Managing an effective board through remuneration policies – an Italian perspective within the European context
May 2017 | SPECIAL REPORT: OPERATING AN EFFECTIVE BOARD
Financier Worldwide Magazine
Clear principles on the governance and structure of the remuneration policies of board members and top managers have become, since the financial crisis of 2007-2008, an important means by which to operate an effective board.
Weaknesses in corporate governance in a number of institutions have, in fact, contributed to excessive short-term management strategies and imprudent risk taking in the banking and financial sector. This, in turn, led to the failure of individual institutions and systemic problems in member states and globally, as recognised by the European Parliament and the Council in the preamble to directives 76/2010/EC and 2013/36/EU.
The European legislator and authorities therefore decided, with the above directives, to lay down the principles of sound remuneration policies that must be followed by credit institutions and investment firms, leaving to member states the responsibility to implement them in compliance with local legislation. The technical aspects were specified by the Committee of European Banking Supervisors (CEBS) guidelines on Remuneration Policies and Practices, published on 10 December 2010.
In Italy, the European principles on remuneration policies were implemented in 2013 by the Bank of Italy, which adopted a very rigid approach, often interpreting the European directive and the CEBS guidelines in the broadest way possible. As a general principle, remuneration policies should be consistent with and promote sound and effective risk management, without encouraging risk-taking that exceeds the risk tolerance level of the institution. To reach this goal, remuneration policies must clearly define fixed and variable remuneration and set out limitations on the latter.
In particular, fixed remuneration should be proportionate to the services rendered, in line with the level of education, expertise and skills required, the relevant business sector and region. Variable remuneration should, instead, follow a fully flexible policy and should decrease as a result of negative performance, even going down to zero in some cases.
Variable remuneration always has to be a percentage of the fixed remuneration and – further to Directive 2013/36 – cannot exceed 100 percent of it, unless a higher ratio is approved through a special procedure by the institution’s shareholders (in which case, variable remuneration can be up to 200 percent of fixed remuneration). Variable remuneration must, then, be performance based and risk-adjusted through quantitative and qualitative approaches.
In order to align the personal objectives of the board directors with the long-term interests of the institution, the performance of the board directors should be evaluated on a long-term basis (at least three to five years) and take into account the outstanding risks associated with the performance. Also, payment of between 40 and 60 percent of variable remuneration should be deferred, i.e., paid after at least one to three years, so that institutions will be able to hold back variable remuneration that has still not been paid in case of bad results. Finally, at least 50 percent of variable compensation should consist of equity-linked instruments of the credit institution or investment firm.
If it is not possible to withhold deferred variable remuneration, as ex-post risk adjustment instruments, remuneration policies should include malus and claw-back clauses to recover any variable compensation already paid to board directors. This is necessary in case the consequences of risks taken present themselves after a number of years, or if there is evidence of misconduct or a serious error by the board of directors.
Although the above rules are clear, a key issue is that it is not easy to clearly define is what is fixed and what is variable remuneration. The definition given at European level – more so in Italy – of variable remuneration is extremely broad and differs from what is usually considered variable remuneration in employment law.
By way of example, compensation for a non-competition clause should not strictly be considered as remuneration for work activity since it is actually paid against the obligation not to work. However, the Bank of Italy, considering that compensation for non-competition agreements could be used as a means to facilitate a significant pay-out by eluding restrictions on remuneration, decided that it may fall within the definition of variable remuneration. Also, the definition of allowances, golden parachutes and severance payments give rise to interpretation problems.
All of the above limitations on variable remuneration, combined with the broad scope of its definition, have and may especially in the future, give rise to a number of practical issues that must, therefore, be handled carefully.
If a severance package is deemed as variable remuneration, then it must comply with all the restrictions applicable to it (deferral, 50 percent as equity instruments, clawback clauses, etc.). Settlement agreements must, therefore, be carefully studied and drafted in order to satisfy the parties but also compliant with legislation on remuneration policies in order to avoid the risk of local authorities reprimanding companies with heavy sanctions which are, in Italy, very heavy.
Provisions on remuneration policies also deal with corporate governance and provide for the establishment of a remuneration committee that must be independent from the institution.
These rules are quite complex and may actually be a burden, especially for small institutions. As a remedy, it has been made clear by the European legislator that the rules on remuneration policies must always be applied in practice, in compliance with the principle of proportionality. So, credit institutions and investment firms may implement the provisions in different ways depending on their size, internal organisation and the nature, scope and complexity of their activities. The more complex they are, the stricter and more sophisticated the remuneration policies must be.
Member states are, however, still struggling with the notion of proportionality as underlined by the European Banking Authority (EBA) in its Guidelines (which entered into force on 1 January 2017) and in the Opinion of 21 December 2015. The EBA therefore stressed the importance of further harmonising the legislation of member states. It will be interesting to see how its Guidelines will be implemented.
As a final note, it must be underlined that, although the above legislation and regulations nowadays concern only the financial and banking sector, they are increasingly being used as a benchmark by listed companies for drafting their own remuneration policies. Listed companies must already publicly disclose information on the remuneration of their board of directors but are not obliged to comply with the specific rules on remuneration policies described above. They have, however, become very sensitive to the problem of regulating their governance and limiting unsound risk-taking by members of the board of directors and are, therefore, autonomously deciding to also follow the principles set out for the credit and financial sectors, which are considered to be best practice for remuneration policies.
Well-drafted remuneration policies can, in fact, be useful for two reasons. On one hand, they prevent excessive risk-taking, by granting more transparent governance, controls and a better alignment of the interests of the board of directors and top managers with those of the company. On the other hand, they are a means to try and immediately limit damage suffered due to irresponsible risk-taking without embarking on long and uncertain judicial proceedings.
The scenario described above shows that it may be advisable for all companies, listed or not, to address the issue of how to operate effective and transparent governance. This includes studying and drafting remuneration policies in line with best practices developed so far.
Emanuela Nespoli is a partner at Toffoletto De Luca Tamajo e Soci. She can be contacted on +39 02 721 441 or by email: firstname.lastname@example.org.
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Toffoletto De Luca Tamajo e Soci