German Bundestag Approves Legislation Reforming Executive Compensation

As the US House of Representaives prepares to pass corporate governance reform, the German federal parliament, Deutshcr Bundestag, has approved legislation reforming corporate executive compensation. The Act on the Appropriateness of Executive Remuneration (Gesetz zur Angemessenheit der Vorstandsvergütung), is desighed to increase the transparency of the setting of executive pay and realign remuneration packages, particularly bonuses and other variable incentive schemes, with the long-term sustainable success of the company. The legislation was pressed by Germany’s Grand Coalition of Christian Democrats and Social Democrats based on a consensus that executive compensation should embody the principle of good pay for good work, which means that the system of executive compensation must be transparent and oriented to the company’s long-term success.

The legislation embodies the G-20’s recent endorsement of changes in executive pay to ensure that compensation structures are consistent with firms’ long-term goals and prudent risk taking. Specifically, the G-20 said that boards of directors must play an active role in the design, operation, and evaluation of compensation schemes. Compensation, particularly bonuses, must properly reflect risk. Payments should not be finalized over short periods where risks are realized over long periods, said the G-20 communiqué, and firms must disclose comprehensive and timely information about compensation.

Under the German legislation, supervisory boards will be more accountable for executive compensation. For example, the entire supervisory board must set executive compensation, not just a board committee, such as the remuneration committee. Supervisory boards would also be accounatble for unreasonable executive salaries. The total compensation of executives must be reasonable. Executive compensation should also be paired more closely with the individual performance of board members.

In order to promote long-term businss sustainability, stock option holding periods were increased from two to four years. The legislation also provides for a non-binding shareholder advisory vote on executive compensation. The legislaition does not put a fixed ceiling on executive compensation.

In an earlier policy statement on the draft legislation, the European Group for Investor Protection said that the German government considers short-term thinking in the pursuit of maximum executive bonuses to be a major cause of the current financial crisis. The Grand Coalition wants to limit the increase of executive compensation, which the government views as excessive in light of the financial crisis, with the expansion of variable remuneration seen as the major cause of that excessive increase.

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