August 24, 2009
On August 5, 2009, the German Act on the Appropriateness of Management Board Compensation (Gesetz zur Angemessenheit der Vorstandsvergütung, "VorstAG") came into force. The VorstAG introduces changes designed to align the compensation structure and incentives for management board members of German stock corporations (Aktiengesellschaft) with a management style that focuses on a sustainable long-term development of the managed company. Therefore, specific criteria to determine "appropriate" compensation are stipulated, the supervisory board’s role and liability for determining such compensation is increased, and additional disclosure obligations on the management board’s compensation are introduced. The changes regarding the supervisory board may also apply to German limited liability companies that have elected to form a supervisory board in accordance with their charter.
1. "Appropriate" (angemessene) compensation for members of the management board and extension of the waiting period for exercising new stock options
The VorstAG introduces clarifications to the criteria that are relevant to determine the appropriateness of board compensation, in particular:
(i) The compensation must not only be appropriate in view of the respective board member’s tasks (as was required before the changes), but also with respect to the individual board member’s performance;
(ii) The compensation shall not exceed "customary" (übliche) levels, unless there is a good reason for such excess. From the legislative material, one can expect that the customary level will need to be determined by taking into account compensation levels in the same industry, country and in companies/groups of a similar size and complexity. Furthermore, the general salary structure in the company/group managed by the management board is an additional criterion for assessing what level of compensation is customary.
(iii) Variable components need to be assessed on a basis of the performance over a period of more than one year and shall include provisions to limit such variable components in the event of extraordinary developments in the business of the company. For listed stock corporations, the compensation structure shall be based on a sustainable development of the company.
Additionally, the VorstAG extends the waiting period for exercising stock options under new stock option plans: New stock option plans launched by a German stock corporation based on a contingent capital increase passed by the general shareholders’ assembly convened after August 5, 2009 must provide for a non-execution period of at least four years (formerly two years).
2. Increased role of the supervisory board in determining the management board compensation and increased liability
According to the VorstAG, the plenum of the supervisory board must now decide on the management board’s remuneration. A deferral of this decision to a committee of the supervisory board, as was common practice in German stock corporations before the VorstAG, is no longer permissible.
The supervisory board shall reduce the management board’s compensation to an appropriate level, if the company’s situation deteriorates to such an extent that maintaining the previous level of compensation would be unfair (unbillig). While a similar right of the supervisory board existed before, the new law introduces a higher standard for the discretion of the supervisory board to use this right ("shall" instead of "may"). If a management board member’s compensation is reduced, the board member may exercise an extraordinary termination right of his/her contract.
Under the existing law, there had always been the threat of personal liability for supervisory board members if unreasonably high management board compensation was culpably determined. However, the VorstAG emphasizes this by expressly mentioning the liability of the supervisory board if management board compensation is deemed inappropriate. Therefore, going forward, courts should be expected to be stricter in applying such liability than before.
3. New mandatory insurance deductible for management board member’s D&O insurance
D&O insurances taken out by the company to cover risks arising from a board member’s professional activities must include a certain deductible. It must be (i) at least ten percent of the individual damage and (ii) at least 150 percent of the respective board member’s annual fixed compensation. Existing D&O insurances that do not contain the deductible need to be amended accordingly no later than July 1, 2010.
If the company is obliged vis-à-vis a board member to take out a D&O insurance without any deductible under an agreement entered into with the board member before August 5, 2009, it can perform this obligation even after July 1, 2010.
The new law echoes the earlier recommendations given under No. 3.8 of the German Corporate Governance Code, which at the time were only implemented by a few German stock corporations.
4. Extended disclosure obligations regarding the compensation of management board members and a cooling-off period after the termination of office
From now on, the annual financial reporting of a German stock corporation must elaborate in greater detail on the executive board members’ compensation. In particular, it is necessary to disclose the compensation payable in the event of an early termination of a management board member’s contract, and the discounted cash effect of compensation owed to the management board member in the event of regular termination of office (including the amounts reserved by the company for such an event), as well as amendments to the compensation package.
It was not uncommon in German stock corporations for members of the management board to transfer to the supervisory board of the same company immediately upon termination of their previous office. This practice is now significantly limited. A two-year cooling-off period starting with the board member’s leave of office generally applies, unless this person is nominated for election to the supervisory board by shareholders constituting over 25 percent of the voting shares in the stock corporation. The new cooling-off period does not apply to supervisory board members who took office before August 5, 2009.
5. Recommended actions
(i) Supervisory boards should now review the existing contracts with management board members and assess whether any adjustments should be made at this time or in the near future in light of the provisions of the VorstAG.
(ii) Supervisory boards should ensure that a deductible of at least ten percent of the individual damage and of no less than 150 percent of the annual fixed compensation of the management board member is included in the board member’s D&O insurance no later than July 1, 2010, unless special circumstances apply.
(iii) Companies should review the bylaws of their supervisory boards and eliminate any provision to delegate compensation decisions to a committee, and, while the preparation of such decisions may still be done by a special committee, the ultimate decision must now be taken by the plenum of the supervisory board.
The provisions of the VorstAG are incorporated into the German Stock Corporation Act (Aktiengesetz). The amendments required by the VorstAG have been reflected in a revised version of the German Corporate Governance Code (www.corporate-governance-code.de).
Gibson, Dunn & Crutcher attorneys are available to assist in addressing any questions you may have regarding these issues. If you have any questions about these particular matters or would like additional information, please contact any of the following attorneys in the firm’s Munich office:
Benno Schwarz (+49 (89) 189 33 110, firstname.lastname@example.org)
Philip Martinius (+49 (89) 189 33 121, email@example.com)
Markus Nauheim (+49 (89) 189 33 122, firstname.lastname@example.org)
Mark Zimmer (+49 (89) 189 33 130, email@example.com)
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