement is one step further removed as the director is simply having a bet on the company’s share price but with (presumably) the bet being hedged by the bookmaker with a covered warrant (which is effectively a contract for differences).

Next appears to have taken the view that the bet is a “dealing” by the directors for the purposes of the Model Code as Next did make a Stock Exchange announcement concerning these arrangements. Interestingly the Model Code wording is very similar to the definition of a security for tax purposes. It does not follow though, that the directors have acquired an “interest in shares” for reporting purposes.

Finally, it remains unclear how, if at all, Next will disclose these arrangements going forward. Clearly the special bonus will need to be disclosed but, if Next take the view that the company is not involved in the rest of the arrangements then it is may also take the view that any gain the participants make will not be disclosed in subsequent directors’ remuneration reports.

Conclusion
There are many reasons why a company might want to consider implementing arrangements based on the approach taken by Next. To date, there has been a fairly mixed response from commentators and no public comment from other potentially interested parties other than the ABI which has stated that it was disappointed that shareholders had not been given a chance to vote on the scheme.
In principle, there is no reason why companies should not continue to be innovative when designing arrangements to recruit, reward, and retain key executives. Simple, at least in terms of delivery mechanism, is not always best. Whether this particular approach turns out to be the next “must have” remains to be seen. However, any company wanting to do this will clearly need to tread carefully to ensure that its objectives can be met.