Credit crunched: executive pay across Europe

Practical Law UK Articles 6-384-2854 (Approx. 13 pages)

Credit crunched: executive pay across Europe

by Simon Evans and Carly McIver, Freshfields Bruckhaus Deringer LLP

Corporate governance principles

Most European countries have already adopted corporate governance codes or transparency regulations which, among other things, address executive pay. These codes aim to ensure that board success is monitored and directors are rewarded fairly.

UK

The Combined Code on Corporate Governance (the Combined Code) is issued by the FSA and provides a set of principles of good corporate governance, including key points relating to remuneration (see box, UK’s Combined Code: key remuneration points).

The Combined Code applies the “comply or explain” principle (see box, Comply or explain). There have been no fundamental changes to the Code since 2003.

While the Combined Code does not itself have legal force, breach of the “comply or explain” principle may amount to a breach of the Listing Rules. As a result, companies and directors can be censured, fined or have the company’s listing suspended or cancelled.

The Combined Code is supplemented by best practice guidelines issued by several institutional shareholder organisations. These guidelines, which are more detailed than the Combined Code, seek to assist remuneration committees in developing remuneration structures. The main guidelines are issued by the Association of British Insurers (ABI), the National Association of Pension Funds (NAPF) and Pensions Investments Research Consultants (PIRC). The guidelines inform the voting recommendations of institutional shareholders on remuneration matters.

France

The French Commercial Code incorporates the main corporate governance principles. It has operated in this form since the mid-1980s. Failure to comply with the Commercial Code may result in criminal and civil liability in certain circumstances. This applies to both listed and non-listed companies.

The Commercial Code is supplemented by best practice guidelines issued by the Association of Private French Enterprises (Association Française des Entreprises Privées) and the French Enterprises Movement, the largest union of employers in France (Mouvement des Entreprises de France) (AFEP-MEDEF), as well as the French market authority (Autorité des Marchés Financiers) (AMF). While not mandatory, the recommendations of the AFEP-MEDEF can carry considerable weight.

Guidance issued on 6 October 2008 has updated the AFEP-MEDEF recommendations. The main features of the new recommendations are:

Separation of roles. An individual should not simultaneously hold a corporate office and an employment contract.
Strict supervision of “golden parachutes” (termination payments). This type of payment should:
- only be authorised in the event of a forced departure;
- be linked to a change of control or strategy; and
- not exceed two years’ fixed and variable remuneration (see “Executive service contracts: planning ahead”).
It should not be made if an executive:
- has left the company of his own volition;
- has merely changed functions within the group; or
- will shortly be able to exercise his pension rights.
Treatment of “performance shares”. Employers should issue additional rules regulating the subscription and acquisition of shares and the allotment of performance shares (shares granted to executives if certain company-wide performance criteria are met).
Fuller reporting. There should be greater transparency in all elements of the remuneration of a company’s chairman, managing director and deputy managing directors.

These recommendations have strong governmental support. Therefore, businesses are likely to adhere to them voluntarily, although the government envisages introducing a bill in 2009 if employers fail to implement the recommendations.

Germany

The corporate governance framework for listed companies is contained in the German Corporate Governance Code. The authority in charge of ensuring that the principles of the Code are correctly applied is the Corporate Governance Code Commission. The Code applies the “comply or explain” principle. It was last amended in February 2002.

The main features of the Code are:

Monetary compensation elements of an executive’s remuneration package. An executive’s remuneration should consist of both fixed and variable elements. The variable elements should include one-off and annually payable components linked to business performance, as well as long-term incentives containing risk elements. The supervisory board is responsible for approving board pay.
Cap on severance payments. Severance payments should not exceed two years’ remuneration. The cap is based on the total remuneration for the previous financial year and, if appropriate, the current year. This recommendation was upgraded from a non-binding suggestion in August 2008. Therefore it only applies to new service contract (entered into after August 2008) and it is now subject to the “comply or explain” principle.
Compliance statements. While the Code is generally non-compulsory, under the German Stock Corporation Act listed companies must publish a compliance statement explaining whether they have or will comply with the Code’s recommendations.

There is a limited exception enabling companies to avoid individual disclosure (see below, Disclosure obligations, Germany).

Although there is no regulatory sanction for breaching the Code, it is possible to bring an action against the company and/or its board members if it can be proved that the company suffered financial loss as a result of a failure to disclose relevant information.

The Netherlands

The Dutch Corporate Governance Code is the source of the main corporate governance principles, and it applies to listed companies only. The Corporate Governance Code Monitoring Committee is responsible for the correct application of the Code. The Code, which applies the “comply or explain” principle, has operated in this form since December 2003.

The main features of the Code are:

Promoting good shareholder relationships. The remuneration structures should promote the company interests in the medium to long-term, and should not encourage management board members to act in their own interests to the company’s detriment.
Variable income. Variable income should be linked to performance targets, which should be tested over the short and long-term.
Vesting of share awards and options. Strict vesting periods and demanding performance conditions should apply to the grant of free shares. Free shares should only vest on the achievement of targets, and should then be held for at least five years, or until termination date. Options should only be exercisable after a minimum three years’ vesting period, and if performance targets have been met. The exercise price should not be lower than the market value at grant.
Cap on severance payments to board members. Generally, severance payment should not exceed one year’s salary. If a company pays more, the annual report must justify this non-compliance.

Spain

The Unified Spanish Corporate Governance Code contains recommendations for the good governance of listed companies. It adopts the “comply or explain” principle, and was last updated in 2006. The Securities Market Commission is charged with supervising the application of the Code.

The main features of the Code are:

Restricting use of shares as remuneration. Remuneration comprising of shares, share options or other share-based instruments should be limited to executive directors.
Using safeguards in variable compensation. Remuneration policies involving variable compensation should include technical safeguards to ensure they reflect the professional performance of the beneficiaries, and not simply the general movements of the markets.
Shareholder vote. The board of directors should submit a report (on an advisory basis) on the directors’ remuneration policy to the general shareholders’ meeting.

Disclosure obligations

Extensive disclosure obligations support and reinforce the “comply or explain principle” in all jurisdictions, although only a minority of them require employers to secure shareholder approval of remuneration levels by subjecting the remuneration report to an advisory shareholders’ vote.

UK

The Directors’ Remuneration Report Regulations require companies to disclose the remuneration policy for directors of listed companies, and the main details of each director’s package in an annual Directors’ Remuneration Report (DRR). This requirement has been in force since 2002.

The DRR must include specific information concerning an individual director’s remuneration, including:

Details of each director’s service contract, including details of the compensation payable to the director on early termination of his employment.
The total amount of salary and fees, bonus and benefits received in the previous financial year.
The total number of shares under option at the start of the financial year, the total number of shares granted or exercised during the year and the total number of shares under option or award at the end of the financial year, and full details of exercised options.
Details of share option performance conditions.
Equivalent details for any share awards.
Details of accrued benefits under a defined benefit pension scheme.
Details of actual termination arrangements.

Under the Regulations, the DRR must be put to a shareholder vote. Despite being only an advisory vote, failure to secure shareholder approval is a serious matter that can amount to a vote of no confidence in the company’s remuneration committee.

France

The French Commercial Code requires listed companies to disclose the aggregate remuneration and all other benefits paid to the directors, chairman, managing director and deputy managing directors (together, the executive directors) during the year covered by the company’s annual report.

The report on internal control and corporate governance must also include details of:

The composition of the board of directors.
The conditions of preparation and organisation of the work undertaken by the board of directors (in particular, allocation of tasks to the various members of the board).
Any internal control and risk management procedures adopted by the company.
Principles and rules approved by the board to determine the remuneration and any advantages in kind granted to executive directors.
Any corporate governance guide used.

The report must also describe the remuneration and benefits paid to each individual executive director. It must distinguish between the fixed, variable and exceptional elements that make up the remuneration and benefits, as well as the criteria used to calculate them and the circumstances giving rise to them.

In addition, the company is required to disclose any specific commitments in favour of its executive directors relating to elements of remuneration, compensation or benefits payable, or likely to be payable, when taking up or ceasing their functions for any reasons. This includes not only severance payments but also “golden hello” payments (a one-off payment made at the start of a new job). Except in very limited circumstances, such payments and commitments are potentially voidable if they are not disclosed in the annual report.

Germany

The German Commercial Code requires all companies to disclose the aggregate remuneration of their board members in the company’s annual report.

Listed companies must disclose the remuneration received by the management board, specifying each member’s name and remuneration details. This includes a breakdown of:

Remuneration’s fixed, short-term and long-term variable elements.
Stock options.
Pensions.
All other existing benefits, such as third party compensation or benefits in the event of early termination or a change of control.

Despite the general requirement to publish a compliance statement (see above, Corporate governance principles, Germany), disclosure of individual remuneration can be avoided if 75% of shareholders pass a resolution to this effect at the shareholders’ meeting.

The Netherlands

Under the Corporate Governance Code, limited companies must publish a report on the remuneration paid to managing board members on their websites. The company shareholders must approve directors’ remuneration in advance, and the supervisory board must seek shareholders’ approval before it can adopt option and share schemes.

The disclosure obligations relating to public companies are far more onerous. Public companies are under an obligation to disclose the amount of remuneration paid to current and former board members during the relevant financial year. The report must include details of:

Periodically payable remuneration plus profit-sharing and bonus payments.
Deferred remuneration.
Severance payments.
Loans, advance payments and guarantees.
Share option rights in the company or its subsidiaries.

Details of each director’s remuneration package, specifically fixed salary, and structure and amount of variable remuneration including performance criteria, redundancy and pension arrangements should be published on the company’s website, or at least made available for shareholders’ inspection after they have been finalised.

Spain

Listed companies must prepare a yearly corporate governance report. The report must disclose:

The aggregate remuneration of directors.
The number (but not the details) of golden parachutes entered into with directors and employees.
A description of any transactions between the company and related parties.
The procedure for determining the directors’ remuneration.
The main clauses of the by-laws describing the procedure for determining directors’ remuneration.

The annual financial report must include a breakdown of the individual remuneration paid to directors, including details of:

Total remuneration.
Shares, share options or other share-based instruments.
Relationship between the remuneration paid and the company’s profits, or some other measure of enterprise results.

The supervisory board of a listed company must provide the Securities Market Regulator with details of:

Any director’s remuneration structure which is related to the price of the company’s shares.
Any transaction involving company shares (or financial instruments which are underlying the shares) carried out by a director.
The aggregate number of voting rights held by each director.

Legal constraints on executive pay

In each jurisdiction, the corporate governance framework is supplemented by legislation that has a direct or indirect impact on executive pay. This includes, for example:

Legislation requiring shareholder approval for lengthy contracts for directors or termination payments with an ex gratia element.
Legislation denying a corporate tax deduction for excessive termination payments or non-performance related pay.

More generally, all countries have a core corporate law principle that directors should act in the best interests of the company and should be aware of or avoid conflicts of interest.

In addition, most countries have a statutory framework for the disclosure of directors’ remuneration and benefits on an individualised basis. This is often loosely based on the UK’s Directors’ Remuneration Report Regulations which, in turn, formed the basis of a draft EU Directive.

UK

Several areas relating to directors’ remuneration require shareholder approval:

Following recent company law changes, shareholder approval is now needed for a director’s service agreement exceeding two years in duration (or with a compensation commitment exceeding two years). Previously, the relevant period was five years. In any event, the legislation is no more than a safety net, as such contracts would be unusual in light of governance standards.
If a director is terminated, shareholder approval is needed for any payment relating to termination (whether as director or employee), save to the extent that it represents a contractual entitlement (or damages in lieu of such entitlement) or a pension in respect of past service. In practice, it is rare for a company to need to obtain approval since the termination payment normally reflects a contractual entitlement of the director.
Other company law and Listing Rules provisions are designed to regulate the transactions between company and director, including a need for shareholder approval for substantial property transactions with directors.

As a separate matter, listed companies must obtain shareholder approval:

Under the Listing Rules, for long-term incentive plans (including share, option and cash-based plans) in which a director participates.
Under the Companies Act, for the Directors’ Remuneration Report.

Where a new long-term plan is proposed, there is a degree of duplication between the DRR resolution (approving the remuneration policy of the company, of which the plan is part) and the specific resolution relating to the new plan.

There is no statutory cap on the amount of pay that can be deducted for corporate tax purposes, or on the salary an executive director may receive. A corporate tax deduction is generally available for gains on share options and awards.

France

Under the French Commercial Code, the shareholders at the general shareholders’ meeting must approve the remuneration of directors. The amount of pay is determined yearly, and it is entirely at the shareholders’ discretion. Directors’ remuneration must be fixed, excluding any indexation. The allocation between directors is decided by the board.

The board of directors determines the remuneration of executive directors. The board can also grant exceptional remuneration for missions or mandates conferred upon individual directors.

Under French case law, benefits and severance payments granted to certain executive directors in both listed and non-listed companies can be considered null and void if they are so disproportionate in relation to a company’s financial situation that these directors could no longer be dismissed without notice, compensation and grounds for dismissal.

Both the company and board members can be convicted of the criminal offence of abuse of corporate assets if the courts deem a payment excessive in light of the company’s financial circumstances.

There is currently no cap on the amount of pay that can be deducted as a business expense for tax purposes, or on the salary an executive or managing director can receive, provided the remuneration is not disproportionate to the services actually rendered to the company.

However, in the last year the French government has sought to restrict termination indemnities (golden parachutes) by introducing the so-called TEPA law. The TEPA law prohibits the award of any deferred compensation or indemnification to corporate officers of listed companies, payable on termination or loss of their office or later, unless such award is conditional on the achievement of performance objectives.

Parliament is also considering several additional provisions to limit the award of golden parachutes. The new provisions focus on the tax and social security treatment of such indemnities, and have been included in the draft finance and social security bills for 2009:

The draft finance bill provides that listed companies will only be entitled to deduct termination indemnities for tax purposes up to a limit of EUR200,000 (about US$252,000). Any amount exceeding this sum will no longer be a deductible expense. This restriction was included the draft 2008 finance bill, but was deleted by the senate before the final vote.
The draft social security bill provides that termination indemnities exceeding EUR1 million (about US$1.2 million) will be subject to social security contributions in full. Currently they are exempt from social security contributions up to EUR200,000 (about US$252,000), whatever their total amount.

Germany

There is no specific legislation in Germany on the amount of pay packages or severance payments, or on the terms of service contracts. However, the Stock Corporation Act provides that the total remuneration of an executive director must be kept in “appropriate relation” to the director’s tasks and the financial situation of the company. The meaning of “appropriate” has yet to be considered by the courts.

An approval of excessive payments can also be a serious criminal offence under the Criminal Code if a supervisory board is found to have breached the fiduciary duty owed to the company.

There is no cap on the amount of pay that can be deducted as a business expense for tax purposes, but this is currently under review.

The Netherlands

Shareholder approval is required for a listed company’s remuneration policy and for the introduction of share and option schemes. Implementation of the policy is the responsibility of the supervisory board.

There is no longer a corporate tax deduction for stock options gains. However, there are no restrictions on the deductibility of executive pay. The Dutch government has recently put forward further tax measures (see below, Government intervention, The Netherlands).

Spain

Shareholder approval is required for the remuneration of managing board members, which must be in accordance with the company’s by-laws. The general shareholders’ meeting must approve any benefits, including the grant of shares or share-based instruments.

Remuneration involving a stake in the profits can only be deducted from the company’s profits for the relevant financial year. In addition, this type of remuneration is only payable if the company:

Has established the mandatory accounting reserves provided by the applicable regulations and the company’s by-laws, if any.
Has agreed to pay a dividend of at least 4% to its shareholders, unless the by-laws set a higher minimum dividend.

There is no cap on the amount of remuneration which can be deducted for tax purposes.

Severance payments are subject to the same restrictions as those provided by the Unified Spanish Corporate Governance Code in relation to ordinary compensation.

Although there is no specific criminal offence in relation to excessive payments to board members, directors can incur liability for misappropriation of assets or disloyal management if acting in their own interests to the detriment of the company or shareholders.

Current reforms

Remuneration packages for directors have been seen as a contributory factor to the current financial crisis and, not surprisingly, there has been much commentary on whether governance structures on executive pay should be improved:

At the EU level, the Council of the European Union has published a report on its Conclusions on Executive Pay.
Governments worldwide have introduced, or are planning to introduce, measures designed to restrict executive pay packages and bonuses.
Some regulators, such as the FSA, have issued statements clarifying their position on the remuneration of high earners.

EU initiatives

The Council of the European Union published its Conclusions on Executive Pay report on 7 October 2008. Seeking to address concerns over the level and structure of executive pay following exponential pay growth in recent years, the report questioned the adequacy of performance conditions and the role of shareholders in controlling remuneration.

The report set out four high-level objectives:

The governance framework should be conducive to an effective control of executive pay by shareholders.
Performance should be properly and comprehensibly reflected in all areas of executive pay. This includes leaving payments (golden parachutes), which should link the contribution of the executive to the company’s success appropriately.
Performance criteria should be structured to provide the right incentives to management.
Care should be taken to prevent potential conflicts of interest for executives conducting mergers and acquisitions.

The Council recognised that while a company’s shareholders and social partners have responsibility for determining pay, national authorities must also contribute by defining an appropriate regulatory framework, encouraging good practices and promoting voluntary self-regulation.

Government intervention

Mirroring the Council’s recognition of the role of national authorities, as well as US legislation, governments worldwide have sought to curb excessive remuneration at banks as the price of stabilisation of the banking sector. The restrictions on pay are aimed at avoiding the politically unacceptable, and illogical, result of bail-out money being used to pay bonuses.

In the UK, where Prime Minister Gordon Brown has previously spoken of wishing to avoid rewarding poor performance, banks accepting bail-out money have been subject to fetters on bonuses this year, and departing directors did not receive their contractual compensation entitlements. The new atmosphere is encapsulated in the following statement from the fundraising circular issued by the Royal Bank of Scotland Group PLC:

The Board expects to be fully engaged with peers and the authorities in developing its approach to compensation in the financial services industry whereby remuneration is linked to long-term value creation. No bonus will be awarded to any Board member for the 2008 financial year and any bonuses earned in 2009 will be paid in restricted shares. Any Board members who leave the Company will receive a severance package which is reasonable and perceived as fair.

Similar conditions were applied to banks receiving financial help in France. The President, Nicolas Sarkozy, underlined the point that any institution receiving guaranteed lending and capital injections under the EUR320 billion (about US$403 billion) rescue package would be subject to pay restrictions.

The German government has announced similar plans as part of the Financial Market Stabilisation Act. In the event of recapitalisation, a fund may require that bonuses will not be permitted and remuneration above EUR500,000 (about US$629,000) may be capped. Economics Minister, Michael Glos, has also encouraged executives to forego bonuses.

In The Netherlands, it has been recommended to impose greater governance restrictions on executive pay as part of their banking rescue plan. Although criticised by the Council of the State, the government has proposed taxation measures with respect to remuneration and severance payments, and is seeking to broaden and support the existing Corporate Governance Code. It is thought that these measures will come into effect on 1 January 2009.

In Belgium, the Prime Minister announced in October 2008 that he was planning to introduce a cap on severance payment for CEOs by amending the Code for Companies. On 7 November 2008, the Council of Ministers adopted two government bills proposed by the Minister of Justice.

The first bill introduces a mandatory declaration on corporate governance, a remuneration report and a remuneration committee.
The second bill envisages a cap on severance payments for listed companies, corresponding to a maximum of 12 months of remuneration, unless the individual’s seniority is in the range of 20 to 25 years, in which case the cap would be increased to between 15 and 18 months. The cap would apply to executive directors, members of the executive committee and directors responsible for the daily company management, irrespective of their employee or self-employed status. It is intended to be a catch-all for all termination indemnities received by the individual in the 12-month period following termination (for example, severance payment or non-compete provision).

These rules would apply to contracts terminated after the new law comes into force.

Greater regulatory pressure

The governmental response, which has been mainly directed at boards, has been mirrored by vigorous pronouncements by some regulators, focusing on the remuneration of high earners below board level. Leading the field has been the UK’s FSA. A statement outlining the FSA’s position on remuneration policies was issued in the form of a letter to the CEOs of the UK’s largest banks.

In the letter, the FSA outlined what it perceived to be “good” and “bad” remuneration policies, and stressed the importance of aligning remuneration policies with sound risk management systems and controls. The FSA makes it clear that it has no wish to become involved in setting remuneration levels. The main criteria are as follows:

Bonuses should be calculated on profit rather than revenues. They should be based on an economic capital calculation, which takes account of appropriate risks (in the context of the firm’s risk appetite).
Bonuses should be based on a moving average of financial results (not just a single financial year), with a suitable link to deferred compensation.
Bonuses should not be based solely on financial performance, but should take into account other measures such as risk management skills and adherence to company values.
There should be a higher fixed component of remuneration, and payment should not be wholly in cash (for example, using options and shares).
Payment of a major proportion of the bonus element should be deferred, so that the effect of one year’s performance on the firm’s long-term profits can be established − in other words, so that over-payment based on a bad bonus decision in one year can be recouped in a subsequent year.
A significant proportion of the deferred element should be held in trust or escrow, with funds vesting having taken account of the future effect of business undertaken in previous years. The performance-adjusted deferred element needs to be legally robust and contractually enforced.
In terms of governance, there should be a board level remuneration committee with a majority of non-executives, with greater responsibility for bonus-setting throughout the firm.
Human resources and risk departments should have a strong and independent role in setting compensation, so that there is a transparent process for managing conflicts.
Valuations and risk reporting should be subject to independent verification, to avoid staff having the ability to influence unduly the valuation of their own positions, such as for example the front-end loading of profits.

There are some practical difficulties with the FSA’s proposals. First, in light of the international nature of most financial services firms and the variety of regulators involved, regulators are likely to need to act in international unison to achieve a successful outcome. Failing that, firms may face an unlevel playing field according to who the regulator is. The FSA is working with the US Federal Reserve and the OECD to avoid employees country-shopping to strengthen their positions.

Secondly, some concepts in the letter are unlikely to stand up to close scrutiny, such as the suggestion that there should be a higher fixed component of remuneration.

Concluding remarks

Across all European countries, the current financial crisis is stress-testing governance frameworks in relation to boardroom pay, and in many countries is leading to their improvement. This is giving impetus to the “comply or explain” regime, backed up by full disclosure of directors’ pay. There has been some legislative interference in response to the crisis but the benefits of the “comply or explain” regime seem to be prevailing. Obviously, there are exceptions, such as the remuneration constraints linked to bank bail-out legislation in some countries.

The authors would like to thank other members of the European Employment, Pensions and Benefits team at Freshfields Bruckhaus Deringer LLP.

Comply or explain

The corporate governance codes in most European countries adhere to the “comply or explain” principle. Under this principle, listed companies are required to indicate in their annual reports the extent to which the corporate governance code has been applied. Where a company has not complied with the code, it must explain why.

Except where sections have specific legislative backing, the comply or explain principle means that corporate governance codes only constitute “soft law”, meaning that they are advisory and not legally binding.

UK’s Combined Code: key remuneration points

Levels of remuneration should be sufficient to attract, retain and motivate directors of the quality required to run the company successfully, but a company should avoid paying more than is necessary for this purpose.
A significant proportion of executive directors’ remuneration should be structured to link rewards to corporate and individual performance.
There should be a formal and transparent procedure for developing policy on executive remuneration and for fixing the remuneration packages of individual directors.
The board should establish a remuneration committee of at least three (or in the case of smaller companies, two) independent non-executive directors.
The remuneration committee should have delegated responsibility for setting remuneration for all executive directors and the chairman, including pension rights and any compensation payments.
Where annual bonuses are paid, performance conditions should be relevant, stretching and designed to enhance shareholder value.
In normal circumstances, shares granted or other forms of deferred remuneration should not vest, and options should not be exercisable, in less than three years.
Directors should be encouraged to hold their shares for a further period after vesting or exercise, subject to the need to finance any costs of acquisition and associated tax liabilities.
Payouts or grants under all incentive schemes, including new grants under existing share option schemes, should be subject to challenging performance criteria reflecting the company’s objectives.
The remuneration committee should consider the pension consequences and associated costs to the company of basic salary increases and any other changes in pensionable remuneration, especially for directors close to retirement. Only basic salary should be pensionable.
Notice or contract periods for executive directors should be set at one year or less. If it is necessary to offer longer notice or contract periods to new directors recruited from outside, such periods should reduce to one year or less after the initial period.
The remuneration committee should recommend and monitor the level and structure of remuneration for senior management below board level.

Credit crunched: executive pay across Europe | Practical Law