Ordinance on excessive pay: lessons learned from daily practice

Update

Ordinance on excessive pay: lessons learned from daily practice

Dr Robert W. Kuipers
Partner, Tax and Legal Services

Implementation of the Ordinance against Excessive Compensation (VegüV/ORAb) is progressing well. Find out more about key experience in practice, and read how a balanced say-on-pay system can strengthen a company’s value creation.

More work for AGMs

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. [1]

[1] The totality of mechanisms that enable shareholders to be involved in defining compensation for the governing bodies of an organisation. In many countries, shareholders vote on either the compensation report or the compensation system. In Switzerland, by contrast, they vote on the amounts of compensation.

The new circumstances have led to more stringent requirements for three groups:

All shareholders who wish to or have to exercise their voting rights (for example Swiss pension funds voting on issues relevant to the ordinance)
Organisations that have to supply the relevant information
Information intermediaries such as proxy advisors [2] who have to provide solid grounds for their recommendations.

[2] Organisations that advise shareholders (especially institutional investors such as pension funds, asset managers, etc.) on exercising their voting rights. The shareholder retains the voting right. Proxy advisors are not proxies. Well-known proxy advisors include Ethos, Glass Lewis, ISS, SWIPRA and zRating.

Figure 1: Average number of items on the AGM agenda of SPI® companies, 2010-2015

Election of compensation committees and say on pay

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 [3], while a third have opted for a mixed approach.

[3] The term ‘prospective vote’ is not really accurate in the case of pay components assigned in the year of the AGM. In practice, however, it has become commonplace to describe any non-retrospective vote as ‘prospective’.

Figure 2: Modes of pay-on-say voting chosen by SPI® companies on SIX Swiss Exchange

The SPI family encompasses various stock exchange indexes with an underlying universe of around 230 stocks. The SPI Large and SPI Mid segments contain companies with medium to large stock market capitalisations.

Mixed approaches generally involve a retrospective vote on the bonus (short-term incentives or STIs [4]), while votes on long-term incentives (LTIs [5]) 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.

[4] A technical term for the variable compensation paid to reward prior-year performance. Organisations link this variable compensation to different factors. There are differences in terms of quantitative and qualitative objectives. Organisations also differ in terms of whether they calculate STIs on the basis of a formula or whether it’s left (in part) to the judgement of the compensation committee.

[5] This term refers to a form of equity compensation that can be paid in the form of shares, options, performance shares, restricted stock units, etc. Ownership of performance shares is only transferred to a manager if they meet specific future performance requirements. Restricted stock units are transferred to participants once a specific blocking period has elapsed. Many companies assign LTI components regardless of prior-year performance. This comes closest to the original idea of LTIs. Other companies pay the bonus for the previous year partly in the form of LTIs. This results in a mixture of backward-looking rewards and forward-looking incentives.

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. [6]

[6] Executive compensation & corporate governance: insights 2014

Information needs for say on pay

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:

Is the amount proposed justifiable and complete?
Is the relationship between pay and performance adequately explained? In other words, is the proposed pay – including amounts paid in the prior reference period – justified in terms of performance?
In cases where the system is not purely formula-based, is the procedure for deciding bonuses clear and transparent?

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:

Is the amount proposed justifiable and complete?
Is the comparison between the targeted maximum and actual pay in the prior period meaningful (i.e. done on a like-with-like basis)?
Are the reasons given for any divergence in total compensation or parts of it and pay in the prior reference period reasonable and justified?
Do shareholders know how total compensation breaks down into the various pay components?
Does the proposal make clear why the proposed system and amounts are deemed to be reasonable?
Variable incentive programmes: are the mechanisms for determining STIs and LTIs reasonable and comprehensible? Are shareholders told how they create incentives for management?
LTI programmes: do shareholders find out whether actual distributions will be disclosed in future compensation reports?
Is the procedure for management compensation transparent?

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 [7]. 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.

[7] An aside on social security: There turns out to be a particular difficulty with the ordinance when it comes to social security contributions. Since it’s impossible to precisely determine these contributions for long-term incentive plans which vest in the future, expected values are used. There have also been major discrepancies in terms of employer contributions, which may account for a significant share. Whatever the case, the idea behind the correct legal interpretation is that shareholders ultimately want to know the true costs of compensation.

Summary

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.

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