Reading time: minutes
Dr Robert W. Kuipers
Partner, Tax and Legal Services
Broader shareholder rights and the implementation of the ordinance against excessive pay have brought a significant but unsurprising change in their wake: the number of items shareholder meetings have to deal with has increased massively (Figure 1). The agenda for the average AGM is about twice as long as it used to be. This inflation in business has to do with the fact that the members and chairman of the board of directors now have to be elected annually, the members of the compensation committee have to be elected on an individual basis, and shareholders have a say on pay.
The new circumstances have led to more stringent requirements for three groups:
In addition to having a say on pay, shareholders now also get to vote on the composition of the compensation committee. This development will essentially have a positive influence on the reputation of committee members. Compensation reports are now subject to a separate check by the statutory auditors. Shareholders are increasingly sensitive to cases where one person is a member of both the compensation and the audit committee. While overlaps facilitate the flow of information, they incur the risk of a lack of independence. This means organisations must explain how they deal with any conflicts of interest in the event of dual membership.
Items relating to the say on pay itself are attracting particular attention. As we explain in the following, there is a close connection between the compensation report and the documentation relating to the binding votes on pay enclosed with the invitation to the AGM. The vote on compensation to boards of directors is generally taken on an AGM-to-AGM basis (while the compensation itself is valid for the financial year, as it was previously). On the other hand, practices vary widely when it comes to the system chosen for the vote on executive board pay. Around two-thirds of entities hold a mainly prospective vote, while a third have opted for a mixed approach.
Mixed approaches generally involve a retrospective vote on the bonus (short-term incentives or STIs), while votes on long-term incentives (LTIs) take a variety of forms. Figure 3 shows a system whereby in any given year t, the AGM votes on the fixed salary for year t plus 1, the LTI for year t, and the STI for year t minus 1.
Another important realisation that is emerging is that there is no uniform practice. Different approaches make sense depending on the entity’s system and philosophy of compensation and its ownership structure. Whichever solution is chosen, it’s important to remember that different voting systems require different approaches to communications by the company.
In the course of our series of Compensation Committee Luncheons we get to talk to organisations, investors and proxy advisors on a regular basis. From this dialogue and our experience with AGMs in 2014 and 2015, we have found that three questions dominate when it comes to retrospective votes:
Figure 3 shows two possible ways of providing information to shareholders. (Combinations of the two are also possible).
The three bright orange arrows indicate pay components on which shareholders are already provided with detailed information at the 2015 AGM. Naturally the compensation report is a particularly important vehicle for this information for retrospective votes, as in this case it refers to the time period in which the vote is held. But even in the case of pay components subject to a prospective vote, the compensation report is significant in various respects. When it comes to the vote on granting compensation, it's important not just to describe the compensation system used in the past. Shareholders need either an indication that the compensation system (and the way it is adjusted) will remain unchanged in the period targeted by the prospective vote, or an explanation of how the system is going to function in the future. This forward-looking information can also be presented in the AGM documentation.
The three dark orange arrows indicate information which shareholders know (or hope) will be contained in future compensation reports or AGM documentation. To a certain extent an organisation can promise shareholders that there will be detailed reporting in future compensation reports. Of course this promise will be more credible if the organisation agrees to hold a consultative vote on future reports.
When it comes to pay components subject to a prospective vote, organisations, investors and proxy advisors primarily ask the following three questions:
Question 7, for example, shows the close correlation between the vote at the AGM in year t and reporting in the subsequent compensation reports. The more credibly an organisation can give shareholders an opportunity to voice their opinion on the deployment of the prospectively approved budget in a future consultative vote on the compensation report (grey arrow in Figure 3), the more likely shareholders are to grant their approval. Shareholders and proxy advisors also want to know whether an organisation is going to disclose the future achievement of LTI targets and the transfer of shares to managers.
Compensation per se might be less important than issues such as capital structure and dividend policy (which for their part are closely tied to the organisation’s growth strategy), but we’re convinced that systematically implementing a balanced compensation system is a strategic factor in the success of a company.
The new regulatory environment places great demands on everyone involved. For the board of directors and management of listed companies, preparing for say-on-pay votes – in other words drawing up a meaningful compensation report, documentation and arguments for the motions for shareholders – requires a lot of work. Despite this, companies benefit if they adopt a holistic approach, involving human resources, legal, finance and the board of directors at an early stage of the proceedings. A successful say-on-pay system has to be grounded in value-based management and reflected in value reporting. That way it can help management, shareholders and other stakeholders get a uniform understanding of the challenges faced by the organisation and the factors in its success. Ultimately this consensus will result in better, value-creating decisions.