The European Commission is gearing up to mandate compensation restrictions for financial institutions and all companies listed on stock exchanges in the European Union, if member states do not voluntarily implement recommendations that the EC issued on April 30.
That would be near-anathema to the European countries, which, despite their EC membership, have a strong bent toward self-regulation. The good news for them is that, as with most other guidelines from the commission in recent years, the recommendations are mostly statements of principle that leave quite a bit of room for interpretation.
Whether legislation ultimately will in fact be needed is questionable. Not only are some countries already adopting compensation restrictions that go beyond some of the EC’s proposals, but the public pressure to rein in remuneration is so great that the member states know they must act on their own or face the loss of sovereignty that they dread, Geert Raaijmakers, a corporate partner at NautaDutilh, a law firm serving Belgium, the Netherlands, and Luxembourg, told CFO.com.
The EC announced in March that it was working on a legislative effort to address compensation policies in the financial-services sector. The effort would be included in a broader package of modifications to rules governing financial firms’ capital requirements, scheduled to be proposed in June.
The extent of the compensation requirements ultimately will be determined, however, at least partly by the degree of self-regulation the sector undertakes, noted Raaijmakers.
That was made clear in EC documents detailing two sets of recommendations, one applicable to employees of financial institutions and the other to directors of public companies in any sector. The commission “invited” member states to notify it by December 31 of measures taken to address the guidelines. That would “enable the Commission to monitor closely the situation and, on that basis, to assess the need for further measures.”
The director recommendations in particular could have a global impact, because they apply to companies outside the EC that list their stock on an exchange in a member country. About 89% of the companies in the S&P 500 index are listed on a foreign exchange, according to data from CapitalIQ.
Some of those recommendations are more specific than any of the ones for financial institutions. For example, stock-based compensation shouldn’t vest for at least three years after shares are awarded, and termination payments generally should not be more than two years’ worth of the non-variable component of a director’s remuneration.
But most of the provisions are more general in nature. “Limits” should be set on any variable compensation, which should be subject to “predetermined, measurable performance criteria.” Those criteria should “promote the long-term sustainability of the company.” Variable remuneration should be deferred “for a minimum period of time.” After share awards vest, directors should retain “a number” of them for the duration of their tenure.
The measures are needed because, according to the commission, “Experience over the last years, and more recently in relation to the financial crisis, has shown that remuneration structures have become increasingly complex, too focused on short term achievements, and in some cases led to excessive remuneration which was not justified by performance.”
Meanwhile, as in the United States, financial institutions are being singled out for heightened scrutiny. “Excessive risk-taking in the financial services industry, and in particular in banks and investment firms, has contributed to the failure of financial undertakings,” the EC said. And, the commission added, there is a widespread consensus that inappropriate remuneration practices induced the elevated tolerance for risk.
But unlike the situation in the United States, the EC wants compensation curbs imposed on all banks, investment firms, insurers and reinsurers, and pension funds (defined as “financial undertakings”), and not just on entities that receive government assistance. Also, most limits in the United States apply to no more than 25 of a firm’s executive officers and other highly compensated individuals. But in Europe, the target is a seemingly much larger group: “those categories of staff whose professional activities have a material impact on the risk profile of the financial undertaking.”
At least for now, though, the details are being left to the individual EU countries. The recommendations state that financial undertakings should have compensation policies that promote sound and effective risk management, and that are aligned with the undertaking’s long-term interests.
Indeed, all of the two dozen or so guidelines for financial firms are similarly open to discretionary treatment. For example, policies should be “structured with an appropriate balance of fixed and variable remuneration components.” Financial undertakings should be able to “withhold bonuses when performance criteria are not met.” Where a “significant” bonus is awarded, the “major part” of it should be deferred. Payments upon early termination should be “related to performance achieved over time and designed in a way that does not reward failure.”
Regarding the measurement of performance, the EC said the compensation amount should be based the combined performance of the individual, business unit, and financial undertaking. And “non-financial criteria, such as compliance with internal rules and procedures [and] with standards governing the relationship with clients and investors, should be taken into account.”
Raaijmakers said that while the principles-based approach is a sound one, its success is not assured. “Self-regulation should work because it presupposes commitment [to the principles], but there is also a risk that self-made guidelines will remain too vague and broad to be effective,” he said.