The Advisors' Blog

– Subodh Mishra, ISS Governance Exchange

The European Commission announced April 9 a package of measures, including a binding say-on-pay vote, to encourage “competitiveness and long-term sustainability” of companies across the 28 nation bloc.

The proposed rule, to be embedded in the European Union’s Shareholder Rights Directive, will empower investors through the provision of greater say on remuneration while also requiring of them enhanced disclosure on their investment and engagement policies. The proposal also provides a framework to make it easier to identify shareholders so, commission officials say, they can more easily exercise their voting rights, in particularly in cross-border situations. According to the EC, 44 percent of shareholders are from another EU Member State or hail from outside the EU. “Today’s proposals will encourage shareholders to engage more with the companies they invest in, and to take a longer-term perspective of their investment,” EC Internal Markets head Michel Barnier said in an April 9 statement. “To do that, they need to have the rights to exercise proper control over management, including with a binding ‘say on pay.'”

Arguing there is an “insufficient” link between management pay and performance which encourages “harmful short-term tendencies,” the proposal calls for companies to disclose clear, comparable and comprehensive information on their remuneration policies and how they were put into practice.

Every company would be required to put its remuneration policy to a shareholder vote on a triennial basis, with the policy spelling out a maximum level for executive pay and how that pay contributes to the long-term interests and sustainability of the company. The policy would also need to explain how the pay and employment conditions of employees of the company were taken into account when establishing the program, including explaining the ratio between average employees and executive pay. Additionally, companies would annually submit their remuneration report to an advisory shareholder vote, in keeping with practices evidenced in the U.K. beginning this year.

A Draconian Step?

Business groups have cautioned on the new rules, suggesting the empowerment of shareholders should not come at the expense of directors well versed in company and human resource nuances. “[A]ny changes to the rights and responsibilities of shareholders should not blur their roles with those of company boards and management, otherwise they will result in inefficient micro-management by shareholders,” said Matthew Fell, Director for Competitive Markets at the London-based Confederation of British Industries, in an April 9 release. “It shouldn’t be shareholders’ responsibility to set specific pay levels or vote on pay ratios, for example. It’s right that shareholders focus on the big picture when it comes to pay, and in the UK they have a vote on company pay policy, but the remuneration committee should retain responsibility for specific pay levels.”

EC officials, however, contend the time is right to introduce sweeping pay reforms that will ensure a level playing field across all member states. Pointing to France and Austria, where shareholders do not have a say on directors’ pay, EC officials say the average remuneration of directors in the years 2006 to 2012 increased by 94 percent and 27 percent, respectively, although the average share price of listed companies in these countries decreased by 34 percent and 46 percent, respectively. While executive pay should not depend only on short-term share price fluctuations, such fundamentally divergent trends are one indicator for a mismatch between pay and performance, officials say.

Similar evidence can be found in Italy and Spain which allowed for an advisory say-on-pay vote in 2011. There, officials say, firm value increased while director pay decreased in the wake of such voting, strengthening the link between pay and performance. A total of 13 EU countries allow for say-on-pay votes. France and Austria are among EU countries where no such right exists, while most others provide for advisor voting.

Greater Demands of Investors

Barnier’s proposal also would require institutional investors to disclose how they take the long-term interests of their beneficiaries into account in their investment strategies and how they incentivize their asset managers to act in the best long-term interests of the institutional investor. This, EC officials say, would “raise awareness of the importance of this issue” and make it transparent whether asset management mandates are based on best practices in this area. The draft directive would also require institutional investors to disclose their engagement policies and how they’re implemented. Once investors “establish longer-term relationships,” officials contend, there will be more incentives for them to engage, resulting in better governance and higher firm and portfolio value.

The rules, which would be applied on a “comply-or-explain” basis, reflect the growing movement toward investor stewardship as best evidenced by the U.K. Stewardship Code and United Nations Principles for Responsible Investment. “We empathise with the Shareholder Rights Directive’s objective to encourage and facilitate long-term shareholder engagement with investee companies,” said Will Pomroy, policy lead for corporate governance at the U.K.’s National Association of Pension Funds, in a statement. “More consistent shareholder rights across Europe, along with greater disclosures from asset managers to their clients, are welcome and should strengthen investor stewardship in the interests of both savers and companies.” Pomroy agreed that pension funds should devise an investment policy that includes stewardship objectives, though warned that new disclosure requirements must be practical. “Care needs to be taken to avoid unintentionally tying the hands of investors or creating a tick-box exercise at the expense of encouraging the right behaviors,” he said.

Strengthening Comply-or-Explain

The draft proposal also aims to improve corporate governance reporting by listed companies more broadly. Most corporate governance regimes in Europe are soft law reflecting a comply-or-explain approach, whereby a company that chooses to depart from the applicable corporate governance code provisions must give reasons for the departure. This approach offers companies an important degree of flexibility, companies argue, though some investors contend companies fail to provide appropriate explanations for the departure.

The EC aims to remedy the latter by providing guidance on how listed companies should explain their departures from the recommendations of the relevant corporate governance codes and to encourage companies to report on how they adhered to code provisions on topics of import to shareholders, in order to “improve transparency and quality of corporate governance reporting in general.” The EC is inviting feedback on the proposals from member states through spring 2015.