Boards should prepare scenarios for variable executive pay in 2021
By Kirsten Aaskov Mikkelsen, Martin Faarborg and Tinus Bang Christensen
On 2 December 2020, the Danish Committee on Corporate Governance ("the Committee") published updated Corporate Governance Recommendations. The update focuses on current trends such as social responsibility, sustainability and a company's purpose, but also new recommendations related to remuneration of the board of directors and the executive board. The recommendations come into force for financial years beginning 1 January 2021 or later. The first time these must be reported is when the annual report is published in 2022.
Several of the previous recommendations on remuneration policy and remuneration report have been deleted from the recommendations, as these have been replaced by legislation through the implementation of the EU Shareholders Rights Directive and have thus become redundant. The rules for the preparation of remuneration policies and remuneration reports also serve as a basis for the updated guide of 27 November 2020 from the Danish Business Authority. However, the deleted recommendations do not lead to less transparency of executive remuneration – quite the opposite. The discontinued recommendations are replaced, for example, by new ones.
In this article, we highlight the role of the board of directors in relation to the fact that the Committee, as something new, recommends that remuneration of the board of directors and the executive board, and other terms of employment, are both competitive and compatible with the company's long-term shareholder interests. It may, of course, be difficult for a company to state that it chooses to explain rather than comply with this recommendation. It is therefore to be expected that most companies will state that they comply with the recommendation.
In determining executive remuneration packages, the board of directors should, where appropriate, consider both national and international comparable positions. According to the Committee, it is important that the board of directors strikes the right balance between avoiding excessive remuneration packages and at the same time being able to attract the right skills. The Committee states in its comment that the board of directors should justify this balance in the remuneration report. If appropriate, the board of directors may with advantage also disclose which peer group the company compares itself to.
So, in practice, the revised recommendation makes it mandatory for the board to assess management's remuneration. Stating compliance with the recommendation may be accompanied by a comment explaining the reason why the company complies with the recommendation – either in the remuneration report or in the template reporting form from the Committee. This could be done, for example, by using analyses of remuneration in the company's peer group based on criteria such as the size of the company's market value, revenue, number of employees and total shareholders’ return (performance).
In implementing the EU Shareholders Rights Directive, it was required by law that the remuneration policy include an "indication of the relative share of the components", as referred to in section 139a of the Danish Companies Act. In practice, this has often been implemented as a form of a cap or upper limit relative to the respective member's base remuneration.
The new recommendation 4.1.3 suggests that a cap be set for the variable part of the remuneration and that this be determined at the grant date. Many companies already follow this recommendation. It is noted that the recommendation does not contain any requirements for the valuation method.
Often, the Black-Scholes model will be used to calculate the fair value of options granted, and Monte Carlo simulation models to calculate the fair value of matching shares, restricted shares, and performance shares granted.
In addition, it is recommended to ensure transparency about the potential value at the time of exercise under pessimistic, expected and optimistic scenarios.
The recommendation does not mean that companies should set an upper limit on the exercise value of share-based remuneration, but merely create transparency about the potential exercise values. This may very well be done by including information on this in the remuneration report.
With the new recommendation, the board will have to deal with the three scenarios. There is no requirement to use a certain method or model for disclosing developments in the economic assumptions from the grant date to the exercise date. There is also no requirement for the economic assumptions to be the same as the vesting criteria (e.g. threshold, target and maximum).
The recommendation reflects an increasing focus on executive remuneration and a desire for more transparency about variable remuneration, especially share programmes and their potential value. In particular, the introduction of the EU Shareholders Rights Directive's remuneration report requirement – in which many companies will make the first report prior to the annual general meeting in 2021 – is likely to lead to increased focus by institutional investors on executive remuneration, the composition of incentive programmes and the link between the components chosen and the company's performance, strategy and objective, in particular whether the selected KPIs (including, for example, on climate and sustainability) support this sufficiently.
Recommendation 4.1.3 may, for some companies, give rise to considerations about whether the company's remuneration policy should be changed as early as at the 2021 general meeting.
However, several companies will already have set an upper limit on variable remuneration at the grant date in their current remuneration policy or in the terms of each incentive programme. It is enough that the limit is set out in the terms of each incentive programme.
The board of directors should also consider whether the recommendation on transparency about the potential value at the exercise date should be written into the future remuneration policy as a requirement for future grants, or whether such value could very well be disclosed in the remuneration report.
Another recommendation that may give rise to changes in the remuneration policy is recommendation 4.1.6 on the possibility of reclaiming variable remuneration ("clawback"), which is now a separate recommendation. The recommendation has been extended to cover not only paid, but also granted or vested remuneration which subsequently turns out to have been granted, vested or paid on an incorrect basis, and clawback should also apply in situations where the beneficiary was in bad faith about circumstances, which resulted in the payment of too much variable remuneration.
Following the implementation of the EU Shareholders Rights Directive, it is a requirement that the remuneration policy contain information on whether the company is using clawback (and reports on its use in the remuneration report), but it is up to each company to assess whether the adoption of clawback is relevant.
Many C25 companies already comply with recommendation 4.1.6. In 2020, 92% of C25 companies disclosed in their remuneration policy the company's clawback option. We also recommend that clawback provisions be implemented or updated in employment contracts and/or in the terms of the companies' incentive schemes going forward.
Typical questions that the board of directors should consider and discuss would be:
- Who is our peer group of comparable companies in respect of executive pay – for the board of directors and for the executive board? Who are we going to compete with for talent? Should we state who we compare ourselves to and explain the reasons why our executive pay is competitive? Would it lead to excessive competition and pressure on salaries?
- Is our management's remuneration competitive in the view of other companies we normally compare ourselves to both in Denmark and abroad? Is the picture the same when looking at each management position?
- Is management's remuneration sufficiently interesting to attract the right skills to the company now and in the long term? Can we optimise the composition of the management packages to better support this – without these packages being too high? Should we involve stakeholders in this assessment?
- Ongoing consideration on the three exercise scenarios for variable executive pay – will remuneration continue to be properly composed in all three scenarios – both from the perspective of the company, management and the relevant stakeholders?
- How should we handle the expected increased focus on executive pay, including composition, size and KPIs, from relevant stakeholders?