Brussels, 6th October 2004
Why has the European Commission decided to adopt Recommendations, which are not legally binding, and not proposed Directives?
The European Commission’s Company Law Action Plan (see IP/03/716, MEMO/03/112) adopted in May 2003, aims to promote the creation of a dynamic and flexible corporate governance framework within the EU. It therefore proposed a mix of binding and non-binding measures, to take account of the diversity of corporate governance practices and systems within the EU and the rapidly evolving environment. These two Recommendations are based on a thorough assessment of the situation at national level and of the some Member States’ efforts to improve their corporate governance framework. The objective is to promote greater convergence within the European Union towards best practices on directors’ remuneration and on non-executive and supervisory directors. The Commission considered Recommendations to be more suitable than Directives, so as to allow Member States to take due account of national corporate governance traditions and practices.
Are the two Recommendations to be interpreted as a starting point for a European Corporate Governance Code?
No. The measures adopted in the two Recommendations are neither in substance nor intent an effort to construct an embryonic European code of corporate governance. They are Recommendations rather than binding Regulations or Directives and do not constitute a set of provisions for direct use by listed companies. It will be up to the Member States to consider the provisions presented in the Recommendations and then to introduce them into their national framework taking into account national specificities. Furthermore, in the case of the Recommendation on independent directors, the Commission offers Member States additional flexibility by drawing a clear distinction between basic principles and, in the annex, additional guidance for the interpretation of these principles. Last but not least, the Recommendations address only some of the numerous issues traditionally covered by national corporate governance codes.
Why are the two Recommendations directed at listed companies only?
The Recommendations invite Member States to adopt measures which would be applicable to listed companies, defined as companies whose securities are admitted to trading on a regulated market in the EU. However, since some features of best corporate governance practice for listed companies could prove to be beneficial also
to other companies, it is left to Member States, if they so wish, to extend all or some of the provisions introduced at national level to all or some categories of non-listed companies.
Both Recommendations would cover all companies listed in the EU, irrespective of whether or not these companies are incorporated in an EU Member State. Is this a response to the Sarbanes-Oxley Act?
EU investors need to be protected whenever they invest in the EU. That is the principle that the Commission applied when deciding on the scope of the two Recommendations. All companies wishing to raise capital in the EU should be subject to similar high-level standards. In this respect, the Recommendations are designed in the same spirit as the Sarbanes-Oxley Act, to improve transparency and to increase the sense of responsibility of management vis-à-vis investors. The Recommendations are not a response to the Sarbanes-Oxley Act, but to the needs of European investors.
Both Recommendations would also apply to companies which offer only bonds on EU regulated markets. Why is it so important that these companies be covered by such Recommendations?
Creditors, including bond-holders, are normally in a better situation than shareholders when a company faces the threat of bankruptcy or has severe solvency problems. Shareholders are last in the queue of claimants. But that does not mean that bond-holders need no protection: the plight of Parmalat’s bond-holders is enough to demonstrate that. The results of corporate malpractice are rarely felt only by (minority) shareholders.
Since these are Recommendations, Member States are free to decide whether to implement them or not. What would the Commission do if a majority of Member States did not follow the main lines of the Recommendations?
Since these are Recommendations, the Commission will not be able to open infringement proceedings against those Member States that do not implement them. The Commission nevertheless invites Member States to inform it by mid-2006 of what they are doing to promote the application of these Recommendations. That will allow the Commission to monitor closely the situation within the EU and to assess whether greater convergence of corporate governance systems and practices has been achieved in the areas covered by the Recommendations. The Commission would then be in a position to assess whether there is a need for further measures, for instance an update of these Recommendations to bring them into line with corporate governance developments.
Recommendation on fostering an appropriate regime for the remuneration of directors
(see also IP/04/1183)
According to the remuneration Recommendation, listed companies would have to disclose a remuneration policy statement that could include detail about performance criteria. Would that not involve the disclosure of confidential information that could affect companies’ competitive position?
The remuneration policy statement should essentially be forward-looking. It should include among other things information related to the importance of fixed and variable remuneration, information on performance criteria and the parameters for annual bonus schemes or non-cash benefits. It should also explain the company’s policy on the terms of executive directors’ contracts. Information about the way the remuneration policy has been drawn up should also be made available.
The Recommendation does not oblige the company to disclose information of a commercially-sensitive nature which could be detrimental to the company’s strategic position.
Why does the Commission consider it important to involve shareholders in remuneration matters?
Shareholders can monitor directly whether the remuneration of executive and non-executive directors provides enough incentive and is appropriate to the company’s policy. The conflict of interest is self-evident: boards awarding themselves money from their shareholders’ assets creates a direct conflict of interest between the owner and the management. This problem can be exacerbated by the use of equity-based pay. To the extent that share options or other rights to acquire shares allow directors to cash in profits as a result of short-term share price increases, this form of remuneration can increase the pressures for executive directors to produce positive results in the short term, even if that may be detrimental to the company’s longer term trading position.
Robust governance controls, including transparency requirements and the possibility for shareholders to make their views known to the board on remuneration policy are therefore needed, to deal with potential conflicts of interest related to the difficulty of choosing an appropriate indicator of performance, the link between the exercise of the options and the performance of the company, the possibility for share options to be repriced or the possible dilution of shares when options give the right to acquire new shares.
Shareholders should have the right to approve such schemes. Their approval should cover the remuneration scheme and the rules applied to establish the remuneration of individuals under the scheme but not the remuneration of individual directors.
What are the advantages of a high level of disclosure of the remuneration of individual directors? Could that not lead to some tensions between management and the workforce?
It is important to give shareholders the information which allows them to hold directors accountable for the remuneration they extract from the company. Disclosure of the remuneration paid by the company to individual directors, both executive and non-executive or supervisory directors, in the preceding financial year is therefore important to help shareholders appreciate whether this remuneration is appropriate in the light of the overall performance of the company. It is also important for shareholders to be fully informed about compensation packages paid to directors on the termination of their contracts, especially when companies have performed poorly.
Such information is important not only for shareholders, but also for other stakeholders, including creditors, employees and customers. Tensions in industrial relations would only arise in companies where a very high level of remuneration has accompanied poor performance and therefore adverse affects on the workforce and a reduction in value of shareholders' investments.
Why provide for the disclosure of remuneration not just to shareholders but to investors in general?
The disclosure of accurate and timely information by securities issuers builds sustained investor confidence and constitutes an important tool for promoting sound corporate governance throughout the EU. To that end, it is important that listed companies ensure appropriate transparency towards investors to enable them to express their views and to make fully informed decisions on where to invest their funds. That is why the Recommendation provides that each listed company should disclose a statement of the remuneration policy of the company (“the remuneration statement”). It should be part of a self-standing remuneration report and/or be included in the annual accounts and annual report or in the notes to the annual accounts of the company. The remuneration statement should also be posted on the listed company’s website.
Recommendation on the role of non-executive or supervisory directors and on the committees of the (supervisory) board
(see also IP/04/1182)
Member States are invited to adopt the Recommendation either through legislation or through a “comply or explain” approach: what would be the difference?
Where the Recommendation was applied under the “comply or explain” clause, companies would have the option of adopting the rules suggested or explaining the reason why they do not. This approach enables companies to reflect sector and enterprise specific requirements. It also allows markets to assess the explanations and justifications provided – and, if they are not satisfied with them, to take that into account in making investment decisions.
Taking into account the diversity of European company law systems, is it appropriate to impose at EU level the involvement of independent directors – a system borrowed from anglophone jurisdictions?
The presence of independent representatives on the board, capable of challenging the decisions of management, is widely considered as a means of protecting the interests of shareholders and other stakeholders. This is true not just in anglophone jurisdictions. For example, independent directors are widely accepted and present in France and Italy and directors' independence is specifically dealt with by the German Corporate Governance Code.
Independent directors have a role to play both in companies with dispersed ownership, where the primary concern is about how to make managers accountable to weak shareholders, and in companies with controlling shareholders, where the focus is more on how to make sure that the company will be run in a way that sufficiently takes into account the interests of minority shareholders. Boards should be organised in such a way that a sufficient number of independent non-executive or supervisory directors play an effective role in key areas where the potential for conflict of interest is particularly high. To this end, nomination, remuneration and audit committees should normally be created within the (supervisory) board, where the latter is playing a role in the areas of nomination, remuneration and audit under national law.
Does the Recommendation say how to determine the proportion of independent directors on the board required to prevent management decisions being affected by conflicts of interest?
In view of the different legal systems existing in Member States, the Recommendation does not precisely define the proportion of independent directors who should be present on the (supervisory) board as a whole. However, it stipulates that the administrative, managerial and supervisory bodies should include in total an appropriate balance of executive/managing and non-executive/supervisory directors such that no individual or small group of individuals can dominate decision making. The Recommendation also identifies three areas where the potential for management to have a conflict of interest is particularly high: nomination of directors, remuneration of directors, and audit. That is why the Recommendation encourages the creation within the (supervisory) board of nomination, remuneration and audit committees with a majority of their members being independent directors.
In several European countries the law mandates the principle of collective responsibility for decisions taken by the board: could the presence of committees be contrary to that principle?
The Recommendation does not put into question the principle of collective responsibility of the (supervisory) board of directors. It specifies that the nomination, remuneration and audit committees should normally make recommendations aimed at preparing the decisions to be taken by the (supervisory) board itself. However, the (supervisory) board should not be precluded from delegating part of its decision-making powers to committees when it considers it appropriate and when this is permissible under national law, even though the (supervisory) board remains fully responsible for all decisions taken in its field of responsibility.
Why are nomination and remuneration committees needed in Member States where shareholders themselves and/or the supervisory board decide on nomination, appointment and remuneration issues?
The role of nomination and remuneration committees created within the (supervisory) board should essentially be to make sure that, where the board plays a role in the appointment and removal process or in setting remuneration (whether it has the power merely to table proposals or to make decisions, as defined by national law), this role is performed in as objective and professional a way as possible. These committees should therefore essentially make recommendations to the (supervisory) board on the decisions to be taken on these issues by whichever body is competent to do so under national company law.
In some Member States the tasks of overseeing financial reporting and risk monitoring and management procedures are performed wholly or partly outside of the (supervisory) board: what is the function of the audit committee in these cases?
The Recommendation allows Member States to replace, in whole or in part, the creation within the (supervisory) board of any of the committees mentioned, by the use of other structures – external to the (supervisory) board – or procedures which are functionally equivalent and equally effective. Those structures and procedures could be either mandatory for companies under national law or best practice recommended at national level through a “comply or explain” approach.
Why did the Commission not include stronger provisions on independent directors in the Recommendation itself and instead include them only as guidance in an annex?
In line with the Commission’s overall approach in the field of corporate governance, the Recommendation deliberately limits itself to the presentation of a number of essential core principles aimed at strengthening of the role of independent directors. To allow sufficient flexibility for national traditions to be respected, additional guidance for the interpretation of the principles set out in the Recommendation is provided in two Annexes, relating to a) the composition, role, operation, and transparency of the various committees and b) the situations which should be considered by Member States when adopting independence criteria tailored to the national context.