Germany: Rules introduced to govern senior managers' pay

The German Government announced new legislation in March 2009 to link the remuneration of senior managers more closely to long-term business development. This includes creating wider scope for reductions where a company performs badly, and greater transparency in management pay-setting.

On this page:
Background
Company law to be amended
Main amendments
Reactions.

Background

The remuneration of senior managers in German companies has traditionally been shrouded in secrecy. However, greater openness has been achieved in recent years by a  code on corporate governance introduced in 2001 and legislation adopted in 2005. The subsequent publication of the details of some executives' huge compensation packages has led to a number of high-profile controversies and mounting public, political and trade union criticism of "excessive" pay. Since 2008, there has also been increasing concern that reward arrangements might have encouraged hazardous risk-taking in financial institutions, contributing to the current crisis.

Following a lengthy debate among the parties in the coalition federal Government - the Social Democrats (SDP), the Christian Democrats (CDU) and their associated Bavarian Christian Social Union (CSU) - on 5 March 2009, the Cabinet agreed on measures to tighten the regulation of company directors' pay. The Cabinet emphasises that there is a need for management pay to be set in the light of the long-term sustainability of companies, as opposed to "short-term stock market success". Commenting on the proposals, the justice minister, Brigitte Zypries, said: "The conduct of some managers has put the foundations of our financial markets out of kilter and these have had to be redressed by the taxpayer through state assistance".

Company law to be amended

The government's initiative involves amendments to the Stock Corporation Law (Aktiengesetz), which regulates the governance of joint-stock companies (Aktiengesellschaften, or AGs), the main form of publicly held company in Germany.

The legislation requires that AGs have a two-tier board structure. A management board (Vorstand) deals with day-to-day management of the company, and its members are equivalent to executive directors in countries such as the UK. It is appointed and overseen by a supervisory board (Aufsichtsrat), whose members are equivalent to non-executive directors. In AGs with 500 or more employees, not only shareholders but company employees are represented on the supervisory board. In AGs with between 500 and 1,999 employees, one-third of the supervisory board is elected by the workforce from candidates nominated by the works council or employees. In AGs with 2,000 or more employees, half of the supervisory board is elected by the workforce, with trade union nominees guaranteed a certain number of seats alongside company employees. In companies with this latter "parity" board representation, the supervisory board's chair is always a shareholders' representative and has a casting vote in the event of a tie.

The "law on the appropriateness of directors' remuneration" proposed by the Government focuses on changing AGs' corporate governance arrangements in respect of compensation for management board members. It does not prescribe levels of executive directors' remuneration but sets out principles for the design of their reward arrangements.

Main amendments

The Government's proposals provide that supervisory boards will be directly responsible for setting the remuneration of executive directors. In contrast to current practice, supervisory boards will not be able to delegate this decision to a remuneration panel. This change is intended to promote transparency and ensure that the entire supervisory board is held responsible for the decision. Supervisory board members will be deemed personally liable for any damages arising from "inappropriate" remuneration.

The supervisory board will have to ensure that executive directors' remuneration is "appropriate". Although this is already a requirement under the Stock Corporation Law, this will now be formulated more precisely. Article 87 of the Law will be amended to require the remuneration of management board members to have an "appropriate relationship" to their performance and to "the situation of the company and customary remuneration". This will also give legal force to what is currently a recommendation in the German corporate governance code. In its explanation of the amendment, the Ministry of Justice explains that the "customary remuneration" criterion embraces a range of considerations, including what is usual in the sector, in companies of the same size, and more widely within Germany. In addition, the supervisory board may consider pay differentials within the company.

It will be a requirement that executive directors' bonuses and rights to shares must constitute long-term incentives to promote the "sustainable development of the company". Supervisory board members will have to ensure that this rule is observed, implying some far-reaching changes to their duties. For example, the Ministry of Justice states that the timescale for assessing whether directors have met performance criteria should be calculated over a longer period than a single reference day. In particular, the draft legislation states that the supervisory board must take subsequent developments into account, such as the impact on company performance of divestments that boost short-term profits but damage the firm's long-term development. There will also be new limitations on executive directors' share options, including options not being exercised for at least four years (currently two years) after being granted.

Provisions that permit a lowering of executive directors' remuneration, already contained in the Stock Corporation Law, will be amended and scope for their application widened. In future, if the situation of the company worsens (previously "substantially worsens"), so that the continued payment of any contractual remuneration appears "unreasonable" (previously "grossly unreasonable"), the supervisory board can apply to a court to reduce any contractual payments. Since remuneration includes a range of future payments, such as pensions, in principle this would allow prospective payments to former directors to be cut. The Ministry states that the "worsening" of a company's situation could include such circumstances as making redundancies, lowering wages, or being unable to pay a dividend.

There will be more extensive disclosure requirements in the event of the termination of a management board member's contract, whether before or at its anticipated date.

Finally, where a company establishes an audit committee (Prüfungsausschuss), with responsibilities for the annual report and accounts, risk management and compliance, membership of this committee will be barred to anyone who has been a member of the management board in the previous three years.

Reactions

The Confederation of German Trade Unions (DGB) stated that the Government's initiative constitutes a step in the right direction, especially in linking senior management remuneration to long-term company performance. However, the DGB believes that the proposals are inadequate and blames the CDU for preventing the coalition from going further. In particular, the unions want to include a requirement in the Stock Corporation Law that companies should be managed in the interest of the "common good" and of their employees.

According to Dietmar Hexel, a member of the DGB executive: "The purpose of a company is not to make shareholders and managers rich. However, most management remuneration schemes are precisely aimed at this goal. Short-term profit is a bad business objective. Other aspects should be central: sustainable and organic growth, the customers' interest in good and inexpensive products, the interest of workers in attractive and secure jobs, the interest of suppliers in stable value chains, and sustainable returns for shareholders."

The Federation of German Industries (BDI) said that the proposed legislation may result in excessive interference in company decision making, and that detailed regulation of senior management pay is unnecessary. The national business organisation agrees that reward systems should be linked to long-term business development, but argues that this is already adequately regulated by company law and the corporate governance code. The BDI thinks that the proposed measures on reducing executive directors' remuneration if the situation of the company worsens are unclearly worded, and will result in legal uncertainty for supervisory boards. It also objects to the proposed ban on recent management board members sitting on audit committees, and suggests that the size of supervisory boards should be reduced to increase their efficiency and professionalism.

The draft legislation will now be finalised through discussions among the coalition parties before going to parliament for debate and adoption. The SDP parliamentary group will be pursuing further restrictions on management pay. Notably, it wants companies to be able to write off management salaries or severance payments against tax only if their value does not exceed €1 million.

This article is based on material provided by Pete Burgess, European Employment Review correspondent for Germany.

European Employment Review 423 (EER 423) contents