When the Second European Shareholder Rights Directive for listed companies was implemented through ARUG II, specific regulations on the maximum compensation were incorporated into the German Stock Corporation Act. hkp.com spoke with hkp///group corporate governance experts Dr. Jan Dörrwächter and Johannes Harrack about the significance of these regulations and the resulting challenges in designing Management Board compensation systems.
Dr. Dörrwächter, Mr. Harrack, could you briefly explain the concept of the maximum compensation and its evidently increasing importance?
Dr. Jan Dörrwächter: Let's begin by explaining some basic legal framework conditions resulting from the implementation of the Second European Shareholder Rights Directive. According to Section 87a (1) of the German Stock Corporation Act (AktG), the compensation system to be agreed by the Supervisory Board and to be presented to the Annual General Meeting as per Section 120a (1) AktG, must include the setting of a maximum compensation for members of the Management Board.
Johannes Harrack: The specification of a maximum compensation is, as a structural definition, a mandatory aspect of the Management Board compensation system and is valid for up to four years. It should be noted here that the Annual General Meeting has a particular role in the setting of this maximum compensation. According to Section 87 (4) AktG, it can, at the request of a quorum of shareholders, reduce the maximum compensation set by the Supervisory Board.
Dr. Jan Dörrwächter: So, the maximum compensation isn’t a trivial matter; it’s a clear requirement with considerable influence on the design of the compensation system and on the communication of Management Board compensation to shareholders and the public.
Which compensation elements does the maximum compensation apply to?
Dr. Jan Dörrwächter: The maximum compensation generally covers the entire compensation promised by the company to a member of the Management Board for a fiscal year, i.e., base salary, short-term and long-term variable incentives, as well as fringe benefits and company pension plans.
What about special payments, such as bonuses for exceptional performance?
Johannes Harrack: Special payments are also covered by the regulation. This is evident from the fact that the German Stock Corporation Act doesn’t stipulate any exceptions to the scope of the maximum compensation.
Does this also include the sign-on bonuses paid upon joining a new company, which have been the subject of much discussion in recent years?
Johannes Harrack: Yes, sign-on bonuses, i.e. payments associated with a Board member taking office, are also included as they are also part of the compensation system. They wouldn’t be permitted otherwise.
Dr. Jan Dörrwächter: It should be noted that, in practice, companies can generally work around this if the amount of the maximum compensation doesn’t allow for the payment of sign-on bonuses. They can either provide for a one-time increase in the maximum compensation for the year of entry or spread the sign-on bonus over several years. In some cases, a deviation from the maximum compensation as per Section 87a of the German Stock Corporation Act (AktG) may also be considered. But it's relatively hard to meet the criteria for this.
What influence does the Annual General Meeting have on the issue of the maximum compensation?
Dr. Jan Dörrwächter: According to the German Stock Corporation Act, the Annual General Meeting can, upon request, reduce the maximum compensation decided on by the Supervisory Board as part of the compensation system. The decrease is binding for the Supervisory Board. It must, however, be noted that current contracts remain unaffected by this. The reduced maximum compensation therefore only applies to contracts concluded after the resolution to reduce the maximum compensation has been passed for the relevant compensation system.
How are companies currently addressing the issue of the maximum compensation? What insights can be gained from the Annual General Meetings?
Johannes Harrack: The reference period for the maximum compensation is particularly interesting. Our analyses show a marked trend in this respect. Of the DAX30 companies that reference the time frame of the set maximum compensation in their compensation systems, the vast majority use the year of which the compensation was agreed on as the reference year, irrespective of the exact point of payout. Only a few companies limit the compensation received in a fiscal year, irrespective of when exactly the compensation element was agreed for.
Doesn't this increase the risk of random outcomes?
Johannes Harrack: It does. Another argument against this approach is that compensation from different fiscal years and therefore different systems would be subject to the maximum compensation applicable to the year of reception. However, this seems difficult to reconcile with the fact that the maximum compensation is always part of a specific compensation system and only applies to that system.
The question as to whether the maximum compensation should be set at individual level or for the entire Management Board arises frequently. What are companies doing in this regard?
Dr. Jan Dörrwächter: The maximum compensation can be set for each member / function of the Management Board individually or collectively for the Management Board as a whole. Both approaches are in line with the requirements of the German Stock Corporation Act. The Supervisory Board has considerable room to maneuver in this respect.
What are the advantages and disadvantages of each approach?
Dr. Jan Dörrwächter: From a practical point of view, the individual approach has several advantages. Imagine a scenario in which the size of the Management Board is increased by one member. In this case, the amount set for the entire Board may no longer be sufficient.
Johannes Harrack: On the other hand, if the Board reduces in size, the maximum compensation applicable to the entire Management Board may not serve its purpose as it’s far too high.
Are specific amounts or maximum compensation values disclosed?
Dr. Jan Dörrwächter: Regardless of whether the maximum compensation is set per Board member or function, or for the Board as a whole, the amount of the maximum compensation must be stated as a concrete figure.
But expressing the maximum compensation solely in relation to a variable ratio, i.e. a multiple of the average compensation of the workforce, would be possible?
Johannes Harrack: No, this wouldn't meet the requirements of the German Stock Corporation Act. Expressing the maximum compensation as a percentage based on the target figures of variable compensation elements or base salaries, which may change over time, is also insufficient. This is also reflected in the right of the Annual General Meeting to reduce the maximum compensation, where a precise figure is required. The Annual General Meeting wouldn’t otherwise be able to assess the necessity of a reduction.
The obligation to specify a definite amount in euros brings us to the matter of determining how high the maximum compensation should be set. What are the considerations here?
Dr. Jan Dörrwächter: A low maximum compensation can result in a reduced incentive to exceed targets and reduce the opportunities for increases in target compensation. On the other hand, a high maximum compensation may raise unjustified expectations of potential compensation among Management Board members. There is also a risk of negative headlines and rejection by individual investors at the Annual General Meeting. This shouldn't be underestimated by any means.
What do investors want in terms of the maximum compensation?
Johannes Harrack: So far, most investors haven’t really voiced their expectations in this regard. It’s worth remembering here that the majority of major institutional investors and proxy advisors have an Anglo-American background. However, the maximum compensation is specific to Germany and isn’t usually covered by the corresponding proxy voting guidelines. In contrast, two of the largest German investors, Deka Investment and Union Investment, have expressed specific views on the maximum compensation. Deka, for example, has expressed the expectation that the maximum compensation of the Management Board, in comparison to the compensation of Senior Executives and the compensation of the workforce as a whole respectively to other companies, should be explainable and communicable to the public.
Dr. Dörrwächter, Mr. Harrack, thank you for the interview.