Statutory cap on directors’ pay

Directors of medium-sized companies whose hearts stopped for a moment as they read the headline should feel reassured – there is now indeed a statutory cap on directors’ pay, but this only affects directors of listed stock corporations.

A little over a year ago, the Shareholder Rights Directive II was transposed into German law (ARUG II). The regulations on the remuneration of directors of listed companies, probably the most debated topic in this regard, are now to be applied from the beginning of 2021.

The following article addresses the remuneration system, being the core element of the regulations on directors’ remuneration, with particular focus on the cap on directors’ pay.

Major principles of the remuneration system

Even before the amendment of the German Stock Corporation Act by ARUG II, the supervisory board of the stock corporation had the power to have the general meeting resolve on the directors’ remune-ration system. However, this was merely an option that the supervisory board could exercise; there was no obligation imposed by the Stock Corporation Act in this regard. At the same time, the Stock Corporation Act did not specify any requirements on how the remuneration system should be designed. The Stock Corporation Act now lists specific requirements for the remune-ration system of listed stock corporations.

The legislator has pursued especially the following goals:

increasing shareholders’ participation in the decision-making process concerning the remuneration of directors of listed stock corporations ("Say on Pay");
ensuring that directors’ pay serves sustainable development of the company and is not linked to short-term objectives; and
capping directors’ pay to respond to the ongoing discussion about excessive remuneration of directors.

Participation of the general meeting

In order to give shareholders more say on directors’ pay, the supervisory board must now submit the directors’ remuneration system to the general meeting for approval at least every four years. For the first time, this must take place as part of the annual general meeting for the 2021 financial year. If any changes are made to the remuneration system within four years of its approval by the general meeting, the remuneration system must be submitted to the general meeting for approval again.

The approved remuneration system does not affect any current agreement with director, but has only effect for future directors’ contracts.

If the general meeting of the stock corporation y does not approve the submitted remuneration system, this will have no direct influence on the directors’ pay. The supervisory board is rather required to examine the concerns of the general meeting about the submitted remuneration system and to submit a verified remuneration system to the general meeting in the following year for approval. However, it is not obliged to adjust the remuneration system after its re-examination.

Although the general meeting was given more say in the remuneration matter by ARUG II, it remains a rather blunt instrument, since the supervisory board continues to hold on to the remuneration system once it has been approved.

The only exception here is the maximum of directors’ pay. In that regard, shareholders have the right to vote against the supervisory board's proposal at the general meeting and propose an exact amount of such cap themselves. If the general meeting supports the countermotion, the supervisory board must strictly comply with it.

Content of the remuneration system

The Stock Corporation Act now also explicitly specifies the individual components of remuneration systems.

With regard to these components, a distinction should be made between the principles governing the remuneration system and the different types of remuneration. The principles governing the remuneration system (e.g. maximum of directors’ pay) must always be submitted to the general meeting. In addition, the general meeting should be informed of the types of remuneration that are to be actually awarded to the directors. This includes, for example, fixed remuneration or the granting of stock options.

Mandatory basic principles to be presented include, e.g.:

maximum of directors’ pay;
presenting how the remuneration contributes to the business strategy and the long-term development of the company; and
considering the salaries of employees of the company when determining the remuneration of the directors.

When drafting the regulation on the maximum of directors’ pay, the supervisory board has the option to cap the remuneration of individual directors or the overall remuneration of all directors. The supervisory board is also given some leeway as regards the amount of the cap – it can choose between an exact amount and a flexible variant in which the cap is set in proportion to the remuneration of the other employees.

Conclusion

Through the implementation of ARUG II, shareholders in Germany are for the first time legally entitled to have a say on the remuneration of the directors, even if this right remains very limited.

It is only through their mandatory vote on capping directors’ pay that the shareholders have the opportunity to teach the company’s management a lesson if they are dissatisfied with the directors’ performance.

In order to avoid capping the remuneration by the general meeting, the company should have in place a balanced remuneration system that aligns the interests of the directors with those of the shareholders.