The Advisors' Blog

– Alberto Bagnara, Salvatore Tedesco, and Eeva-Liisa Räikkönen, RiskMetrics’ European Research

From RiskMetrics’ Governance Weekly: The European Commission (EC) has released two recommendations on executive remuneration and financial services sector pay as a first step in a strategy outlined in March on “Driving European Recovery.” The recommendations, released April 29, are non-binding instruments that advise member states to introduce measures to facilitate the convergence of national legislation on issues of common interest within the European Union.

This initiative follows conclusions drawn in December by the Ecofin (Economic and Financial Affairs) Council, which represents the economics and finance ministers of the EU’s 27 member states. In light of the recent financial crisis and the current focus on executive and director remuneration, the EC sees its role as “leading a wide-ranging reform to apply the lessons of the crisis and deliver responsible and reliable financial markets for the future.”

The recommendation on remuneration at listed companies is intended to complement recommendations adopted in 2004 and 2005 on executive pay and the role of non-executive directors and board committees, respectively. While the existing compensation recommendation is based on the idea of pay for performance through disclosure of the remuneration policy, the EC now considers it necessary to address the structural flaws of remuneration policies that have become apparent.

The new principles are based on best practices found in the national legislation or corporate governance codes of member states. It is important to note, however, that the recommendation does not aim at harmonizing pay levels. Guidance is given with regard to the structure of remuneration policies to better align pay with performance. The main focus is on variable pay. Variable components should be capped, and the award of variable compensation should be subject to predetermined and measurable performance criteria.

In addition, severance payments should generally not exceed two years’ fixed salary, and should not be paid if termination is due to inadequate performance. Other principles focus on promoting a company’s long-term sustainability. The guidance advocates a minimum three-year vesting period for stock options, as well as a requirement to hold a fixed number of shares until the end of employment. The EC also promotes the deferment of “a major part” of variable pay. Furthermore, “clawback” provisions should be included in contracts to enable companies to reclaim variable pay granted on the basis of accounts that are subsequently proved to be manifestly misstated.

The recommendation further sets out principles relating to the governance of remuneration policies, which mainly focus on strengthening remuneration committees by requiring, for instance, at least one member of the committee to have knowledge and experience in the field of remuneration policy. The impartiality of remuneration consultants used by remuneration committees should also be ensured. To mitigate conflicts of interest, non-executive directors should not receive stock options as part of their remuneration. The EC also states that companies should encourage shareholders to participate at general meetings and use their votes regarding director remuneration.

The second EC recommendation specifically deals with remuneration at companies in the financial services sector. According to Internal Market Commissioner Charlie McCreevy, “Up to now, there have been far too many perverse incentives in place in the financial services industry. It is neither sensible nor sane that pay incentives encourage excessive risk-taking for short-term gain.”

Member states are urged to introduce stricter remuneration rules for financial firms having an office within their territories that apply to all employees whose activities have an impact on the company’s risk profile. Accordingly, the recommendation outlines principles to address four areas of concern:

– First, remuneration policies for risk-taking staff should be consistent with and foster sound and effective risk management. Consequently, there should be “an appropriate balance” between fixed remuneration and bonuses. Companies should be allowed to withhold bonuses if performance criteria were not met and the payment of the major part of the bonus should be deferred. Moreover, performance criteria should be aligned with the long-term financial performance of the firm.

– Second, remuneration policy should be “transparent internally, clear, and properly documented.” Board members and consultants involved in the formulation of the remuneration policy should be independent.

– Third, remuneration policy and its features should be adequately disclosed to shareholders in a clear and understandable way that explains the main components of the remuneration policy, its design, and operation.

– Finally, the EC stresses the importance of supervision. Supervisory authorities should ensure that financial services companies apply the principles of sound remuneration in compliance with effective risk management.

While maintaining disclosure as an underlying principle, these two new recommendations stress the importance of a balance between fixed and variable pay, the existence of measurable performance criteria, and the presence of sound supervision. In setting such guidelines for remuneration policies, the EC intends to improve risk management and align pay incentives with sustainable performance.

These two initiatives are part of a broader strategy that the EC intends to pursue, and there is a possibility of similar steps in other financial sectors, such as insurance. To complement the recommendation on financial services pay, European regulators plan to amend the existing Capital Requirements Directive in June to address risk management and supervision of remuneration policy at banks and investment firms.

The impact of the recommendations and their application by member states will be assessed in one year. The EC intends to keep monitoring the remuneration practices adopted by listed companies and financial services providers, and their impact on the long-term sustainability of the European financial sector.