NED remuneration and activist attack

Activist investors are increasingly scrutinizing the composition and compensation of company boards, in particular pushing for greater alignment between non-executive directors (NEDs) and long-term shareholder interests. This drive, coupled with the ongoing hunt for top-tier talent, is bringing the issue of NED equity ownership and share-based compensation to the forefront, as activists look to internationalise practices already common in the US. 

Boards outside the US need to understand these evolving expectations in the context of the legal and cultural constraints in their own jurisdiction so that they can pre-empt potential challenges from activists.

The US blueprint: alignment through equity

In the United States, the approach to NED compensation is largely at the discretion of the board. Market forces and activist investor pressure ensure a strong focus on shareholder alignment, and US corporate boards are encouraged to offer reasonable compensation that properly incentivizes NEDs while aligning their interests with shareholders.

A key pillar of this alignment is share-based compensation. The vast majority – nearly 95% – of S&P 500 companies have director stock ownership guidelines, requiring NEDs to hold a minimum amount of company stock. Annual grants of equity awards, typically with service-based vesting, are the most common route, with companies generally allowing several years to meet the required share ownership quotas. 

Indeed, NED equity awards are typically blessed by shareholders. To protect against challenges of excessive compensation, many companies include director compensation limits (or at least the equity-related portion of it) in their equity incentive plans, as these are subject to shareholder approval. Institutional Shareholder Services, Glass Lewis and other proxy advisory firms look for the inclusion of director compensation limits when making their voting recommendations.

Proxy advisory firms, and most institutional investors, generally favor NED programs that include share-based awards on the basis that they better align the interests of non-executive directors with shareholders. This is the culture that most US activist investors bring with them when launching campaigns against non-US companies.

Europe's shifting sands: the UK example

Against this backdrop, we are beginning to see a shift in attitude in other jurisdictions. In the UK, for instance, recent Financial Reporting Council (FRC) guidance signals a move closer to US standards, more explicitly permitting the direct payment of a portion of NED fees in shares or the grant of share options (provided they are not performance-linked). Disclosure of share-based remuneration is still required, with NED independence remaining paramount.

Implementing these changes is not without its complexities. UK companies face several legal and regulatory hurdles which are likely not understood by all activists. Key among these are the Companies Act rules, where exemptions for 'employee share schemes' – for aspects such as authority to allot, pre-emption rights and financial assistance – would not typically apply to NEDs, as they are not employees. Existing shareholder-approved remuneration policies also may not permit payment to NEDs in shares, meaning policies must be amended and presented for refreshed shareholder approvals before any changes can be made. 

All of this means that the most common approach route to increasing NED share ownership in the UK so far has been NEDs using post-tax cash fees to purchase shares in the market, either through a company-assisted arrangement or independently. It remains to be seen whether the recent FRC guidance will change this practice and further popularise share-based remuneration for NEDs. 

A global patchwork: navigating diverse standards

While the drive for NED equity alignment is gaining traction in the UK, the global landscape remains a patchwork of divergent approaches, offering activists room for strategic engagement. The tension often lies between encouraging shareholder alignment and maintaining the independent, supervisory role of NEDs.

Spain’s CNMV Good Governance Code recommends alignment of directors’ interests with those of shareholders and permits share-based remuneration for NEDs provided it is transparent and strictly long-term oriented, typically through mandatory holding periods. In practice, non-executive share ownership is common among IBEX-35 issuers and is viewed positively by investors. However, the prevailing model is still that of predominantly fixed cash fees, with equity as a complementary element rather than the core of NED pay and is explicitly not encouraged to be performance-linked or variable. By contrast, the Netherlands’ Corporate Governance Code provides that NEDs should not be remunerated in the form of shares because it could impair independence and lead to conflicts of interest. But although it is not common for NEDs of companies in the Netherlands to receive share-based remuneration, there has been a recent increase in the number of companies deviating from the Code – mostly companies that are US-based and/or operate in the US markets. In Germany, share-based remuneration is also not common but where it is implemented for NEDs, it is usually done by way of ownership guidelines, which require NEDs to acquire shares in the company and hold them for a certain period of time. 

The risk of jeopardizing the independence of NEDs features in other jurisdictions. In Hong Kong, the listing rules set out factors for determining independence, and these include whether the NED receives shares or interests in the securities of the company or its subsidiaries. Rules in India prohibit stock options for independent non-executive directors (but permit them for other NEDs). 

A common theme across these jurisdictions is that share options or performance-linked long-term incentive plans are generally reserved for executive directors. Where share-based pay is used for NEDs, it tends to be “simple” share delivery linked to service, with clear caps and holding locks to preserve independence. The methods for achieving this will vary across jurisdictions depending on local tax and regulatory considerations but would usually comprise: 

• Share-settled fixed fee: Allowing or requiring part of the fixed annual fee to be paid in listed shares of the company, usually by market purchases funded with post-tax cash fees. This method is often preferred as it is considered part of the fixed remuneration and easier to defend in governance terms.
• Granting securities: Granting securities as part of the directors’ remuneration, which may require shareholder approvals.
• Encouraging open market purchases: Encouraging NEDs to invest their own cash in the market (open market purchases) and then imposing or recommending minimum holding or retention obligations in the remuneration policy or board arrangement (for example, to hold all shares received as remuneration until the end of their mandate).

Preparing for scrutiny: action points for boards

As activists increasingly target perceived misalignments in NED compensation, companies must be prepared with a compelling narrative. Many US based activists may not appreciate the different regulatory environments outside of their home jurisdiction and so companies must be able to educate them on the relevant constraints and justify their policies. 

The appropriate position for a company to take on this issue will depend on a mix of a range of factors such as the composition of the company’s shareholding base (eg US or European), the jurisdiction of incorporation, the company’s listing venue and the composition of the board (US or non-US NEDs), some of which may pull the company in different directions. 

Before an activist campaign materializes, we recommend that companies:

• Review current NED fee structures: Assess whether the company’s current remuneration packages are competitive in the market before considering an equity component.

• Understand the legal and regulatory hurdles: Understand the specific taxation, legal and regulatory constraints that apply to share-based remuneration for NEDs. Consider what structures might be used to accommodate them or if this is not possible, be prepared to articulate those constraints to an activist.

• Articulate the strategic case: Clearly define why share-based remuneration might be beneficial for the company, linking it to objectives such as talent retention and long-term alignment.

• Shareholder engagement and approval: If considering share-based pay, be ready to engage with the company’s wider shareholder base to gather support for any changes.

Companies that proactively address these issues, balancing shareholder alignment with robust governance and local legal realities, will be better positioned to withstand activist pressure.

Our global network has extensive experience advising listed companies on the interplay and conflicts between various regulatory regimes and activist expectations. Please feel free to contact your usual Freshfields contact or one of our authors for further information.