Executive pay caps, ratios and sustainability – Germans converge with the Brits and others
10/09/2018
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In the wake of the UK’s Financial Reporting Council review of its governance code (see HERE) the Germans have published the findings of their own working group.

The working group consisted of board representatives from major organisations, institutional investors, academics as well as corporate governance specialists.

The report, with the English title “Guidelines for sustainable management board remuneration systems” repeats themes that have now become familiar.

  • Remuneration structures are complex
  • LTIP objectives may not be creating sustainable value for shareholders.
  • Significant negative say on pay votes reveal shareholder dissatisfaction with the status quo, despite modest increases in CEO pay over the last decade.

The main concerns of the working group’s members were:

  • The quantum of remuneration,
  • Alignment with the company’s long-term success;
  • Payments made despite serious misconduct and/or missed targets;
  • Inappropriate termination payments
  • Complexity and lack of transparency

The group proposes a set of guidelines for the supervisory boards of German companies when setting management remuneration to address these concerns.

(In the German system, there are two boards, a management board and a supervisory board. The latter consists of directors appointed by shareholders and employee representatives and sets the remuneration of the former.)

Some interesting points noted within the guidelines are:

Remuneration principles

Should focus on simplicity, sustainability and transparency (similar to the concerns of another UK group setting new guidelines for LTIs – see HERE).

Benchmarking

Benchmarking was considered desirable, as long as it is done properly, with the guidelines specifying:

“The analyses should consider:

  • the choice of the peer group,
  • the company’s position within the peer group
  • and the applied remuneration components.

Increases in remuneration should typically be justified by improved company results, improved individual performance, additional duties or changes in the job description or a different positioning of the company.”

GA Comment: A similar concern re US company boards under executive chairmen selecting peers who all seemed to pay more resulted in a US legislative change and the SEC requiring proxies to disclose the peer companies used for benchmarking.

Caps

Companies should set absolute caps for total management board remuneration (Including special bonuses, pension benefits, sign-on bonuses, termination packages.) Individual components of variable remuneration should have an upper limit that includes share price performance.

GA Comment: This would limit the applicability of profit share plans, which are appropriate for high value added human capital companies, such as investment managers or investment banks

Executive shareholding requirements

Should be at least one years’ fixed salary. The guidelines also note that 300% to 500% will be expected by many shareholders.

Malus and clawback

Policies should be introduced for serious breach of duty, misconduct and grave violations of material compliance and governance requirements.

GA Comment: Malus is already popular in Germany (it is a German word), and clawback may be more feasible under German law than most common law based legal systems

Termination payments

Should be limited to two years total remuneration or the remainder of the contract (Or three years for change of control.). No payments for termination for material cause. No early vesting of equity before the end of the performance period.

GA Comment: This reflects common European practice, although exceeds UK and Australian practice.

Internal relativity

Taking a page out of the US and UK’s books, the guidelines note the importance of internal relativity, recommending that the supervisory board disclose the management board’s remuneration in relation to “upper management” and other employees over a period of time.

GA Comment: Pay ratio disclosures have been adopted in the US, UK and some other European countries. There has been some discussion in Australia that a Labor government, if elected, will also require this

Consistency

All of the management board should be on the same remuneration structure.

GA Comment: This would appear contrary to the perspectives of some, such as financial regulators, which would prefer CRO’s to be on different pay structures to other management. It also assumes that a common pay structure remains fit for purpose. This is frequently not the case.

Structure

Remuneration should have only three “pillars” being fixed salary, annual variable remuneration and multi-year variable remuneration. There should be a “reasonable” relationship between fixed and variable remuneration.

GA Comment: What “reasonable” means will be open to broad interpretation. This structural limitation eliminates several alternative remuneration frameworks currently being tried in the UK, Australia and elsewhere.

Performance conditions

Variable remuneration should be predominantly long term and include sustainability objectives (e.g. innovation, environmental and social impact, culture, customer satisfaction and employee satisfaction).

GA Comment: In Germany, it seems the push for non-financial long-term incentives is also strong. The trouble is finding long-lived, measurable, conditions and disclosing them appropriately.

Disclosure

KPIs to be disclosed, at least on an ex post basis including threshold, target and maximum levels and achievement against those KPIs.

Transparency regarding discretion, one-time payments, remuneration increases (including peer group companies used for benchmarking) and remuneration ratios.

Engagement

Regular dialogue is expected with stakeholders, especially after negative say on pay votes. (Higher than 25% against.)

The report can be found HERE.

© Guerdon Associates 2020
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