Leonardo Sforza discusses governance rules for executive pay from both an EU and G20 perspective in the November 2013 edition of Benefits & Compensation International.

1. Governance Rules for Executive Pay
– the EU and G20 perspectives
Leonardo Sforza
Leonardo Sforza leads the Brussels office of MSLGROUP, Publicis’ strategic communications
and engagement group. With more than 25 years’ experience in corporate strategy and public
affairs, he advises organizations on EU policy issues and all aspects of multi-stakeholder
communication. Before joining MSLGROUP, Mr Sforza was the Head of Research and EU Affairs
at Aon Hewitt, where he pioneered thought-leadership projects on corporate governance,
people management and cross-border pension instruments. In 2012 he was named
Consultant of the Year by financial magazine PLANSPONSOR Europe. Since 2005 he has chaired the
scientific committee of the European Club for Human Resources and is a member of the
European Corporate Governance Institute. Mr Sforza has a postgraduate degree in Law (summa
cum laude) from the University of Bari and his working languages are English, French and Italian.
Over the last decade directors’ remuneration has become
a hot issue for policy makers and supervisory authorities,
from Brussels to Washington and from Beijing to Brasilia.
When one looks at what has been achieved in terms of
statutory or soft law requirements, what is on the
agenda for legislators and what still needs to be
delivered in practice, directors’ remuneration is likely to
remain an issue under increasing scrutiny from policy,
investor and public opinion perspectives.
that range from the business rationale
beyond a compensation package to the role
of shareholders in the decision-making process; from
the nature and scope of performance indicators
applicable throughout the organization to employee
reward practices and financial participation in business
results; from moral hazard in executive compensation
and earnings management2 to the role of the
supervisory authorities in preventing and mitigating
such risks.
This time, Europe seems to be leading the way in
addressing executive compensation and corporate
governance policies. The diversity of corporate
governance models, and shareholding and management
cultures/structures, may have been a source of
inspiration, rather than a barrier, for such developments.
At the initiative of both the European Union (EU)
institutions and the 28 EU countries and following direct
citizens’ pressure in leading business-friendly
Switzerland,* changes in policy are well under way in
this area, with more to come soon.† More importantly,
changes in the direction of enhanced corporate
governance in practices and behaviours are also
expected to follow, though not without pain.
Albert Einstein, once questioned about the meaning of
success, wisely said, “Try not to become a man of success,
but rather try to become a man of value”, certainly not
thinking in terms of the pay packet – a recommendation
that everyone, not just executives, would be well advised
to follow. What that value consists of can be debated,
ranging from the narrow shareholders’ value creation
theory, celebrated by Milton Friedman in a famous article
of the 1970s in The New York Times Magazine, to the
broader stakeholders’ value creation model more widely
accepted in modern corporations3. I would add to the
There are two major risks to avoid in this process of
reform that is under way but still has a long way to go.
First, the temptation of regulators to shift from a
framework of principles and key objectives of reference
for the legitimate convergence of good governance to a
prescriptive one-size-fits-all rule book that risks becoming
another ‘tick-box’ exercise deprived of substance. Second,
there is a risk that public opinion and policy
representatives view the debate about excessive pay only
through the lens of demagogy by placing all executives,
irrespective of their performance and the sustainable
value created for shareholders and stakeholders in
general, in the same category, labelling them ‘fat cats’.
* Following the results of a Federal referendum held in
March 2013, Switzerland held a plebiscite to give
shareholders an absolute binding vote on executive pay.
The measure, known as the Minder Initiative, was passed
with a 67.9% majority, spurring a new regulatory
framework on executive compensation.
† For further information, please see ‘Switzerland Leads
the Way in Executive Compensation & Corporate
Governance’ by Piero Marchettini, B & C International,
May 2013.
‡ At the time of writing, there were more than 7.2 million
referenced articles on Google concerning executive reward
for failure.
§ The Top 10 in 1986 on the Forbes list of the highest-paid
CEOs earned, in aggregate, US$57.88 million while
the 10 highest paid in the 2012 Forbes list earned
US$616.40 million in total, or 10.65 times the amount in
1986. Over the same period, the consumer price index
variation was no more than 103%.
The all too many examples of executives being rewarded
for failure‡ and receiving substantial increases in their
pay packages over the recent past§1 may well justify this
sentiment. Nevertheless, this should not stop us from
addressing the whole question of executive
compensation in relation to a greater array of factors
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2. BOX 1
Argentina
Australia
Brazil
Canada
China
France
Germany
Hong Kong
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completed the implementation of the FSB Principles
and Standards (P&S) in their national regulation or
supervisory guidance. The focus now is on the
effective supervision of the implementation of these
rules by relevant companies.
Current Members of the FSB
I
I
I
I
I
I
I
I
India
Indonesia
Italy
Japan
Korea, Rep. of
Mexico
Netherlands
Russia
I
I
I
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Saudi Arabia
Singapore
South Africa
Spain
Switzerland
Turkey
United Kingdom
United States
G
The disclosure of compensation practices has
improved. Most jurisdictions report that the majority
of the supervised companies now disclose
significant and detailed information on
compensation structures in annual remuneration
reports. Most authorities are of the view that the
implementation of the P&S and related supervisory
action, among other factors, has had a heavy impact
on changes in compensation practices for supervised
institutions. Reported trends since the 2011 peer
review suggest that most compensation structures
are being revised in the direction indicated by the
P&S. Most jurisdictions report increases in (a) the
percentage of pay that is deferred and/or (b) longer
periods of deferral; increases in the use of equity as
a form of compensation; and increased use of ‘malus’
clauses for both (a) financial performance and (b)
compliance or behaviour issues.
G
Several authorities note that companies still express
some level playing-field concerns regarding
jurisdictions that may not have fully implemented
the P&S or that do not supervise companies
adequately for this purpose. Meanwhile, national
authorities do not acknowledge, in the absence of
any real evidence, that the implementation of the
P&S has impeded or diminished the ability of
supervised institutions to recruit and retain talent.
The Bilateral Complaint Handling Process, which the
FSB initiated for addressing level playing-field
concerns, has not so far been activated by
companies in FSB member jurisdictions.
G
Certain regulatory initiatives currently being
implemented could materially change compensation
structures in some FSB member jurisdictions. In
particular, the adoption by the EU of the fourth
Capital Requirements Directive (CRD IV) includes
requirements on compensation structures that go
aspiration of being a person of value the objective of also
being a person of values, with the emphasis on the ‘s’.
Many of these developments are designed to tackle
the most critical aspects from both a general interest
and a market perspective. We will focus on those
emanating from supranational bodies and institutions,
in particular the Financial Stability Board (FSB) and the
European Union, given their broader and effective reach.
THE ACTIONS AND IMPACT OF THE FSB
In the context of the G20 agenda, although the last
summit in St Petersburg was dominated by the dramatic
situation in Syria, a group of diligent ‘Sherpas’ under the
remit of the FSB prepared an accurate and thoughtful
report on the state of implementation of its principles
for sound compensation practices and standards among
the 24 FSB member jurisdictions.
The G20 London summit of 2009 decided to establish the
FSB as a successor to the Financial Stability Forum, the
latter having been founded in 1999 to promote
international financial stability and facilitate discussion
and co-operation on the supervision and surveillance of
financial institutions involving Finance Ministers and
Central Bank Governors of the G7 countries and other
industrialized economies. BOX 1 above provides a list of
current members of the FSB. The following organizations
also take part in the FSB’s work: the Bank for International
Settlements, the European Central Bank, the European
Commission, the International Monetary Fund, the
Organisation for Economic Co-operation and
Development and The World Bank4.
Under the chairmanship of Mario Draghi in 2009,
Governor of the Bank of Italy at the time, one of the very
first documents adopted by the FSB and with which the
G20 members committed themselves to complying was a
set of Principles for Sound Compensation Practices and
Implementing Standards*5. The second progress report,
finalized in August by the FSB Compensation Monitoring
Contact Group, focuses on the remaining gaps and
obstacles to its full implementation while analysing some
of the key challenges and evolving practices in this area.
* The FSB’s October 2011 thematic peer review on
compensation set out several recommendations to support
the full and effective implementation of the Principles and
Standards by both national authorities and companies. The
G20 leaders in Cannes called on the FSB to: “undertake an
ongoing monitoring and public reporting on compensation
practices focused on remaining gaps and impediments to
full implementation of these standards and carry out an
ongoing bilateral complaint handling process to address
level playing field concerns of individual firms.” The FSB has
established a Compensation Monitoring Contact Group that
is responsible for monitoring and reporting to the FSB on
national implementation of the P&S. The first implementation
progress report in this area was published in June 2012. In
addition, a Bilateral Complaint Handling Process was
launched in April 2012, which establishes a mechanism for
national supervisors from FSB member jurisdictions to
bilaterally report, verify and, if necessary, address specific
compensation-related complaints by financial institutions
based on level playing-field concerns.
The main findings of the FSB report seem encouraging
on the state of progress of national implementation,
although the remaining work on the ground is still
material from a supervisory and corporate practice
perspective. In particular, the principal findings of the
review covered by the report are as follows:
G
With the only exceptions being Argentina and
Indonesia, all FSB member jurisdictions have now
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3. beyond those in the P&S. The implementation of the
Directive will foster the convergence of
compensation practices for all credit institutions and
designated investment management firms operating
in the European Economic Area. At the same time,
concerns have been expressed, especially by a few
non-EU FSB member jurisdictions, about the
prescriptive nature of these requirements. In
particular, these jurisdictions suggest that the
introduction of a limit on the ratio between fixed
and variable compensation for material risk takers
(MRTs) may have unintended consequences, such as
creating obstacles to the ability of internationally
active companies to implement a global approach to
compensation structure and adopting a larger
proportion of fixed compensation in their EU
operations. These issues are also relevant to
ensuring a level playing-field.
G
The European Commission, by adopting its temporary
State aid rules for assessing public support to financial
institutions during the crisis, is aiming to improve
the restructuring process, and the level playing-field,
for banks. In particular, banks will be required to
work out a sound plan for their restructuring or
orderly winding down before they can receive
recapitalization funds or asset protection measures.
Moreover, in the case of capital shortfalls, bank owners
and junior creditors will be required to contribute
first, before the banks can ask for public funding. In
this context, a full section of guidelines is dedicated
to compensation*6. In this respect, the rules
provide that failed banks should apply strict
executive remuneration policies. The new Banking
Communication sets a cap on total remuneration as
long as the entity is being restructured or is reliant
on State support. This is supposed to give management
the appropriate incentives for implementing the
restructuring plan and repaying the aid. The rules apply
for as long as market conditions dictate. The
Commission may revise them as necessary, notably in
the light of the evolution of the EU regulatory
framework for banking.
The report concedes that further work is needed on
the identification criteria for MRTs. This is an area
where there is a broad range of practices across
jurisdictions and companies, partly due to
differences in relevant national regulations and
supervisory guidance and partly because of the
different size, nature or complexity of institutions. It
is not yet clear whether the diversity in practices and
experimentation among companies and jurisdictions
is leading to significantly different outcomes or
which approaches are most effective.
Remuneration and Capital Adequacy for the Banks
More broadly, in relation to the financial services sector,
the Commission presented legislative proposals
empowering national supervisors to oblige financial
institutions to implement remuneration policies
consistent with effective risk management. Indeed, new
provisions on remuneration in the financial services
sector were adopted on 17 July 2013 when the latest
amendment to the CRD IV was made. In addition, the
Commission said that similar legislative initiatives in
other financial sectors, such as insurance, should be
considered.
Irrespective of national implementing progress reported
by the FSB and regardless of local corporate culture,
there is no more room for directors to cut corners or to
perform their tasks without embedding high standards
of governance into business decisions and practices
throughout the organization.
THE EUROPEAN UNION AGENDA
The CRD IV package which transposes – via a Regulation
and a Directive – the new global standards on bank
capital (commonly known as the Basel III agreement)
into the EU legal framework came into force on
17 July 2013. The new rules, which will apply from
1 January 2014, tackle some of the vulnerabilities shown
by the banking institutions during the crisis, among
which are remuneration policies.
The European Union, mainly at the initiative of the
European Commission, its executive arm, has been
tackling the issue of directors’ compensation as part of
the broader process of modernizing company law with a
view to enhancing corporate governance in listed
companies. However, as already mentioned in the
context of the FSB report, most of the binding measures
taken are more prominently addressed to the banking
and financial services sector, where related pay policies
and practices have been identified as one of the critical
causes of the last financial crisis.
Pay Constraints on Banks under Public Rescue Plans
An important, compelling illustration of the European
Commission’s determination can be found in the
guidelines adopted last July by the Commission on crisis
rules for banks and by their immediate application one
week later in relation to the rescue package granted by
Italy to the bank Monte dei Paschi di Siena (the oldest
bank in the world, active since 1472).
* The EC Communication adopted on 11 July 2013 replaces
the 2008 Banking Communication and supplements the
remaining crisis rules. The combined revised rules define not
only the common EU conditions under which member states
can support banks with funding guarantees, recapitalization
or asset relief but also the requirements for a restructuring
plan. In 2008-09, following the collapse of Lehman Brothers,
the Commission adopted a comprehensive framework for
co-ordinated action to support the financial sector during the
crisis, so as to ensure financial stability while minimizing
distortions of competition between banks and across
member states in the Single Market. It spells out common
conditions at EU level for access to public support and the
requirements for such aid to be compatible with the internal
market in the light of State aid principles. It comprises the
Banking Communication, the Recapitalisation
Communication, the Impaired Assets Communication and
the Restructuring Communication.
In this context, Joaquín Almunia, Vice President of the
EC responsible for competition policy, in a polite but
firm letter to the Italian Minister for the Economy
considered inappropriate and clearly challenged the
compensation package put forward by the Board of the
Bank, among other controversial points raised regarding
the Monte Paschi’s rescue plan which had been
submitted by the national authority for EU clearance.
3

4. However, a study for the Commission published in 2009
revealed significant shortcomings in applying the
‘comply or explain’ principle that reduce the efficiency
of the EU’s corporate governance framework and limit
the system’s usefulness. In particular, the study revealed
that, in over 60% of cases where companies chose not to
apply recommendations, they did not provide sufficient
explanation11.
The Directive complements the Recommendation by
implementing international standards and practices at
EU level through the introduction of an express
obligation on credit institutions and investment
management firms to establish and maintain, for
categories of staff whose professional activities have a
material impact on their risk profile, remuneration
policies and practices that are consistent with effective
risk management. In particular, the Directive specifies
clear principles on governance and on the structure of
remuneration policies; makes the distinction between
fixed remuneration and variable remuneration, with a
maximum ratio set between the two; assigns the task to
the management bodies to adopt and periodically
review the remuneration policies in place; and ensures
that competent authorities have the power to impose
qualitative or quantitative measures on the relevant
institutions7.
Other EC Responses to the Financial Crisis
The financial crisis showed up serious weaknesses in the
way in which financial markets were regulated and
supervised. There is a broad consensus that
compensation schemes based on short-term returns,
without adequate consideration for the corresponding
risks, contributed to the incentives that led financial
institutions’ engagement in over-risky business
practices. In addition, wider concerns have been voiced
about substantial increases in executive remuneration,
the increased importance of variable pay in the
composition of directors’ compensation packages and
an alleged short-term focus of remuneration policies
across all sectors of the economy.
EU Clairvoyance on Compensation and Governance
It is worth remembering that the work of the European
Commission in the area of directors’ compensation,
even beyond financial services, goes back to 2002 – well
before the 2008 crisis. The seeds of today’s
developments can be found in the report of a High Level
Group of Company Law Experts appointed by the
Commission that focused on corporate governance
pitfalls and remedies in the EU8.
Within this context, in April 2009 the Commission
adopted two complementary Recommendations on
remuneration policies that are still valid. These deal, on
the one hand, with the regime for the remuneration of
directors of listed companies and, on the other hand,
with the remuneration policies in the financial services
sector12.
In 2003, less than a year after the experts’ report, the
Commission adopted an Action Plan on modernizing
company law and enhancing corporate governance in
the European Union, recognizing the need for
shareholders to be able to fully appreciate the
relationship between the performance of the company
and the level of remuneration of directors, both ex-ante
and ex-post, and to make decisions on the remuneration
items linked to the share price9. The Action Plan was
followed in 2004 by a wide consultation process and a
specific Recommendation on directors’ remuneration. It
recommended member states to ensure that listed
companies disclose their policy on directors’
remuneration, that shareholders are informed of
individual directors’ remuneration packages and are
given adequate control over these matters, including
share-based remuneration schemes. The 2007 report on
the application of the Recommendation shows that
corporate governance standards had been improving
and that transparency standards were more widely
followed. Meanwhile, the more controversial issue of a
shareholders’ vote on pay remained untackled in several
member states10.
In a second phase, for companies listed on the stock
exchange, the Commission published an Action Plan on
European company law and corporate governance in
December 2012, following the Green Paper (in 2011) and
the public consultation (in 2012). It identifies three main
lines of action:
– enhancing transparency;
– engaging shareholders; and
– supporting companies’ growth and competitiveness.
As announced in the Plan, the Commission will propose
an initiative later in 2013, possibly through an
amendment of the Shareholders’ Rights Directive, to
improve transparency on remuneration policy and to
make it compulsory to grant shareholders the right to
vote on the remuneration of directors13. The
forthcoming Commission’s commitment on this front
has been more recently confirmed in the response given
by the executive EU agency to a parliamentary question
raised by MEP Marc Tarabella earlier in 2013.
The corporate governance framework for listed
companies in the European Union is based to a large
extent on soft law, namely corporate governance codes.
While these codes are adopted at national level,
Directive 2006/46/EC requires that listed companies
refer to a code in their corporate governance statement
and that they report on their application of that code on
a ‘comply or explain’ basis. This approach means that a
company choosing to depart from a corporate
governance code has to explain which parts of the code
it has departed from and the reasons for having done so.
The advantage of this method is its flexibility, as it
allows companies to adapt their corporate governance
practices to their specific situation in relation to their
size, shareholding structure and sector of activity.
In particular, the new European Commission proposals
will address how to improve the functioning of the
‘comply or explain’ approach within the EU corporate
governance framework. This should help to address the
alleged problem of the low quality of corporate
governance explanations provided by some companies
departing from corporate governance code provisions.
Currently, they often provide no or insufficient
explanations. This makes it difficult for investors
to judge the appropriateness of the company’s
corporate governance arrangements and to assess
whether the company has good reasons not to
comply with a given arrangement. As mentioned
earlier, the advantage of the ‘comply or explain’
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5. more powerful proposal. Executives of listed companies,
investors, national bodies in charge of updating and
monitoring the corporate governance codes and their
respective advisers need to stay tuned for what will
come next from Brussels in this area and assess the
implications in their respective contexts. Moreover, they
must not hesitate to speak up, giving their perspective
to EU representatives and making their voices heard
during the decision-making process. Irrespective of how
good the guidelines and rules will end up as being in this
area, business leaders today are more than ever in the
driving seat to restore trust while safeguarding their
own priceless reputations.
Ω
approach is that it allows companies to adapt
their corporate governance arrangements to their
specific needs. Companies may have very good
reasons for non-compliance; however, in this case they
should be clearly indicated. Insufficient or generic
information does not make it possible to assess whether
or not the company has good reasons for noncompliance.
The legal nature and scope of forthcoming initiatives
have not yet been finalized but we can anticipate that
most of the European Commission’s consideration and
guidelines presented above will materialize in a new,
References
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19
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Richard Flinger, ‘Is the end of gigantic, unfair, and absurd CEO pay near?’, Forbes, 18 March 2013.
Bo Sun, ‘Executive Compensation and Earnings Management Under Moral Hazard’, for the Board of Governors of the Federal Reserve
System, International Finance Discussion Papers, No. 985, December 2009.
See especially Lynn Stout, Shareholder Value Myth: How Putting Shareholders First Harms Investors, Corporations, and the Public, 2012.
‘Implementing the FSB Principles for Sound Compensation Practices and their Implementation Standards’, Financial Stability Board,
26 August 2013.
‘FSF Principles for Sound Compensation Practices’, Financial Stability Forum, 2 April 2009 and, for further information on compensation
monitoring by the FSB, see Compensation Monitoring, Financial Stability Board.
State aid temporary rules established in response to the economic and financial crisis, Official Journal of the European Union,
European Commission, Vol. 56, C 216, 30 July 2013.
‘Directive 2013/36/EU of the European Parliament and of the Council’, Official Journal of the European Union, Vol. 56, L 175, 27 June
2013 and ‘Regulation (EU) No. 575/2013 of the European Parliament and of the Council’, Official Journal of the European Union, Vol. 56,
L 176, 27 June 2013.
‘Report of the High Level Group of Company Law Experts on a Modern Regulatory Framework for Company Law in Europe’, The High
Level Group of Company Law Experts, 4 November 2002.
‘Modernising Company Law and Enhancing Corporate Governance in the European Union – A Plan to Move Forward’, Commission of
the European Communities, 21 May 2003.
‘Report on the application by Member States of the EU of the Commission Recommendation on directors’ remuneration’, Commission
of the European Communities, 13 July 2007.
‘Monitoring and Enforcement Practices in Corporate Governance in the Member States’, European Commission, 23 September 2009.
An assessment of the level of implementation of these recommendations is included in the EC’s report covering measures taken by EU
member states to promote their application. See ‘Report from the Commission to the European Parliament, The Council, The European
Economic and Social Committee and the Committee of the Regions’, European Commission, 2 May 2010.
‘Action Plan: European company law and corporate governance – a modern legal framework for more engaged shareholders and
sustainable companies’, European Commission, 12 December 2012.
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