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Sound Compensation@ARUG II & DCGK

Current topics in the implementation of the new requirements for the remuneration of Management Board members in listed companies

Listed companies have currently to implement the new requirements of ARUG II and the revised German Corporate Governance Code for the remuneration system for the Board of Management. In this Client Alert, we discuss selected topics relating to the implementation of the requirements.

The structure of the (abstract) remuneration system: Section 87a AktG and its interaction with Section G DCGK

Section 87a (1) sentence 2 of the German Stock Corporation Act (Aktiengesetz, AktG) specifies a catalogue of parameters for the (abstract) remuneration system in number 1 to 11, which must be included in the remuneration system materially and in its presentation. The catalogue follows a rule-exception principle: In general, the remuneration system must (only) contain details of the parameters from the catalogue in relation to the individual remuneration components that are actually implemented. Parameters from the catalogue that are not part of the actual compensation of the Management Board do not need to be included in the compensation system pursuant to Section 87a AktG. Only the following parameters must be included in the compensation system: (1) Determination of the total remuneration of the members of the Management Board (No. 1), (2) Explanation of how the remuneration and employment conditions of the employees are taken into account in determining the remuneration system (No. 9), (3) Presentation of the procedure for determining, implementing and reviewing the remuneration system (No. 10) and (4) the information specified in No. 11 for presenting the remuneration system to the annual shareholders' meeting.

The new version of the German Corporate Governance Codex (Deutscher Corporate Governance Kodex, DCGK) has in fact partially deviated from this rule-exception principle. Section G of the DCGK contains several recommendations for the structure of the remuneration of the members of the Management Board, which are also included in the catalogue in accordance with Section 87a (1) sentence 2 AktG. This applies, for example, to recommendations (1) on the disclosures of which financial and non-financial performance criteria are relevant for the granting of variable remuneration components (G.1 DCGK, Section 87a (1) sentence 2 no. 4 AktG) or (2) on deferral periods for the payment of remuneration components (G.1 DCGK, Section 87a (1) sentence 2 no. 5 AktG) or (3) the predominant form of variable remuneration in shares or share-based (G.10 DCGK, Section 87 (1) sentence 2 no. 7 AktG). In their annual declaration of compliance to be published in the Federal Gazette, companies must state the extent to which they comply with the DCGK and which recommendations of the DCGK they do not apply and why (Section 161 (1) sentence 2 AktG). In the past, the transparency obligation established by the declaration of compliance has meant that many listed companies have followed a large proportion of the recommendations in the DCGK on Management Board remuneration. A similar approach has also been adopted by many listed companies in implementing the new version of the DCGK - with the result that the remuneration systems already published often contain details of all parameters listed in the catalogue of Section 87a (1) sentence 2 AktG.


"Comply or Explain" – applied as required for the individual Management Board remuneration system

In individual cases, it may be necessary to deviate from the recommendations of the DCGK in terms of the content of Management Board remuneration. This is particularly the case if the purpose pursued by the DCGK in the respective recommendation for the specific remuneration of the members of the Management Board cannot be fulfilled in the way intended by the DCGK or is not relevant. The inclusion of provisions for the reclaiming of variable remuneration components that have already been paid out (clawback, G.11 DCGK) may not be relevant in individual cases if the situation typically associated with a clawback provision in the DCGK - realisation of a negative contribution to earnings relevant to remuneration only in a subsequent reference period after payment of the variable remuneration component - cannot generally occur at the company, for example with regard to the risk-averse operating business or risk strategy. In such cases, the DCGK recognises a permissible deviation from its recommendations and states in its preamble that a well-founded deviation from the DCGK recommendation may be in the interests of good corporate governance. The justification for the deviation must be factual, rational and oriented towards the company's well-being - and should already be documented together with the development of the remuneration system pursuant to Section 87a AktG.


The appropriateness test in accordance with Sections 87 (1) sentence 1, 87a (1) sentence 2 no. 1 AktG, G.2 et. seqq DCGK

The review of the horizontal and vertical appropriateness of the existing and planned remuneration of the members of the Management Board is a central component of the revision of the (rules) on the remuneration of the Management Board.

The Supervisory Board must perform the review of horizontal appropriateness using a suitable peer group from other companies that is comparable to the company in terms of the specific product-related and geographic market, the industry and size. In accordance with G.3 of the DCGK, the peer group should be chosen with care to avoid an automatic upward trend in remuneration ("race to the top").

The peer group must not only include companies from the immediate industry market environment (which often do not even exist), but can also include companies from outside the industry - not listed on the stock exchange - which are of comparable size in terms of number of employees and turnover. These key figures for the size of a company are decisive for the appropriate level of remuneration and are thus established as an assessment criterion for the purpose of comparing remuneration. The size of the company in particular has the greatest influence on the amount and range of remuneration paid to the members of the Management Board.

The Supervisory Board must plausibly justify any deviations in the total remuneration of the Management Board from that of the peer group in the documentation of the appropriateness test.

The review of vertical appropriateness relates to the relationship between the remuneration of the Management Board and the remuneration of senior management and the workforce as a whole and must also take the relationship in terms of time into account (G.4 DCGK). As a rule, the upper management circle comprises the first reporting level; in individual cases, the Supervisory Board may also set up an extended peer group. In the specific examination, the development over time should cover at least a three-year reference period; with regard to the five-year reference period to be applied for the remuneration report in accordance with Section 162 (1) sentence 2 AktG, in practice a period of at least five years should be applied.

(Temporary) deviations from the remuneration system - and their documentation in the remuneration system (Section 87a (2) AktG)
According to Section 87a (2) sentence 2 AktG, the Supervisory Board may (only) temporarily deviate from the remuneration system if this is necessary in the interest of the long-term well-being of the company and if the remuneration system specifies the procedure for deviation and the components of the remuneration system from which deviations may be made. The reasons for the temporary deviation in practice can be many and varied – at the same time, the statutory requirement of Section 87a (2) sentence 2 AktG requires a comprehensive reflection of possible deviation scenarios already when the remuneration system is drawn up. In addition, the scope of application of the exceptional deviation should only be limited to special crisis situations of the company. In practice, a combined approach is generally advisable here: On the one hand, the remuneration system should specify concrete case constellations for a necessary deviation in individual cases (e.g. appointment and employment of a new member of the Management Board in possible crisis situations of the company, which in individual cases require special remuneration incentives or modifications of the general system of the remuneration system). At the same time, the remuneration system should design the concretely defined case groups as examples of rules in order to have a sufficiently flexible scope for structuring in the specific individual case – in accordance with the adopted remuneration system. Sign on bonuses, which are sometimes demanded of new members of the Management Board when appointing and employing them during a crisis in the company, should be treated with particular care in this context. In accordance with the requirements of Section 87a (2) sentence 2 AktG, the reason for granting them must already be included in the remuneration system, but not in terms of the amount.

According to Section 120a (1) AktG, the annual shareholders' meeting must approve the compensation system. If it refuses to do so – as was recently the case based on the recommendation of voting consultants for lack of transparency – the compensation system must be revised and submitted for approval again. This does not create a good public image in this perceptive area. For this reason, too, particular care must be taken in the design and presentation of the remuneration system.


Conclusion

Listed companies must carefully observe the requirements of ARUG II, the DCGK and the interrelationships between them when implementing the specific remuneration of the Management Board, and must carefully implement the specific content of the regulations – taking into account their respective regulatory purpose and the resulting scope for argumentation – in the remuneration system envisaged for their Management Board members. 

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