Increase in power for the Shareholders' Meeting
The German Act Implementing the Shareholders' Rights Directive (Gesetz zur Umsetzung der Aktionärsrechterichtlinie) puts the remuneration competence of the Supervisory Board to the test
The supervisory board has authority over personnel decisions relating to the management board. This authority has two components: first, the supervisory board appoints and removes members of the management board; second, the supervisory board negotiates and agrees their service contracts with them, in particular their remuneration which, as the crucial incentive and control instrument, is the supervisory board's most important tool for successful personnel management apart from the prudent selection of directors. At the same time, authority to determine directors' remuneration is the central instrument in balancing powers between the shareholders' meeting, the supervisory board and the management board.
Loss of fundamental confidence
In the decades after 1965 i.e., under our current stock corporation law system, there was never any doubt that the authority to determine directors' remuneration had to lie solely with the supervisory board. Since the millennium, however, this general understanding has begun to falter with respect to listed stock corporations because of various factors. Apparently, with the dissolution of Germany Inc. and the adoption of US practices in Germany, fundamental confidence has been lost that the supervisory board would – on its own initiative – comply with the long-established statutory requirement of ensuring an appropriate level of directors' remuneration. Lawmakers first tried to restore confidence by providing transparency: as of 2005, levels of remuneration had to be disclosed for each member of the management board, which put supervisory boards under pressure to justify each individual compensation. Moreover, the effect which lawmakers had presumably hoped to achieve, i.e. that outliers would be avoided because of the pillory effect, did not materialise. On the contrary, remuneration levels were generally adjusted to approximate the highest amounts published. This should not have come as a surprise, since the same had happened in the US and American economists had predicted that this would happen in Germany as well.
In the period before the financial crisis of 2008, actual or merely perceived remuneration excesses were intensely discussed by the public, particularly in the banking sector. Lawmakers responded in 2009 by imposing stricter substantial rules in order to promote remuneration structures that were more geared to ensuring the long-term welfare of companies. For the first time, a say-on-pay resolution was incorporated into the law, i.e. a resolution of the shareholders' meeting on the remuneration system proposed by the supervisory board for the management board (not including the individual compensation of its members). However, passing such a resolution was voluntary and did not give rise to any rights or obligations; it was, in a sense, more a statement of the shareholders' meeting about its corporate governance policy. In any event, cases in which the shareholders' meeting refused to follow the supervisory board's proposal were broadly discussed, resulting in considerable pressure being put on the supervisory board to change the remuneration system.
But the remuneration excesses – at least the perceived ones – did not stop after that. Moreover, the EU started to deal more intensely with issues of directors' remuneration and expressed its position in terms of both content and procedure. These positions were strongly influenced by Anglo-Saxon ideas, i.e. those rooted in a legal system in which stock corporations are managed by a single-tier board (board of directors) and not, as in Germany, by a two-tier system: a management board monitored and advised by a supervisory board. Yet, the German representatives in Brussels were at least able to prevent the 2017 reform of the shareholders' rights directive from creating an extensive paradigm shift in German stock corporation law. Fortunately, the German legislature mostly limited itself to transposing the directive only insofar as was absolutely mandatory under the EU directive. But the supervisory board's loss of authority over remuneration issues nevertheless continues to progress. The German act implementing the directive will enter into force – slightly delayed – on 1 January 2020, presenting us with various new rules on directors' remuneration in terms of both content and procedure.
Stricter rules for directors' remuneration shift more power to shareholders' meetings
In future, starting with the 2021 shareholders' meeting at latest, a say-on-pay resolution of the shareholders' meeting will no longer be optional, but will be required every four years or earlier if the remuneration system is subject to material ammendments. What remains unchanged is the fact that the shareholders' meeting is only allowed either to approve or reject the proposal for a remuneration system presented by the supervisory board, but not to propose any amendments. If the supervisory board's proposal is rejected, it must present a reviewed (but not necessarily revised) remuneration system for approval to the shareholders' meeting the following year. While it is still true that the say-on-pay resolution will not give rise to any rights or obligations, in negotiating remuneration with members of the management board, the supervisory board will only be allowed to agree to remuneration levels that are within the framework of the remuneration system presented to (but not necessarily approved by) the shareholders' meeting (which means that the supervisory board must abide by its own proposals). The minimum requirements in terms of the content of the remuneration system is defined in detail in numerous clauses and sub-clauses. Some items are mandatory (for example, information on the maximum level of remuneration), whereas other items are only required in the event that the supervisory board opts for certain remuneration components (for example, stock-based remuneration).
Each year, the supervisory board must present a remuneration report – the content of which also is defined in detail in the Act – to the shareholders' meeting for approval. That report must be included in the audit of the annual accounts. The remuneration report also has to itemise the remuneration of each member of the management board. Contrary to previous practice, opting out under a resolution of the shareholders' meeting is no longer permissible. Furthermore, future levels of directors' remuneration must be compared to that of the employees' compensation (vertical comparison). Beyond the fact that this might give rise to discussions that are seldom helpful and tend to be rather emotional, one can guess the problematic direction in which European lawmakers are going with their ideas for potential future maximum levels of directors' remuneration. Rightly, resolutions on the remuneration system and the remuneration report cannot be challenged by shareholders in court: they will not give professional claimants fresh ammunition for legal action.
A practical test for supervisory boards
German supervisory boards, their chairpersons and offices will adjust soon enough to the increasing transparency and increased workload associated with remuneration issues. More important, however, is to restore public confidence in their remuneration authority and to avoid any further shifts to the shareholders' meeting. If we wish to retain the two-tier management system of stock corporations in Germany, at least for co-determined corporations, any further weakening of remuneration as a control instrument of the supervisory board is undesirable. This means first and foremost: in any future amendment of the law, the say-on-pay resolution of the shareholders' meeting should not become a binding requirement for the supervisory board, resulting, for example, in the supervisory board being able to enter into remuneration agreements only on the basis of such a resolution.
To achieve this, supervisory boards must demonstrate that they are willing and able to guarantee a level of directors' remuneration that is both supported by the majority of shareholders and widely accepted by the public without a regulatory straitjacket being necessary. This requires, among other factors, recognition and acceptance of the fact that directors' remuneration at listed companies is not an issue that only affects the owners of the company, but that also needs to be based on some degree of consensus in society. Such a consensus in Germany may be different from one that prevails in the US. If this results in disadvantages in the global competition for talented managers, politicians will have to find ways to work on changing the societal consensus. Andreas Austmann