The Theory and Practice of Directors Remuneration New Challenge PDF

The Theory and Practice of Directors
Remuneration
New Challenges and Opportunities

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The Theory and Practice of
Directors Remuneration
New Challenges and Opportunities
Edited by
Alexander Kostyuk
Ukrainian Academy of Banking of the National Bank of
Ukraine, Sumy, Ukraine
Markus Stiglbauer
Friedrich-Alexander-Universitt Erlangen-Nrnberg,
Nuremberg, Germany
Dmitriy Govorun
Ukrainian Academy of Banking of the National Bank of
Ukraine, Sumy, Ukraine
United Kingdom North America Japan

India Malaysia China
Emerald Group Publishing Limited
Howard House, Wagon Lane, Bingley BD16 1WA, UK
First edition 2016
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Contents
List of Contributors xi
Introduction from Editors xiii
Practitioners Outlook xvii
Academic Outlook xxiii
Director Remuneration is a Matter of Growing Importance
in the EU xxiii
Legislation on Directors Remuneration xxiv
Corporate Governance Codes xxiv
Remuneration Should Be Guided by Market Demands and
Linked to the Companys Results xxv
EU Commission Recommendation xxvi
Some of the Experience of Member States xxvii
Three Recommendations on Disclosure of Remuneration
Policy xxviii
Remuneration Should Promote the Long-Term Sustainability xxix
Remuneration Policy xxx
Remuneration Policies in the Financial Services Sector xxxi
Section I Theory of Corporate Governance and

CHAPTER 1 Corporate Governance and Remuneration

Udo C. Braendle and Amir Hossein Rahdari 3
Introduction 3
The Theory of the Firm The Theory of Transaction Costs? 6
Beyond the Firm and Market Dichotomy 8
Incomplete Remuneration Contracts 9
Agency Theory 11
Adverse Selection 13
Moral Hazard 14
Different Agency Conicts 15
v
vi CONTENTS
Management and Collective Production 16

Outlook and Conclusion 18
References 19
CHAPTER 2 Directors Remuneration and Motivation

Udo C. Braendle and John E. Katsos 21
Introduction 21
Agency Theory and Managerial Compensation 23
Base Salary 26
Bonus 26
Stock Options 27
Employee Motivation 29
Current Intrinsic Motivator: Takeover Threats 30
Well-Balanced Packages 31
Conclusion 32
References 32
CHAPTER 3 Executive Compensation in the 21st Century:

Future Directions
Udo C. Braendle and Amir Hossein Rahdari 35
The 21st Century 35
Compensation and Motivation 36
Compensation Plans: Pay-Performance Link 37
Redening Performance Evaluation in the Age of Sustainability 38
Conclusion 41
References 41
Section II Cross-Industrial Remuneration

Practices Analysis
CHAPTER 4 Financial Companies

Regina W. Schroder 47
Introduction 47
The Crisis and Its Effects on Remuneration Governance in
Financial Institutions 48
Elements of the Corporate Governance of Financial
Institutions 48
Pre- and Post-Crisis Remuneration Governance 50
European Initiatives for Enhanced Governance and
Remuneration 50
Corporate Governance 50
Contents vii
Remuneration 51
Structuring Variable Bonuses over Time 52
Discounting 52
Alternative Discounting Functions 53
Exponential Discounting 53
Hyperbolic Discounting 54
Quasi-Hyperbolic Discounting 54
Evaluation 55
Conclusion and Prospects 55
References 56
CHAPTER 5 Industrial Companies

Yusuf Mohammed Nulla 59
Introduction 59
Background 59
Literature on CEO Compensation 60
Research Design 62
Results 62
Directors Remuneration Policy 64
Directors Remuneration Design 65
Directors Remuneration Factors 66
Boards Role in Directors Remuneration 67
Accounting Regulation 67
Conclusion 68
References 69
Section III Cross-Country Remuneration

Practices Analysis
CHAPTER 6 Directors Remuneration in the United States

Andrew J. Felo 73
Introduction 73
Remuneration Regulation and Reporting 75
Remuneration Design 78
Empirical Evidence on Director Remuneration 81
The Determinants of Director Remuneration 81
Characteristics of Firms Adopting Outside Director
Stock-Option Plans 81
Director Remuneration and Compensation Committees 82
Director Remuneration and Compensation Consultants 83
Director Remuneration and Board Independence from CEO 83
Director Remuneration and Board Overlaps 84
viii CONTENTS
Summary of Determinants of Director Remuneration 84

The Impact of Director Remuneration on the Firm and Its
Stakeholders 85
Market Reaction to Adding Equity to Director
Remuneration Plans 85
Director Remuneration and Financial Reporting 87
Director Remuneration and Dividend Paying 89
Director Remuneration and Shareholder Lawsuits 89
Director Remuneration and Corporate Social Performance 90
Summary of the Impact of Director Remuneration on
Stakeholders 90
Remuneration Challenges 91
References 92
CHAPTER 7 Directors Remuneration in the

United Kingdom
Jean J. Chen and Zhen Zhu 95
Remuneration Regulation 95
The Greenbury Report 1995 96
The Combined Code on Corporate Governance 1998
and Its Subsequent Revisions 98
The UK Corporate Governance Code 2010 99
The UK Corporate Governance Code 2012 101
Remuneration Design (Schemes) 103
Remuneration Reporting 110
Directors Remuneration Report Regulations 2002 110
The 2012 Directors Remuneration Reporting Reform 111
Problems in UK Executive Remuneration 113
Challenges for Remuneration Policy 115
Acknowledgements 115
References 116
CHAPTER 8 Directors Remuneration in Germany

Markus Stiglbauer, Julia Wittek and Sven Thalmann 119
The German Two-Tier System 119
Remuneration Regulation of the Management Board and
Supervisory Board 120
Remuneration of the Management Board 122
Remuneration of the Supervisory Board 126
Contents ix

References 130
CHAPTER 9 Directors Remuneration in Italy

Marco Artiaco 133
Introduction 133
Listed Companies 135
Bank and Banking Holdings 139
Government-Owned Unlisted Companies 141
Unlisted Companies 142
Remuneration Design Schemes 142
Conclusions 152
References 154
CHAPTER 10 Directors Remuneration in Spain

Montserrat Manzaneque, Elena Merino
and Regino Banegas 157
Regulation for Listed Companies 157
Regulation for Financial Institutions 163
The Remuneration Policy for Directors in Spain. A Question
Linked to the Board Structure 166
Remuneration Systems Elements in Spanish Companies 169
Practice Regarding Remuneration Systems in Spain
(20042011) 175
References 181
CHAPTER 11 Directors Remuneration in Ethiopia

Hussein Ahmed Tura 185
Introduction 185
Prole of Ethiopian Companies 186
The Emerging Separation of Ownership and Control in the
Ethiopian Share Companies 187
Directors Remuneration in Ethiopian Share Companies 190
Remuneration Design (Scheme) 192
x CONTENTS
Participation of Employees Other than Directors on Annual

Share in Prots 207
Conclusion 210
References 211
CHAPTER 12 Reviewing Institutions Remuneration

Requirements: From European Legislation
to German Implementation
Oliver Kruse, Christoph Schmidhammer and Erich Keller 213
Introduction 213
Prerequisites of an Incentive-Compatible Remuneration
System 215
Regulative Remuneration Standards of the EU 216
The Implementation of Remuneration Regulations in
Germany 219
Incentive-Compatibility of the European and German
Regulation of Remuneration Systems 220
Conclusion and Perspectives 220
References 222
CHAPTER 13 The European Approach to Regulation of

Roberta Provasi and Patrizia Riva 225
Introduction 225
Literature Review 228
European Approach to the Regulation of Directors
Remuneration 231
Recommendation 2004/913/EC 232
Remuneration Policy 233
Remuneration of Individual Directors 234
Share-Based Remuneration 235
Recommendation 2005/162/EC 235
Additional EU Interventions 237
Evidence on the Actual Compliance of the Italian Remuneration
Reports to the CG Code 244
References 252
Index 255
List of Contributors
Marco Artiaco University of Rome Tre, Rome, Italy

Regino Banegas University of Castilla-La Mancha,
Cuenca, Spain
Udo C. Braendle American University in Dubai, Dubai
UAE; University of Vienna, Vienna,
Austria
Jean J. Chen University of Southampton, UK
Andrew J. Felo Nova Southeastern University, Fort
Lauderdale, FL, USA
Amir Hossein Rahdari Tarbiat Modares University, Tehran,
Iran; Corporate Governance and
Responsibility Development Center
(CGRDC), Tehran, Iran
John E. Katsos American University of Sharjah,
Sharjah, UAE
Erich Keller Deutsche Bundesbank University of
Applied Sciences, Hachenburg,
Germany
Oliver Kruse Deutsche Bundesbank University of
Applied Sciences, Hachenburg,
Germany
Montserrat University of Castilla-La Mancha,
Manzaneque Cuenca, Spain
Elena Merino University of Castilla-La Mancha,
Ciudad Real, Spain
Yusuf Mohammed Monarch University, Hagendorn-Zug,
Nulla Switzerland
Roberta Provasi Bicocca Milan University, Milan, Italy
Patrizia Riva Piemonte Orientale University,
Novara, Italy
xi
xii LIST OF CONTRIBUTORS
Christoph Deutsche Bundesbank University of

Schmidhammer Applied Sciences, Hachenburg,
Germany
Regina W. Schrder Herdecke University, Witten,
Germany; Libera Universit di
Bozen-Bolzano, Bozen, Italy
Markus Stiglbauer Friedrich-Alexander-Universitt
Erlangen-Nrnberg, Nuremberg,
Germany
Sven Thalmann Friedrich-Alexander-Universitt
Germany
Hussein Ahmed Tura Addis Ababa University, Addis
Ababa, Ethiopia
Julia Wittek Friedrich-Alexander-Universitt
Germany
Zhen Zhu University of Surrey, Guildford, UK
Introduction from Editors
D
ear readers and friends! We are happy to present to you
our new book The Theory and Practice of Directors
Remuneration: New Challenges and Opportunities.
Corporate governance faced critical new challenges during and after
the world nancial crisis and this book focuses on one of these:
remuneration practices. Both practical and theoretical fundamentals
needed urgent review. International organizations, researchers, and
practitioners have all pointed out the necessity for reform and
change. The excessive remuneration of executive directors and the
ineffective remuneration of non-executives are seen as key problems
and reasons for the nancial crisis.
The main objective of this book is to outline the practical and
theoretical issues and discuss and analyze new approaches to direc-
tors remuneration due to changes made in corporate governance
practices during the post-crisis period. Its secondary purpose is to
ignite a new debate on the issue. The book is divided into three parts
to give readers a full understanding of remuneration issues the
theoretical foundations, a cross-sectoral view, and a cross-national
analysis of current practice.
The book is the result of a great deal of work done by our inter-
national network of corporate governance professionals, many col-
leagues, and friends. We are pleased to deliver our warm regards to
Markus Stiglbauer (Germany). His contribution to editing the book
adds great value to our project. We would also like to thank Philip
J. Weights (Switzerland), who is a well-known expert in corporate
governance and banking in Europe and worldwide. The academic
outlook written by our colleague Rado Bohinc (Slovenia) sheds light
on the scholarly discussions around the topic as well as debates
among practitioners.
Our contributors are, of course, worthy of special thanks. But the
most important words of acknowledgment should be addressed to our
families who consistently supported us in undertaking this major work.
Alexander Kostyuk
Ukrainian Academy of Banking, Ukraine
Dmitriy Govorun
Ukrainian Academy of Banking, Ukraine
xiii
xiv INTRODUCTION FROM EDITORS
The recent nancial crisis has led to a loss of trust in the quality
of corporate governance and the balance of the European nancial
market. Banks play a key role in modern economies and perform
integral functions. These issues have also affected Germany espe-
cially as nancial companies play a major role in the German corpo-
rate governance system (German bank-based system). This is
made apparent by a traditionally dominant creditor protection
within commercial law accounting, which by its nature undervalues
assets and overvalues debt in nancial accounting. A sound banking
and nancial system is critical for the performance of the German
economy, particularly in the wake of the nancial crisis that began
in 2007. Since then, remuneration issues and practices in combina-
tion with extraordinary appetite for risk have been much criticized
and the implementation of the pay for performance principle
without any doubt represents a basic standard for good corporate
governance.
Thus, the German government passed two laws concerning
remuneration. The rst was the Act Regarding the Disclosure of
Management Boards Remuneration. Its main purpose is to provide
companies an incentive toward establishing appropriate, perfor-
mance-based management compensation. Nevertheless, against all
expectations, management salaries have been leveled and, unfortu-
nately, even boosted. Companies commonly argue that one cannot
separately evaluate the performance of individual board members,
said Mller, Head of the German Corporate Governance Code
Commission, in a heavy criticism. Consequently, the German gov-
ernment passed the act regarding the Appropriateness of
Management Boards Remuneration in 2009. It aims to link the
variable remuneration of the management board to the companys
development based on several years assessment data, as well as the
implementation of a cooling off period for former members of the
management board before they are able to become members of the
supervisory board. As a result, for example, Allianz SE, now assesses
the short-, middle- and long-term elements of managers variable
remuneration equally and enforces its malus system in case of bad
performance, as does Deutsche Bank AG.
Despite these positive reactions, one must differentiate the argu-
mentation when examining general empirical ndings on German
listed companies reaction toward these new regulations. Between
2007 and 2009, German companies reduced overall management
reward (16 percent) and approximately 55 percent pay less than
h500 tsd. to a member of the management board, and only 19 per-
cent pay over 1 million euro to an individual board member this
limit is psychologically important. Nevertheless, with regard to the
payment structure, we rate the development as negative. We found
that companies in general, and particularly those in the nancial
Introduction from Editors xv
sector, increased xed managerial pay within the payment structure

and reduced variable bonus pay. Moreover, considering the eco-
nomic upswing in Germany in 2010, we are observing that the cur-
rent structure and overall management compensation is comparable
to the beginning of the nancial crisis, with a slight increase in long-
term incentives.
Overall, these measures dont seem to be appropriate to moti-
vate managers to act in companies and shareholders best interest
because such remuneration structure lowers managers individual
consequences in the event of a severe nancial/economic situation by
reducing their personal income risk on one hand and res normal
workers or reduces their working time (and consequently their
income) on the other hand. Additionally, higher xed managerial
pay makes companies less exible in a further crisis and generally
does not lower company risk, but rather possibly increases manage-
rial risk taking. Further, the regulatory requirements of an appropri-
ate management boards remuneration are not yet well implemented.
Bonus pay and share-based pay are still short-term oriented in many
cases. Further, in the case of negative rm development, bonus pro-
grams often do not involve managers sufciently. With regard to the
act regarding the Disclosure of Management Boards Remuneration,
there are only few listed companies that choose to opt out and not
publish management and supervisory board members remuneration
individually. A company may use this option for ve years when 75
percent of the shareholders represented at the shareholders meeting
vote for this exception. Shareholders are able to renew the decision
to opt out after ve years.
In summary, this is a clear mandate for a thorough and critical
discussion of existing remuneration structures for management board
members by supervisory boards and remuneration committees.
Markus Stiglbauer
Professor at Friedrich-Alexander-Universitt Erlangen-Nrnberg
(Germany); German Association of University Professors (DHV);
European Academy of Management (EURAM); Association of
University Professors of Management (VHB); Virtus Global Center
for Corporate Governance (VGCCG)
Practitioners Outlook
I
t was with great pleasure that I accepted the invitation from
Dr. Alexander Kostyuk, Chairman of the Board of the
International Center for Banking and Corporate Governance,
to write a Foreword to this important new book The Theory
and Practice of Directors Remuneration: New Challenges and
Opportunities. This topic is of interest to many people, including
employees, investors, executives, auditors, regulators, and politi-
cians. We have witnessed the devastating effect of the global nan-
cial crisis which began in 20072008. This evolved into a Sovereign
Debt Crisis by 2010, and caused the loss of millions of jobs world-
wide. The effect is still felt today, as illustrated by the collapse
of one of Portugals largest banks, Banco Esprito Santo, as recently
as August 3, 2014. Post-crisis analysis by the World Bank and
the International Finance Corporation has identied Corporate
Governance failures as the main contributing factor to the crisis.
The failures are in four main areas: Risk Governance;
Remuneration and alignment of incentive structures; Board inde-
pendence, qualications and composition; and Shareholder
engagement. This book addresses perhaps the most emotional and
controversial of these, the remuneration issue.
The news headlines post-crisis routinely discussed Corporate
Greed, Market Abuse, with Banks Too Big to Fail, and bank-
ers Too Big to Jail. Public outrage led to the birth of the Occupy
Wall Street protest movement in September 2011. The main issues
raised were social and economic inequality, greed, corruption and
the perceived undue inuence of corporations on government, parti-
cularly from the nancial services sector. Greed is reinforced in pop-
ular culture, as illustrated in the movie Wall Street where Gordon
Gekko, a corporate raider played by the actor Michael Douglas,
says The point is, ladies and gentleman, that greed, for lack of a
better word, is good. Greed is right, greed works.
In the real world of business, politicians, voters, and investors
want to control excessive greed. On October 13, 2014, Thomson
Reuters published a press release from their subsidiary Incomes
Data Services with the headline FTSE 100 Directors Total
Earnings Jump by 21% in a Year. It explains that share-based
xvii
xviii PRACTITIONERS OUTLOOK
incentive payments and bonuses are driving the increase. IDS points
out that the median total earnings for a FTSE 100 director is now
2.4 million. The median total earnings for FTSE 100 Chief
Executives are 3.3 million. This is 120 times more than a full time
employee in 2014, compared to 47 times more than a full time
employee in 2000. Such an increasing gap is causing great concern,
and measures are now being taken in the United Kingdom to make
directors and executives more accountable, introduce Remuneration
Governance, curb bonuses, and establish mandatory bonus claw-
back periods.
The same reaction to corporate greed is felt in Switzerland. In
March 2013, Swiss voters approved a plan to severely limit execu-
tive compensation. This national referendum, commonly referred to
as the Initiative against rip-off salaries was prompted by the pub-
lic outrage against the executives of Swissair, the agship airline that
collapsed in 2001, and the political storm when Novartis, the phar-
maceutical company, agreed to a $78 million severance pay-out for
its departing chairman. The intense criticism from investors forced
Novartis to scrap the pay-out. The Swiss vote gives shareholders of
companies listed in Switzerland a binding say on the overall pay
packages for executives and directors. Swiss companies are no
longer allowed to give bonuses to executives joining or leaving the
business or to executives when their company is taken over.
Violations can result in nes equal to up to six years of salary and a
prison sentence of up to three years.
In the United States, executive remuneration is also a major con-
cern. It is reported that by 2006, CEOs made 400 times more than
average workers, a gap 20 times bigger than it was in 1965. To
address this situation, on January 25, 2011, the SEC adopted rules
for Say-on-Pay and Golden Parachute Compensation as required
under the Dodd-Frank Wall Street Reform and Consumer
Protection Act. Say-on-Pay votes must occur at least once every
three years, and Companies must disclose on an SEC Form 8-K how
often it will hold the Say-on-Pay vote. Under the SECs new rules,
companies are also required to provide additional disclosure regard-
ing golden parachute compensation arrangements with certain
executive ofcers in connection with merger transactions. Despite
the new rules, a report titled 2013 CEO Pay Survey produced by
Governance Metrics International Ratings grabs attention when it
states that the rst two executives named in their Top Ten List of
Highest Paid CEOs earned more than $1 billion in a single year, and
all 10 CEOs made at least $100 million. Historically, Oracle has
one of the highest paid US executives. For the past two years, share-
holders voted down the CEOs pay package. However, the resolution
is non-binding. Most of the votes for were cast by the CEO him-
self as he owns a quarter of the company (CNNMoney (New York),
Practitioners Outlook xix
2013). This illustrates two Corporate Governance issues, one being

that shareholders in the United States do not yet have the right to
approve the remuneration of top executives. The second issue is
that a Chairman (who may also be the CEO) can vote in favor of a
compensation issue, despite the obvious conict of interest.
The European Union has taken signicant measures to deal with
the remuneration issue. This includes issuing Directive 2013/36/EU
of 26 June 2013 on Access to the Activity of Credit Institutions and
the Prudential Supervision of Credit Institutions and Investment
Firms. In point 53 of the introductory text, there is a clear state-
ment that weaknesses in corporate governance contributed to exces-
sive and imprudent risk-taking in the banking sector which led to
the failure of individual institutions and systemic problems in
Member States. The Directive also recognizes that the general provi-
sions on governance and the non-binding nature of a substantial
part of the corporate governance framework, based essentially on
voluntary codes of conduct, did not sufciently facilitate the effective
implementation of sound corporate governance practices. Articles
9296 cover the specic new rules regarding Remuneration. Of par-
ticular interest from a transparency and reporting perspective is
Article 96 titled Maintenance of a website on corporate governance
and remuneration. Here the Directive requires Financial
Institutions to explain on their website how they comply with
Articles 8895 dealing with all the Governance Arrangements
including the new remuneration rules.
Corporate Governance is of universal importance.
Remuneration Governance is one of the key challenges to ensure the
correct balance between risk and reward, and ensure that Directors
compensation is equitable to all parties and stakeholders. It seems
clear that the trend is to enhance the Remuneration Governance.
Increasingly, this is via a formal and transparent policy and proce-
dure for implementing executive remuneration and for xing the
remuneration packages of individual directors. Many countries are
introducing regulations for Companies to include the remuneration
gure for top executives and directors in their annual nancial
report, along with the introduction of binding shareholder votes on
boardroom remuneration.
It is therefore timely and relevant that this new book The
Theory and Practice of Directors Remuneration: New Challenges
and Opportunities has been written. The book examines the current
theories, practices, and regulations and explains them in detail.
Section I, Theory of Corporate Governance and Directors
Remuneration, is written by Prof. Udo Braendle of the American
University in Dubai, UAE, and covers in Chapter 1 the key topic
of Corporate Governance and Remuneration, followed by
Chapter 2 (co-written with Prof. John E. Katsos of the American
xx PRACTITIONERS OUTLOOK
University in Sharjah) covering Directors Remuneration and

Motivation. Professors Braendle and Katsos suggest that the failure
of Remuneration Governance can be remedied by switching the
balance of compensation packages from extrinsic motivators such as
pay-for-performance bonuses and stock options, to intrinsic motiva-
tors such as ring and prestige.
In Section II, Cross-industrial Remuneration Practices Analysis,
Regina W. Schrder provides an analysis of the practices in the
Financial Services sector. She argues that attention has not been
paid to the present value of remuneration, and the discounting
method by which this value should be calculated. The discounting
method and its disclosure are important elements of the corporate
governance, allowing stakeholders to anticipate the amount of the
incentives and rewards paid, and evaluate the associated risk. The
Industrial Sector analysis is provided by Dr. Yusuf Mohammed
Nulla who explores the energy, metal, mining, and health industrys
effects on Directors remuneration in Canada and the United States.
Section III, Cross-country Remuneration Practices Analysis, pro-
vides an analysis of Directors Remuneration in various countries.
The US perspective is covered by Dr. Andrew J. Felo, Associate
Professor of Accounting, Nova South-Eastern University in Florida
who highlights the two main challenges regarding Directors
Remuneration. The rst is that directors have signicant input into
their own pay packages, while the second challenge is to make the
remuneration package attractive enough to attract quality directors
to the board. Prof. Jean J. Chen provides an excellent analysis of the
regulations, challenges for Directors Remuneration in the United
Kingdom. She notes that two problems in UK remuneration prac-
tices have been highlighted in recent scrutiny, the divergence of
executive pay from rm performance and decreased clarity and
transparency caused by increasingly complex remuneration report-
ing. She explains that in response to the failings in the corporate
governance framework for executive remuneration, the UK
government has announced a comprehensive package of reforms
including binding shareholder votes and greater transparency in the
directors remuneration reports. Prof. Dr. Markus Stiglbauer and
his Corporate Governance team at the University of Erlangen-
Nuremberg present a comprehensive analysis of the German
remuneration regulations and how the system functions within the
two-tier Board framework of a management board and a supervi-
sory board. One of the key challenges is noted as the failure in 2013
of the German Government to pass a proposed new Act to improve
the Supervision of Board Remuneration. This Act included empow-
ering the annual general shareholder meeting to review and approve
management board remuneration as proposed by the supervisory
board. The remuneration situation in Italy is explained by
Practitioners Outlook xxi
Dr. Marco Artiaco, Professor of Economy and Management at the

Universita di Roma Tre. He argues that the Italian Corporate
Governance system still seems weak, and remuneration polices of
Italian regulated rms, seem to be oriented to nding solutions in order
to acquire and retain top managers. In his view, the solutions selected
by authorities in order to regulate nancial rms such as transparency,
remuneration system structure, incentive mechanism control, and risk
management should be extended to all the companies in which
remuneration is a critical issue. Directors remuneration in Spain is
addressed by Prof. Montserrat Manzaneque, together with Elena
Merino Madrid and Regino Banegas Ochovo of the University of
Castilla-La Mancha in Spain. They mention the Spanish government is
currently considering new measures to limit variable remuneration and
allowances, and changing the advisory vote of the General
Shareholders Meeting regarding the remuneration of Directors to a
binding vote. Dr. Hussein Ahmed Tura of the Ambo University in
Ethiopia critically analyzes Directors Remuneration in Ethiopia. He
explains that the Ethiopian Commercial Code of 1960 is outdated,
unchanged, and lacks rules and principles on many aspects of company
governance including adequate provisions on directors remuneration.
He also mentions that National Bank of Ethiopia recently adopted a
directive limiting the directors remuneration in the banking industry to
approximately US$2500 per year. He argues this may have an adverse
effect on the independence of directors, and the retention of talented
experts. Chapter 12 deals with remuneration requirements from
European legislation to German implementation. It is written by
Professors Oliver Kruse, Christoph Schmidhammer, and Erich Keller at
the Deutsche Bundesbank University of Applied Sciences. Their chapter
analyzes the implementation of remuneration policies in German bank-
ing institutions starting from European legislation standards. They
mention that BaFin surveys illustrate some institutions try to under-
mine regulatory requirements by not fully dening risk takers or imple-
menting asymmetric variable remuneration components. It is suggested
that some German institutions are investing signicant efforts to avoid
regulatory remuneration standards. Chapter 13 is written by Roberta
Provasi from Bicocca Milan University, Italy and Patrizia Riva from
Piemonte Orientale University, Italy and deals with European specics
of directors remuneration regulation.
Professor Alexander Kostyuk, Virtus Interpess, and the Global
Center for Corporate Governance are to be commended for this
comprehensive review and analysis of the international state of
Governance and Directors Remuneration.
Philip J. Weights
ACIB, CIA, CISA, CRMA, Founder and Managing Partner,
Enhanced Banking Governance LLC, Zurich, Switzerland
Academic Outlook
R
emuneration, compensations, and other benets of directors
is rather new and not much publicly discussed and even not
much researched topic. However it is, especially in times of
crisis, very relevant for successful and efcient corporate govern-
ance. Without a doubt, it is a legitimate concern and expectations of
the shareholders that directors remuneration should not exceed the
agreed levels and that it should be disclosed for public scrutiny.
This book makes more familiar the issues, related to remunera-
tion, compensations, and other benets of directors. It is very topical
issue, relevant to a wide range of readers, like scholars from a vari-
ety of disciplines, professionals outside academia and also students
for use in courses. The book is also recommended to general readers
interested in the eld of business, economy, law, corporate govern-
ance, nance, accounting, and management; it is on one hand of
great theoretical interest and on the other currently needed to the
practitioners in this eld.
In the Section III of this book (Cross-Country Remuneration
Practices Analysis), the presentation of practices analysis in some
individual EU member states and in addition the EU regime for the
remuneration of directors of listed companies is presented.
Director Remuneration is a Matter of

Growing Importance in the EU
Director remuneration is a matter of growing importance in most of
the EU countries and at the level of EU as well. According to
European Commission, experience over the last years, and more
recently in relation to the nancial crisis, has shown that remunera-
tion was focused on short-term achievements and in some cases led
to excessive remuneration, which was not justied by performance.
Also remuneration policies in the nancial services sector showed
inappropriate remuneration practices in the nancial services indus-
try and also induced excessive risk.
xxiii
xxiv ACADEMIC OUTLOOK
EU Commission Recommendation of April 30, 2009, comple-

menting Recommendations 2004/913/EC and 2005/162/EC as
regards the regime for the remuneration of directors of listed compa-
nies and Commission Recommendation on remuneration policies in
the nancial services sector SEC(2009) 580 SEC(2009) 581,
Brussels, 30.4.2009 C(2009) 3159 imposed several approaches and
practices.
Legislation on Directors Remuneration

Legislation and corporate governance codes mostly apply to all
types of companies; however, in some countries they apply only to
listed companies. There are often stricter rules on transparency and
disclosure for listed companies. Most of the rules on executive
directors remuneration apply only to domestically incorporated
companies, whereas prospectus regulation and ongoing disclosure
rules and regulations apply to all companies, the securities of which
are listed on the Stock Exchange.
Directors remuneration in EU countries is regulated by different
Laws (Acts), Decrees, Supreme Court decisions, Case law,
Regulations of the Ministries, Stock Exchange or Financial Services
Authority rules and recommendations and best practices. As for
laws, most often directors remuneration would be regulated by
Public Limited Companies Acts or Stock Corporations Acts
(Austria, Germany, Spain) or just Companies Acts (Finland, UK,
Ireland, Luxembourg, Portugal), Civil Codes (Italy, Netherland),
Accounting Laws, Capital Markets Acts, Securities Trading Acts,
Stock Exchange Acts and rules (like Disclosure Obligations for
Issuers, Stock Exchange Admission Regulation, Listing Rules, etc.),
Commercial Codes, like in France, etc.
Corporate Governance Codes

Best practices would normally be described in private ethical codes
mostly called Corporate Governance Codes or Principles of Good
Governance and Code of Best Practice or Code of Ethics for
Companies Boards of Directors and different other non-binding
recommendations. A so-called comply or explain principle is often
applicable to compliance with the relevant provisions by companies.
Where the comply or explain principle applies, the evidence
whether companies generally comply with best practices is in some
countries available in companies annual reports. However, there
are countries where the Code is only applied if a company is ready
to accept the rules, expressing that by way of declaration to accept
Academic Outlook xxv
and to obey to the rules. In some other countries, there is a legal

obligation to report on compliance of the companies rules and
behavior with the code.
It is recommended by most corporate governance codes that the
Board create a Remuneration Committee with the powers to propose
to the Board of Directors the amount of the Directors annual remu-
neration to review the remuneration programs and consider their
appropriateness and results, and to ensure transparency in remunera-
tion. The Remuneration Committees mission is also to assist the
Board in setting and supervising the remuneration policy. In general,
these committees role is basically informative and consultative,
although they may exceptionally be given decision-making powers.
Remuneration is a key aspect of corporate governance where
conicts of interest may arise and a strong control right for share-
holders can signicantly improve the accountability of boards. Unlike
in other areas of corporate governance for which soft-law measures
remain appropriate, the Commissions efforts to improve governance
on pay through soft-law measures (three Recommendations on
directors remuneration, in 2004, 2005, and 2009) have not led to
signicant improvement in this area. It is therefore necessary to
proceed with a more prescriptive approach involving binding rules on
remuneration.
Remuneration Should Be Guided by

Market Demands and Linked to the
Companys Results
Generally, the company is free to establish the remuneration; yet it
should be guided by market demands and having regarded to the
responsibility and commitment of the role which each Director
plays. Director remuneration should be set so as to offer sufcient
incentives to dedication by the Director while not compromising his
independence.
On the other hand, Directors remuneration, should be linked to
the companys results, since this will bring the Directors interests
more into line with those of the shareholder, which it is sought to
maximize. It is recommended that remuneration comprising shares
of the company or group companies, stock options or options refer-
enced to the share price be limited to executive or internal directors.
There are different advantages or disadvantages of the various forms
of remuneration (incentives, payments in stock, stock options, etc.),
some of which face tax obstacles in some countries, which do not
exist in other countries.
xxvi ACADEMIC OUTLOOK
It is the responsibility of the Boards directors to adjust the

remuneration to each companys individual circumstances. It is
important to review remuneration policies periodically in order to
ensure that the amounts and structure are commensurate with the
Directors responsibilities, risks, and duties. Accordingly, it is advisa-
ble for the Board itself, with the help of reports drafted for this pur-
pose by the Remuneration Committee, to evaluate these matters at
least once per year and disclose information on this area in the
annual report.
EU Commission Recommendation
According to EU Commission Recommendation of April 30, 2009,1
experience over the last years, and more recently in relation to the
nancial crisis, has shown that remuneration was focused on short-
term achievements and in some cases led to excessive remuneration,
which was not justied by performance. That is why the existing
regime for the remuneration of directors of listed companies should
have been strengthened by principles which are complementary to
those contained in Recommendations 2004/913/EC and 2005/162/
EC. The structure and level of executive pay is a key tool to ensure
that directors incentives on how to run a company are aligned with
those of the company and its owners. In the past years, there were
repeated cases of mismatch between executive pay and performance
of the company. Shareholders often face difculties in being properly
informed and in exercising control over directors pay (i.e., the man-
agement of the company).
Transparency on pay and oversight thereof is insufcient; only
15 EU Member States require disclosure of the remuneration policy
and 11 Member States require disclosure of individual directors
pay. In addition, only 13 Member States give shareholders a say
on pay through either a vote on directors remuneration policy
and/or report. Shareholders need information and rights to challenge
pay, particularly when it is not justied by long-term performance.
The lack of proper oversight on remuneration leads to unjustied
transfers of value from the company to directors.2
1
Commission Recommendation of April 30, 2009, complementing
Recommendations 2004/913/EC and 2005/162/EC as regards the regime
for the remuneration of directors of listed companies (Text with EEA rele-
vance) (2009/385/EC) (Recommendation of 2009).
2
As it is shown in the Commissions impact assessment accompanying the
Recommendations 2004/913/EC, 2005/162/EC and 2009/385/EC proposal.
Academic Outlook xxvii
An increase of the transparency on pay was therefore needed. It

would have also given shareholders a right to approve the remunera-
tion policy of the directors every three years and a right to vote
annually on the remuneration report explaining the pay packages of
directors in an advisory manner.
Some of the Experience of Member

States3
The experience of Member States demonstrates that there is often an
insufcient link between pay and performance where shareholders
do not have a say on pay.
For instance, in France and Austria, where shareholders do not
have a say on directors pay, the average remuneration of directors
in the years 20062012 increased by 94% and 27% respectively,
although the average share prices of listed companies in these coun-
tries decreased by 34% and 46% respectively. While executive pay
should not depend only on short-term share price uctuations, such
fundamentally divergent trends are one indicator for a mismatch
between pay and performance.
In Italy and Spain, before the introduction of an advisory say on
pay in 2011, the average share price in the years 20062011 went
down by 130% and 40% respectively, while the average remunera-
tion of directors of listed companies increased by 29% and 26%.
However, since the law was adopted in 2011, the average share
price of listed companies has increased by 10% and decreased by
5% respectively, but the remuneration of directors has also
increased by 1% and declined by 10%.
Such links between pay and performance are even stronger in
Member States where shareholders have a binding say on pay on
remuneration policy, since their opinion cannot be overruled by the
board of directors.
In Sweden and Belgium, before the adoption of a binding say on
pay in 2010 and 2011 respectively, the average share price from
2006 to 2009 and from 2006 to 2011 went down by 17% and
45%, while average pay of directors of listed companies increased
by 18% and 95%. However, since the laws were adopted in 2010
3
Communication From The Commission To The European Parliament, The
Council, The European Economic And Social Committee And The
Committee Of The Regions Action Plan: European company law and corpo-
rate governance a modern legal framework for more engaged share-
holders and sustainable companies (Action Plan 2012).
xxviii ACADEMIC OUTLOOK
and 2011, the share price has increased by 16% and 18% but the
remuneration of directors has also increased by 18% and decreased
(as a correction) by 10%.
To conclude, currently, not all Member States give shareholders
the right to vote on remuneration policy and/or the report, and
information disclosed by companies in different Member States is
not easily comparable. The Commission will propose in 2013 an
initiative, possibly through a modication of the shareholders rights
Directive, to improve transparency on remuneration policies and
individual remuneration of directors, as well as to grant share-
holders the right to vote on remuneration policy and the remunera-
tion report.4
Three Recommendations on Disclosure

of Remuneration Policy
The main recommendations related to remuneration are disclosure
of remuneration policy and the individual remuneration of executive
and non-executive directors, the shareholders vote on the remunera-
tion statement, an independent functioning remuneration committee
and appropriate incentives which foster performance and long-term
value creation by listed companies. Commission reports show that a
number of Member States have not adequately addressed these
issues.5
In 2009, the European Corporate Governance Forum (EUCGF)
recommended that disclosure of remuneration policy and individual
remuneration be made mandatory for all listed companies. It also
recommended a binding or advisory shareholder vote on remunera-
tion policy and greater independence for non-executive directors
involved in determining remuneration policy.6
According to EUCGF, disclosure of the remuneration policy of
listed companies and of the individual remuneration of directors
(executive and non-executive) and any material change to it should
4
Communication From The Commission To The European Parliament, The
Council, The European Economic And Social Committee And The
Committee Of The Regions Action Plan: European company law and corpo-
rate governance a modern legal framework for more engaged share-
holders and sustainable companies.
5
Commission Recommendations 2004/913/EC, 2005/162/EC and 2009/
385/EC.
6
The Commission also consulted on this issue in the 2010 Green Paper on
Corporate Governance in Financial Institutions.
Academic Outlook xxix
be mandatory for all listed companies in the EU.7 Disclosure of the

remuneration policy, its structure and individual director pay is
necessary in order for shareholders to have an appropriate level of
control over director remuneration.8
In 2004, the Commission issued a Recommendation9 to
Member States dealing with remuneration disclosure and the role of
shareholders and non-executive directors. According to the remu-
neration Recommendation, listed companies would have to disclose
a remuneration policy statement that could include details about
performance criteria. The remuneration policy statement should
include among other things information related to the importance of
xed and variable remuneration, information on performance cri-
teria and the parameters for annual bonus schemes.
Remuneration Should Promote the

Long-Term Sustainability
The remuneration of executive directors is an important element of
the governance regime of companies. In the last two decades, a fun-
damental shift has occurred to introduce and increase the level of
variable pay, both in cash and in shares and rights to acquire
shares.10
As stipulated in this recommendation, the structure of directors
remuneration should promote the long-term sustainability of the
company and ensure that remuneration is based on performance. It
is necessary to ensure that termination payments, the so-called
golden parachutes, are not a reward for failure and that the
7
EUCGF, Statement March 23, 2009 Statement of the European
Corporate Governance Forum on Director Remuneration; According to
EUCGF, currently only about 60% of Member States require disclosure of
the remuneration policy and about two thirds of Member States require dis-
closure of individual director pay (see the Commission Working Staff
Document referred to above).
8
According to EUCGF, the effective impact of the Recommendation has
been minimal: see the Commission Working Staff Document SEC (2007)
1022 of July 13, 2007. 527 68 Remuneration, Compensations and Other
Benets of Directors non-cash benets. It should also explain the companys
policy on the terms of executive directors contracts. Information about the
way the remuneration policy has been drawn up should also be made
available.
9
Recommendations 2004/913/EC and 2005/162/EC as regards the regime
for the remuneration of directors of listed companies.
10
EUCGF, Statement March 23, 2009 Statement of the European
Corporate Governance Forum on Director Remuneration.
xxx ACADEMIC OUTLOOK
primary purpose of termination payments as a safety net in case of

early termination of the contract is respected. Schemes under which
directors are remunerated in shares, share options or any other right
to acquire shares or be remunerated on the basis of share price
movements should be better linked to performance and long-term
value creation of the company.11
In order to facilitate the shareholders assessment of the com-
panys approach to remuneration and strengthen the companys
accountability toward its shareholders, the remuneration statement
should be clear and easily understandable. Moreover, further disclo-
sure of information relating to the structure of remuneration is said
to be necessary.12
Remuneration Policy
A remuneration policy also includes a maximum amount of remu-
neration. This should ensure that companies make a conscious
choice as to what is the value of good management for their com-
pany. For new recruitments, the company will be able to deviate
from the maximum, but only subject to prior or ex post approval by
the shareholders.
The remuneration policy approved by shareholders should
explain how the pay and employment conditions of employees of
the company were taken into account when setting the policy or
directors remuneration by explaining the ratio between the average
remuneration of directors and the average remuneration of full time
employees of the company other than directors and why this ratio is
considered appropriate.
This ensures that companies make a conscious choice and reect
on the relative value of good management for the company and on
the interaction between executive pay and a companys general
working environment. The policy may exceptionally be without a
ratio in case of exceptional circumstances. In that case, it shall
explain why there is no ratio and which measures with the same
effect have been taken.
The remuneration policy should be submitted to shareholders
for a vote every three years. Executive remuneration can only be
awarded or paid if it based on an approved remuneration policy. In
view of the signicant differences of Member States company law,
it will be for Member States set out in detail how these principles
11
Recommendation of 2009.
12
Recommendation of 2009.
Academic Outlook xxxi
will be complied with and what procedures would need to be fol-

lowed if shareholders reject the remuneration policy.
Remuneration Policies in the Financial

Services Sector
According to the Commission Recommendation on remuneration
policies in the nancial services sector,13 inappropriate remuneration
practices in the nancial services industry, also induced excessive
risk14.
Creating appropriate incentives within the remuneration system
itself should reduce the burden on risk management and increase the
likelihood that these systems become effective. Therefore, there is a
need to establish principles on sound remuneration policies. The
recommendation on remuneration in the nancial services sector is
presented in order to improve risk management in nancial rms
and align pay incentives with sustainable performance.
The recommendation sets out general principles applicable to
remuneration policy in the nancial services sector and should apply
to all nancial undertakings operating in the nancial services indus-
try. Remuneration policy covers those categories of staff whose pro-
fessional activities have a material impact on the risk prole of the
nancial undertaking. The governing body of the nancial undertak-
ing should have the ultimate responsibility for establishing the remu-
neration policy for the whole nancial undertaking and monitoring
its implementation.
The framework is not the same as for credit institutions and
investment rms. Directive 2013/36/EU, part of the CRD IV pack-
age (MEMO/13/690), has introduced, inter alia, a maximum ratio
13
Commission Recommendation on remuneration policies in the nancial
services sector SEC (2009) 580 SEC(2009) 581, Brussels, 30.4.2009 C
(2009) 3159. Remuneration, Compensations and Benets in the German
AktG 68.2 taking and thus contributed to signicant losses of major nan-
cial undertakings.
14
Financial undertaking according to the recommendation, means any
undertaking, irrespective of its legal status, whether regulated or not, which
performs any of the following activities on a professional basis: (a) It accepts
deposits and other repayable funds; (b) It provides investment services and/
or performs investment activities within the meaning of Directive 2004/39/
EC; (c) It is involved in insurance or reinsurance business; (d) It performs
business activities similar to those set out in points (a), (b) Or (c). A nancial
undertaking includes, but is not limited to, credit institutions, investment
rms, insurance and reinsurance undertakings, pension funds and collective
investment schemes.
xxxii ACADEMIC OUTLOOK
of 1:1 between the xed and the variable component of the total
remuneration, with some exibility provided for shareholders to
approve a higher ratio, up to 1:2.
Dr. Rado Bohinc

Professor of corporate law at University of Ljubljana, Slovenia
Section I
Theory of Corporate Governance
and Directors Remuneration
CHAPTER
Corporate Governance
1 and Remuneration
Udo C. Braendle and

Amir Hossein Rahdari
C
oase (1937) was one of the rst scholars who asked why
rms exist and what precisely a rm was. Both questions are
fundamental to understand corporate governance and remu-
neration. Before the 1930s the rm was often seen as a black box
which was assumed to behave like any other self-interested utility
maximising economic actor. Although Adam Smith already cited the
problems like the separation of ownership and control in rms, it
took more than 150 years before economists such as Coase and
Williamson put theories around these questions. In the meantime
catchwords like agency theory try to explain what corporate govern-
ance is and what part remuneration plays. This chapter lays the
basis by examining the different theories of the rm, legal and eco-
nomic ones, how they are connected and what they mean for the
corporate governance and remuneration discussion. But this chapter
shall also show the limitations of these theories and present some
outlook for new theories of the rm.
Introduction
The directors of such companies [joint stock companies]
however being the managers rather of other peoples money
than of their own, it cannot well be expected, that they
3
4 UDO C. BRAENDLE AND AMIR HOSSEIN RAHDARI
should watch over it with the same anxious vigilance [as if

it were their own].
Smith (1776)
Theories of the rm are ways of conceptualising the rm and under-

standing why remuneration matters (Braendle & Katsos, 2013). The
answers to the questions why rms exist and what precisely a rm is
are fundamental for the understanding of corporate governance.
Theories of the rm not only try to answer why businesses are orga-
nised in rms but how the relationships within the rm as well as
between the rm and society at large look like.
Since the seminal article of Ronald Harry Coase on the nature
of the rm (Coase, 1937), these questions were brought to the
attention of a large number of economists and a growing number of
lawyers, mainly in the area of Law and Economics. Many econo-
mists (still) use the tool of neo-classical economics to explain
why business activities are carried out with the structure of a rm
and to develop policy implications in corporate governance and
compensation.
Company law and corporate governance proposals are based
on particular understandings of what rms are for and whose inter-
ests they should serve. Therefore the theory of the rm is an indis-
pensable starting point for corporate governance and remuneration
studies.
Before the 1930s, the rm was very often seen as a black box
which was assumed to behave like any other self-interested utility
maximising economic actor. This view was based on the belief about
the rms ability to almost instantaneously adjust itself to a changing
environment. Consequently, resources of a rm were assumed to be
put to their most efcient use without having to look inside the
rm. It was treated as an entity competing with other rms in the
market. Although the limitations of this macroeconomic view have
already been cited by authors like Adam Smith (17231790), the
contemporary legal concept of separate legal personalities of compa-
nies supports this theory. Only this broad and abstract perspective
of rms can identify problems such as monopolies and oligopolies,
where one or a group of rms is able to drive competitors out of the
market. Antitrust law is a response to these sorts of market failures.
But at the same time rms are a collection of individuals as
well all having their own preferences and values (highly relevant
in terms of compensation) tied together in legal relationships
within the legally constructed black box of the rm. Although this
microeconomic view of rms is less abstract than the black box per-
spective, it does not explain why these individuals prefer organising
themselves into business structures rather than remaining indepen-
dent and making contracts on their own.
Corporate Governance and Remuneration 5
In a free market environment the answer must lie in signicant

economic benets of organisation within the structure of a rm com-
pared with contractual relationship on a market. In his seminal
1937 article, Coase developed a theory of the rms which was
against the mainstream literature at this time and put emphasis on
these relationships within the rm. Coase challenged economists and
was the starting point of various theories of the rm. What was ori-
ginally a research area for a few economists has, in the meantime,
become a playing eld for lawyers and economists interested in cor-
porate governance. Reviews of the theories of the rm and catch-
words like the separation of ownership and control, agency theory
and corporate social responsibility make this research area very
prominent.
This chapter will, starting from Coase, present the transaction-
cost economics of the rm (see section The Theory of the Firm
The Theory of Transaction Costs?). Theories look at the rm as an
alternative to markets.
Oliver Williamson, an institutional economist, further developed
Coases theory of the rm through a deeper analysis of different
forms of contracts (see section Beyond the Firm and Market
Dichotomy). As most theories of the rm are based on the idea of a
rm being a nexus of incomplete contracts (which will be dealt with
in section Incomplete Remuneration Contracts), opportunism may
inuence the relationships within rms and highlight compensation
issues.
The latter are based on asymmetric information, where one
party like the directors of a company can misuse the informational
advantage to exploit another party like the shareholders.
Remuneration and monitoring are two measures to reduce this
agency problem, which will all be discussed in section Agency
Theory. Agency theory developments can be bifurcated into two
major literature bodies of principal-agent theory and positive agency
theory (Fama & Jensen, 1983). Principal-agent theory models
principal-agent relationship based on logical deduction, mathemati-
cal evidence and viable assumptions (Eisenhardt, 1989). While, posi-
tive agency theory examines the manager-owner relationship and
focuses on areas of interest divergence and develops instruments to
align their interests and curb opportunistic behaviour. Ownership
structure (Jensen & Meckling, 1976), efcient capital markets and
controlling opportunistic behaviour (Fama, 1980), and separation
of ownership-control and monitoring mechanisms (Fama & Jensen,
1983) have been investigated in positive agency theory.
This is called Alternative Mechanism. There are various
notable theories of alternative mechanisms. The denition of classi-
cal rm looks at a rm as a production function personied by an
entrepreneur. These theories of rms are merely theories of markets
that look at rms as important entities as they explain why a rm

exists but fail to elucidate on the signicance of a rm as an organi-
zational structure. That is why they refer to rms as black box con-
structions (Mntysaari, 2012). According to Smith (1776) rms
exist to motivate and coordinate economic activity of specialists.
Common resource pools (Ostrom, 1999) and set-of-contracts theory
of the rm (Alchian & Demsetz, 1972) are other theories of rm.
These theories are inuential in the study of incentives within
the rms. The principal has a responsibility to compensate the agent
for their efforts but conict arises when determining the amount,
type and timing of these compensations (Spulber, 1990).
But this chapter will not only present theories of the rm but
also try to highlight the relevancy of each of these theories for the
corporate governance and remuneration debate and what practical
importance they have for policy makers.
The Theory of the Firm The Theory of

Transaction Costs?
The theory of the rm was traditionally one branch of
Microeconomics, which studied the supply of goods by prot-maxi-
mising agents. In this theory, production costs played a crucial role.
Coase (1937) was one of the rst to point out that in addition to
production costs of the usual sort, one must also consider transac-
tion costs in explaining institutions like the rm. He focused on the
comparative transaction costs of alternative organisational struc-
tures, such as rms and markets. This theory was later extended by
Oliver Williamson and became widely known as transaction-cost
economics (Williamson, 1979) or more broadly the economics of
organisation.
Transaction costs are costs (e.g. in terms of money or time)
incurred when making an economic exchange. If we extend this
term, transaction costs do not only include bilateral transactions but
subsume contractual relationships between individuals. In general,
transaction costs symbolise friction losses, that is the lost resources
for the involved parties, but which are inevitable to reach certain
goals. In rms, transaction costs may include the costs of organising
business activity over time, planning the future and limiting as well
as allocating risks which may arise in the future. It therefore includes
the elements of uncertainty and opportunism, which are both indis-
pensable for debates in corporate governance.
Coase argued in his 1937 article that transaction costs explain
both the existence of rms and their optimal size. In The Nature of
the Firm he identied certain transactions which are prohibitively
costly if the parties involved could only deal with instant market
transactions. In order to carry out a market transaction it is neces-
sary to identify the party one wishes to deal with, establishing terms
and conditions, conducting negotiations and concluding a contract.
After the conclusion of the contract, monitoring is needed to make
sure that all terms and conditions are fullled. If slight changes are
wished, the whole transaction process needs to be initiated again.
Or, to put it in other words, Coase emphasised that making con-
tracts and purchasing assets and other property in markets incurred
costs that were not accounted for by the price mechanism.
Individuals would therefore organise rms and maintain them when
the organisational entity provided implicit savings in terms of assem-
bling resources, assets and labour internally.
This describes situations in which market transactions would
show their relative inexibility to re-contracting when changes in
the existing relationship arise. Regularly recurring transactions and
long-term transactions might be good examples. In such situations
longer, incomplete contracts, which are typical for rms, provide
much more exibility for the parties in a world of uncertainty.
These contracts can be left open to be exible in case of a changing
environment.
On the other hand, dissimilarities of transactions, the probabil-
ity of changes in the market prices for the relevant resources as well
as the spatial distribution of the relevant resources and transactions
highlight factors which increase the costs of using a rm.
One might argue in this context that transaction costs would be
minimised in a world without transactions. This could be achieved if
rights and duties would initially be assigned in the right way.
Based on this idea Armen Alchian and Harold Demsetz built
their theory of property rights. Property can be tangible (e.g. equip-
ment in a rm) and intangible (intellectual property), and property
rights theory argues that the ownership, which includes residual
rights to the benets of ownership, of productive assets provides a
foundation for explaining rms. According to Oliver Hart, one of
the leading scholars in this area, a rm without property is just a
phantom (Hart, 1995). In situations where ordinary contractual
relationships fail, rms arise and the ownership of capital assets puts
(collection of) persons in the position to organise production
through the purchase of economic factors, including labour (Hart,
1995).
Applied to corporate governance and remuneration, this theory
provides a supplement to contract theories. The theory claims that
legal systems should assign and secure property rights and addition-
ally explains that those who invest in or own productive property
and capital of the rm have a privileged position as legal agents to
bargain with other parties such as directors, employees, suppliers

and other constituencies.
Coase, in his theory of the rm, built a connection between the
above discussed property rights and transaction costs. In a world
without the latter, the initial assignment of property rights would be
irrelevant as each error in the assignment of these rights could
easily be rescinded by additional transactions. This is the idea of the
Coase Theorem for property rights.
The applicability of the Coase Theorem to companies is ques-
tionable as the idea rests on the assumptions that there are no legal,
strategic and informational barriers to bargaining. But in modern
rms all these barriers normally exist and make transactions more
expensive, that is incur transaction costs.
Beyond the Firm and Market Dichotomy

Institutional economists like Williamson have further developed
Coases theory of the rm through a deeper analysis of different
forms of contracts. He developed governance structures which can
be seen as a spectrum of contracts between the extremes of Coases
market versus rm analysis. His theory of transaction costs provides
answers why rms change organisational structures over time.
Modern phenomena such as competition law, merger control as
well as outsourcing can be explained with the help of this theory.
Concerning the latter, a rm may nd that it is cheaper in terms of
direct and administrative costs as well as legal liability to conclude
an arms-length contract for labour services rather than bearing the
cost of hiring employees directly. This inuences the size of a rm
(which wont grow) but the outsourced services will expand the gen-
eral market for those services. In a broader context this has implica-
tions on merger control. By suggesting circumstances in which
integration (or outsourcing) might be efcient, transaction costs the-
ory inuences decisions of rms. This in turn has implications on
competition law as vertical and horizontal mergers may disrupt
competitive markets and lead to market structures which need regu-
lation to enforce competition.
In his theory, Williamson presented the rm and instant market
transactions as lying on a spectrum of forms of organisations (gov-
ernance structures) rather than as simple alternatives. The three
forms of intermediate structures are the classical, neo-classical and
relational contracts. The classical contract is characterised by full
contingency, that is the contract should be as complete as possible,
looking for regulations for each uncertainty. The contract should
provide a complete guide to the terms of all consequential
transactions.
A neo-classical contract, however, leaves some terms open. Here

the goal of the parties is not completeness of contracts, but to estab-
lish mutually acceptable mechanisms to minimise the costs of leaving
contractual terms open. To put it in other words, leaving parts of a
contract open about an uncertain future should allow efcient re-
negotiations at a later stage. But this incompleteness of contracts
opens room for exploitation of one of the contractual parties.
To assure exibility whilst minimising the risk of opportunism,
special legal devices were developed. These include referees and arbi-
trators as third parties to resolve disputes as well as external refer-
ence points such as stock indices or interest rates. All these devices
have one common feature, namely reducing the risk of exploitation
of one of the parties.
The relational contract as a third governance structure stands
for future decision making rather than attempting to make decisions
in advance. For the parties involved, the goal is a trade-off in terms
of maximising the gains of the transaction whilst trying to minimise
transaction costs. The contract itself prescribes the governance struc-
ture, its operations and may restrict and place boundaries on its
discretion. To avoid a wide degree of discretion, some of the neo-
classical safeguards mentioned above may be used.
Compared to Coase and his extremes of rms and markets,
Williamsons governance structures can be seen as a spectrum
between these boundaries. Given a certain set of transactions,
Williamson identied factors for the optimal choice of governance
structure. This is inuenced by the frequency of transactions as well
as the transaction-specicity. Concerning frequency there are likely
to be efciency gains in making long-term arrangements if one party
needs a particular resource. A transaction-specic investment arises
when one party requires an unusual or idiosyncratic resource.
Consequently alternative sources of supply are unlikely to be readily
available. As one or both parties make greater investments in the
transaction, they are more vulnerable to opportunism by the other
party and therefore will try to make satisfactory arrangements cov-
ering the future.
Incomplete Remuneration Contracts

One might now argue that all problems could easily be avoided by
writing a complete contract between shareholders and managers. A
complete contract is a concept in contract theory that describes an
agreement that would specify the respective rights and duties for
every possible future state of the world. As it would be prohibitively
expensive to write such a complete contract, contracts in the real
world are usually incomplete. Just think about a typical employment
contract of a chief executive in a company. It would be impossible

to write a contract which makes clear what this executive should do
in each future situation. Furthermore, not only that the future
remains uncertain, even if a detailed contract could be written, it
would be very costly.
To avoid confusion, it is necessary to point out that this con-
cerns a contract from an economic perspective. As should be evident
from our contract law classes, a contract is a binding agreement
between two or more parties to perform certain obligations, whereas
a complete contract is one which includes all essentialia negotii.
From an economic perspective, a contract is everything which pic-
tures observable states, or, to put it in other words, an instrument
which facilitates an exchange of property rights.
It is fairly obvious that the denition of an economic contract is
much broader and therefore a complete contract more difcult to
achieve. It would need explicit regulations to cover every possible
state in the future, and to highlight the rights and duties of each
party. A complete contract therefore remains a ction.
Basically, there are six reasons why a contract (in economic
terms) remains incomplete: rstly, ambiguous diction within the
contract. In addition, the parties may have forgotten about regula-
tions for certain points of the contract. Thirdly, despite the aware-
ness of the parties, the costs of bargaining for some issues might be
prohibitively high. Asymmetric information is another reason for
incompleteness, an area we will discuss in more detail in the next
section. Bounded rationality is a concept based on information eco-
nomics which gives an explanation why contracts are incomplete. It
rests on the idea that economic actors do not have perfect informa-
tion and/or may not be able to process all available data adequately.
Therefore, the amount of information plays a crucial role. Think
again about the employment contract with the chief executive of a
company. Even if it would be possible to foresee the future and write
a complete contract for every possible state that may occur, it would
be impossible to write such a voluminous contract in time and no
party would be able to process all of the information in the contract.
Bounded rationality asserts that decision makers are intended to
be rational, that is they are goal-oriented and adaptive, but because
of human cognitive and emotional architecture, they sometimes fail
to be so, even when it comes to important decision making. Finally,
the heterogeneity of the market serves an explanation for incomple-
teness of contracts.
If we assume that the rm is a nexus of contracts, that is empha-
sising the network of different kind of contract made by individuals
to compose a rm, the incompleteness of contracts has substantial
consequences. As contracts are incomplete, parties have to agree on
the allocation of control rights for all situations that are not
specied in the contract. The resulting institutional design constitu-

tes what we describe as corporate governance. It assigns control
rights for the use of the rms assets.
Agency Theory
One of the key elements of agency theory is opportunism, a point
stressed heavily by Williamson. If one party (the agent) has discre-
tion which she is supposed to exercise for the benet of another (the
principal), she may exercise it to maximise her own utility instead.
This is inefcient where the resulting loss to the principal exceeds
the benets of the agent. If the agent is rewarded by the principal on
a basis which does not correlate her effort to the reward, the agent
may not have the incentive to exercise the highest effort. The costs
resulting from this agency problem includes both the loss of poten-
tial benets and the costs of measures designed to reduce the loss of
potential benets. Michael Jensen and William Meckling (Jensen &
Meckling, 1976) identied these costs and termed them agency
costs.
Applied to corporate governance, legal protection against fraud
and other forms of dishonesty may provide some protection. But
economic analysis suggests that internalising some of these market
transactions into a rm may substantially reduce the risks of oppor-
tunism. But despite reducing some of the costs of opportunism in
the market, the special structure of rms creates other forms of
opportunism in those entrusted with economic responsibility to
manage the rm.
Agency theory is based on the incompleteness of contracts and
the separation of ownership (shareholders) and control (manage-
ment), which is the main characteristic of corporations nowadays.
Though the resulting problems were already mentioned by Adam
Smith in the 18th century, they were prominently highlighted by
Adolf Berle and Gardiner Means in the 1930s.
They argued that a company does not behave in accordance
with the classical model, which assumed that despite the manage-
ment of companies by agents, these agents act in the best interest of
the owners of the rm. As a consequence the owners would ensure
that the agents do act in their interest. But this idea, the stewardship
theory, assumes that managers do not necessarily work only in their
personal interest. Managers are seen as honorable wealth builders
and can therefore be instructed with the management of
corporations.
Berle and Means argued that the interests of managers and
shareholder may diverge and that shareholders would not act as
owners, exacerbating the agency problem. Concerning the rst
argument, the stockholders (principals) want their agents (managers)

to maximise the value of the shares. But the manager may be better
off pursuing some other strategy and therefore acting opportunisti-
cally. Despite the law asserting that an agent has a duciary duty to
serve the principals interest, the agent will also tend to serve their
own self-interests. If we think about staff, sales, size of the rm,
remuneration, etc., being an input-vector, we can assume that the
vector which maximises the prots of the rm does not necessarily
maximise the managers wealth. We can assume that most managers
will choose the vector which maximises their own wealth. The
recent nancial scandals with stories about greedy managers all over
the world conrm this picture.
On the other hand, the second point of Berle and Means should
not be forgotten. Due to the shareholders perceived limited liabi-
lity and the shareholders inability in practice to control the man-
agement, the agency conict is exacerbated. Limited liability means
that a company is responsible for its own debts and liabilities.
Shareholders are only liable to the company to pay up their share
capital. In other words, they are sharing the companys prots, but
they are not responsible for all of its losses. Limited liability, so the
argument goes, shifts the risk of business failure from the companys
shareholders to its creditors. Both, the companies owners and man-
agers therefore may have too much of an incentive to take risks, as
the creditors would be the party which would suffer most in case of
a bankruptcy. This could result in an inefcient use of resources.
The diversity and large number of shareholders in a typical pub-
lic company cannot or will not exert effective control over the man-
agement for various reasons such as the existence of a coordination
problem. This includes problems of different interests of share-
holders as well as bringing together shareholders with the same
beliefs.
In general we refer to the collective action problem, where it
might be rational for each of the shareholders not to engage in con-
trol. Just think about yourself being one of many small shareholders
of a public company. Your incentive for attending the general meet-
ing of the company or exercising control in any other way is mini-
mised as the transaction costs of controlling (in monetary terms as
well as time) exceed the benets. You need to spend time in reading
bulky reports of the company, the general meeting might not be
close to your home, you have to spend a whole day at the meeting
and all of these costs might exceed the benets you get from voting
your rights. It is therefore rational not to engage in the control of
the company. With the imminent problem of free riding, that is each
shareholder wants to avoid the costs of control by hoping that the
other shareholders are exercising the necessary control, this leads to
a collective action problem. Each of the shareholders is acting
rational, when not exercising control. But this leads to a situation

where nobody controls the management at all.
All this means that managements incentive as to how they exer-
cise their powers of management may not be aligned with the inter-
ests of the companys shareholders, giving rise to manifold economic
problems, such as various forms of opportunism.
Due to the consequent danger of the inefcient use of resources
there is a justication for correction. To reinforce the classical model
of the company where the interests of the owners and managers of
the company are aligned, regulatory measures mainly in the form
of laws and codes are used.
These include strengthening shareholders voting rights, for
example with the help of minority shareholder rights. In addition
the accountability of the management to shareholders is achieved by
imposing penalties on managers when they behave wrongly.
Furthermore, enforced publicity and disclosure should reduce the
asymmetric information between the parties and therefore lead to
better control.
All of these measures are reected in corporate governance
reforms around the world (Mallin, 2012). As it is impossible to
write complete contracts between the different parties, a rst best
contract does not exist and leaves a gap which should be lled by
corporate governance. All control forms involve agency costs; there-
fore, corporate governance revolves around nding the control
which minimises agency costs.
Agency theory relies on the idea of writing a contract to align
the incentives of both parties involved. In other words, it tries to
strike a balance between providing incentives for managers and
guaranteeing a maximisation of shareholder value. To achieve this
goal, monitoring refers on the one hand to strategies of managerial
supervision and oversight to improve performance. This explains the
existence of board systems and other external monitoring such as
rating agencies and institutional investors. On the other hand, high-
powered incentive contracts such as shares and stock-options to
remunerate directors were implemented in most companies over the
last years. In Chapter 2 we will have a closer look at the pitfalls of
these remuneration schemes. For the moment being, two problems
of asymmetric information in rms shall be presented. We distin-
guish between moral hazard (hidden action) and adverse selection
(hidden information).
ADVERSE SELECTION
Adverse selection describes an agency problem where asymmetric
information exists before the transaction occurs, leading to an inef-
cient allocation of resources. Originally, the term adverse selection
came from the insurance industry. It describes a situation of private

information where the insured are more likely to suffer a loss than
the uninsured. As an example, think of two groups of car drivers.
On the one hand, the careful and risk-averse drivers and on the
other hand the reckless, risk-taking drivers. An insurer selling car
policies cannot easily assign the different drivers to these groups, so
each of them pays the same premium. But reckless, risk-taking car
drivers are much more likely causing damages than the careful, risk-
averse ones. Consequently, the car insurance is a better deal for the
beneciaries of the reckless drivers. As the insurance companies do
not want to lose money, they will set the premiums accordingly
high. This in turn may result in a situation where careful drives may
want to go uninsured (as the premium is too high for them) and
only the high-risk drivers remain on the market, as they benet from
the insurance.
Economists like George Akerlof applied the concept of adverse
selection into markets other than insurance, where similar asymme-
tries of information may exist. Applied to corporate governance,
investors very often face problems of adverse selection. When buy-
ing a share an investor usually has incomplete information about
the management of the company in which she intends to invest.
In his seminal 1973 article Michael Spence (born in 1943) pro-
posed a way how two parties could get around the problem of
adverse selection. The idea is having the informed party sending a
signal that would reveal some piece of relevant information to the
uninformed party. The latter interprets the signal and adjusts her
purchasing behaviour accordingly. In our example, the disclosure of
information from companies could be interpreted as signals to the
stock market.
Another way to overcome adverse selection is screening. Here
the uninformed party takes actions to separate different types of
informed parties. In the example, the investor could try to collect
data about the risk of each company and adjust the investment
accordingly.
MORAL HAZARD
Compared to adverse selection, moral hazard describes an agency
problem which exists after a transaction is made, leading to an inef-
cient allocation of resources. The term moral hazard as well has its
origin in the insurance industry.
Applied to corporate governance, the shareholder-manager
agency relationship is a good example of moral hazard. Directors of
a company may, after signing their employment contract, start act-
ing in a way which benets themselves but not the shareholders.
This leads to all of the problems discussed above with managers act-
ing opportunistically.
Monitoring and incentive compatible contracts are two ways to
overcome moral hazard. Monitoring builds on the straightforward
idea that opportunistically acting managers will stop doing so if they
are detected and penalised. But monitoring itself is on the one hand
very costly and consequentially reduces the exibility of companies,
a fact which is very often neglected. Incentive compatible contracts,
however, are a cheaper way to reduce the moral hazard problem.
With the help of incentives, managers should be motivated to align
their interests to the ones of their shareholders. Bonuses and stock-
options are just two measures to achieve this goal. Unfortunately,
these measures are themselves subject to new problems like short-
term prot maximisation of managers to cash-in their bonuses and
stocks, without thinking too much about the longer term. Another
problem, which became especially immanent during the nancial
scandals, is that managers used their creativity in accounting to
reach their bonus threshold.
Although most of the literature puts emphasis on this classical
agency problem between the suppliers of equity the shareholders
and management, agency conicts can arise between various groups
of stakeholders in a rm.
DIFFERENT AGENCY CONFLICTS

In addition to this relationship, the conicts between majority and
minority shareholders as well as between shareholders and other sta-
keholders should be mentioned. The latter became prominent in the
literature as the shareholder-stakeholder debate or Corporate Social
Responsibility.
The conict between majority and minority shareholders is typi-
cal for companies with a concentrated ownership structure. The con-
ict revolves around the term of private benets of control,
highlighted by Lucian Bebchuk in 1994. The question is to what
extent the majority shareholders of a company can enjoy additional
benets from the company which are not shared with the other
shareholders. In this context the purchase of shares below market
value or the change of a product mix should be mentioned. Mark
Roe describes in his 2003 book the effects of corporate governance
in social democracies and illustrates how political ideas can be used
to identify the conicts between majority and minority shareholders.
Traditionally, some corporate governance systems have to deal with
this conict if we just think about the power of banks or the state.
Both, banks and the state as owners of companies may follow other
interests than the rest of the shareholders do.
The third conict is between shareholders and other interest

groups such as employees and creditors and concerns the classical
shareholder versus stakeholder differentiation. The stakeholder
model claims that the rm should serve wider interests of
stakeholders rather than shareholders only. Stakeholders such as
employees, creditors, suppliers, customers and local communities
have long-term relationships with the rm and therefore affect its
long-term success. The company is seen as an entity embedded
within the society it operates and therefore should take care of it. In
the meantime there is a huge debate all over the world about
whether it is the duty of company law in general and corporate gov-
ernance in particular to solve this conict between shareholders and
other stakeholders or, what the Anglo-Saxon literature and practice
favours, that the legislator should deal with this problem exclusively
within labour law and other social legislation.
Management and Collective Production

Whatever one might think about agency theory, the separation of
the two functions, shareholder and management, makes economic
sense. The shareholders on the one hand provide equity capital
together with subsequent risk-bearing, whereas professional man-
agers on the other hand do not have to possess capital and risk-
bearing expertise but provide managerial expertise.
As management can be performed more efciently in a small,
cohesive body, it is better to have a professional management than
let a large number of shareholders decide on the day-to-day busi-
ness. The risks associated with providing equity capital, however,
can be borne more efciently when shared among a large number of
people. These, in turn, can protect themselves by holding diversied
portfolios of investment.
Armen Alchian and Harold Demsetz took up the structure of
companies and drew attention to the analysis of team production
(1972), itself an extension of the earlier work by Coase. According
to this theory, the rm is preferred to the market because of the ben-
ets of team production. Nevertheless, team production always
involves a metering problem. Where parties are engaged in some
form of collective business activity, there may be difculties in mea-
suring the contribution made by each participant and matching their
reward to their actual contribution. The rewards of the participants
of the team may be, to a greater or lesser extent, determined not by
their individual effort, but by their collective effort as a team.
The metering problem therefore presents a fertile soil for a form
of opportunism known as shirking. In a team where each members
reward is not fully related to their actual input, the member has too
little incentive to contribute fully to the teams activities. However,

the incentive to obtain utility in other ways (to shirk) is increasing.
As the members enjoy the full benet of their shirking, but share the
costs with other members of the team, shirking is a common moral
hazard problem in many rms. Obviously this theory is based on
certain assumptions about peoples motivation in working and their
afnity to shirk.
As a result, shirking is more likely to be a problem for larger
teams where shirking is less likely to be detected and where mem-
bers are less motivated by a sense of loyalty to their entity.
Corporate governance, in this context, should try to minimise
the scope for shirking by all participants and conserve the gains
from using a rm. In theory, this should be easy to implement as the
team members are likely to gain more from less shirking by other
team members than they lose from their resulting inability to shirk.
Responses to shirking are the reduction or removal of the meter-
ing problem and monitoring in the form of management. The former
may be possible if we think about many modern trends in organisa-
tion such as outsourcing, franchising and the replacement of
employees with self-employed contractors. In these entire organisa-
tion forms, the traditional team and the problems related to it are
reduced.
If shirking undermines the gains from team production, Alchian
and Demsetz argue, the efcient solution is monitoring with the help
of a hierarchical management structure. This includes a central man-
ager who coordinates the individual contributions or inputs. Being
the recipient of the teams residual income, she takes all the surplus
prots and bears any losses. Under these conditions the manager has
the optimum incentive to maximise the output of the team.
To explain management hierarchies with the help of team pro-
duction we assume that the monitors themselves are opportunistic
and therefore exposed to shirking. Consequently the monitors need
monitoring themselves. To avoid problems with the implication that
the monitors at the top of the hierarchy have no monitors, incentive
systems need to be established. This is one of the tasks of a good
corporate governance system.
For company law implications the theory of team production is
useful in highlighting problems in the hierarchical structure of com-
panies. If the different monitors do not keep in mind what is best for
the company but misuse monitoring to gain private benets, share-
holders should enjoy some rights. They should be able to replace
individuals or whole boards that are not monitoring on their behalf.
To impede fraudulent and unethical managerial behaviour,
levers of control are implemented. Four levers of control are men-
tioned in literature (Horngren, Datar, & Rajan, 2012). Diagnostic
control systems are implemented to discover fraudulent activities,
unethical behaviour and misappropriation of funds. Boundary sys-

tems are codes of conduct that dictate ethical behaviour. Belief sys-
tems are the mission, purpose and core values of a company.
Interactive control systems are formal information systems used by
managers to focus the attention and learning of the company on key
strategic issues using different analyses and tools like Strength,
Weaknesses, Opportunities, and Threats analysis and Critical
Success Factors analysis.
Outlook and Conclusion

The market and the rm are two alternative forms of allocating
scarce resources. The rm exists because in many cases it is more
efcient to organise production in a non-price environment. Coases
transaction-cost theory was one of the rst neo-classical attempts to
dene the rm theoretically in relation to the market. This theory
was later extended by Williamson through a deeper analysis of dif-
ferent forms of contracts. He developed governance structures which
can be seen as a spectrum of contracts between the extremes of mar-
kets and rms. Alchian and Demsetzs analysis of team production
is another extension of the earlier work by Coase.
By looking at the common elements of all of these theories it is
obvious that they provide negative reasons for the existence of the
rm. All theories revolve around the existence of rms to overcome
inefciencies. None of these offer a positive theory of the rm, with
functions like generating value. But Demsetz himself in his 1988
article considered the positive function of the rm as an efcient
device for accumulating, storing and using information.
Whereas most theories of the rm are primarily concerned with
predicting the behaviour of rms in external markets, the last two
decades brought forward a knowledge-based theory of the rm as
an alternative view. Knowledge is seen as the most important
resource of a rm. This includes all the intellectual abilities and
knowledge possessed by employees, as well as their capacity to learn
and acquire more knowledge. Thus, knowledge resources include
what employees have mastered, as well as their potential for adapt-
ing and acquiring new information. These resources are seen as
being extremely important for sustaining competitive advantage in
todays environment. Participants and input-providers are viewed
as assets rather than sources of inefciency.
Based on the idea that the rm is a nexus of contracts, the
incomplete contract literature helps us to understand the need for
corporate governance and remuneration. If it would be possible to
x the relationships between the owners and the managers of a com-
pany contractually and consistently, there would be no divergences
between the two parties. But as the costs of writing such contracts
are prohibitively high, the abstract structure of corporate govern-
ance has to be introduced.
Complete contracts, which do not exist in the real world, would
also provide a solution to the agency theory. If one party (the agent)
has discretion which one is supposed to exercise for the benet of
another (the principal), they may instead exercise it to maximise
their own utility. The shareholder-manager relationship is the classi-
cal example for such an agency relationship. Agency theory results
from information asymmetries between parties, where especially the
concepts of adverse selection and moral hazard are of relevance in a
corporate governance and remuneration framework.
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CHAPTER
Directors
2 Remuneration and
Motivation
Udo C. Braendle and John E. Katsos
M
oney may not be everything, but it is certainly something
that can easily be measured, in contrast to power or pres-
tige. One of the main control mechanisms that share-
holders have used to rein in rogue managers is compensation.
Through a combination of intrinsic and extrinsic incentives, share-
holders have tried to provide the right balance to motivate senior
managers to perform at their best. Shareholders have often failed in
achieving this balance through compensation. In this chapter, we
argue that this failure is not the result of compensation packages as
such, but on the focus of compensation packages on extrinsic moti-
vators such as pay-for-performance bonuses and stock options.
Instead, the focus of compensation packages should be on cultivat-
ing intrinsic motivators such as ring and prestige.
Introduction
Money may not be everything, but it is certainly something that can
easily be measured, in contrast to power or prestige. Executive con-
tracts are supposed to provide explicit and implicit incentives that
align the interests of managers with those of shareholders. The
empirical literature has focused on the sensitivity of pay (explicit
incentives) and the dismissal of executives (implicit incentives) to
corporate performance. The high payments were justied with the
extraordinary gains in wealth shareholders received through most
of the 1990s. Incentive pay was characterised as one of the
21
22 UDO C. BRAENDLE AND JOHN E. KATSOS
driving forces for the high market valuation of US corporations

(Kaplan and Holmstrom, 2001). But recently, while stock prices
decrease and executive pay does not, a rethinking of the compensa-
tion scheme is needed. Switzerland with its successful peoples
initiative against fat-cat pay is the latest example of this trend (The
Economist, 2013).
All forms of control by shareholders over management involve
agency costs; therefore, corporate governance revolves around nd-
ing control mechanisms that reduce agency costs. To achieve this
goal, monitoring refers, on the one hand, to strategies of managerial
supervision and, on the other, oversight to improve performance
(Braendle & Noll, 2004). This explains the existence of board sys-
tems (Kostyuk, 2006) and other external monitoring such as rating
agencies and institutional investors. On the other hand, high-
powered incentive contracts, such as shares and stock options, were
implemented to remunerate directors in most companies over the
last years (Armstrong, Ittner, & Larcker, 2012).
One of the main control mechanisms that shareholders have
used to rein in rogue managers is compensation. Through a combi-
nation of intrinsic and extrinsic incentives, shareholders have tried
to provide the right balance to motivate senior managers to perform
at their best. Shareholders have often failed in achieving this balance
through compensation. In this chapter, we argue that this failure is
not the result of compensation packages as such, but on the focus of
compensation packages on extrinsic motivators such as pay-for-
performance bonuses and stock options. Instead, the focus of
compensation packages should be on cultivating intrinsic motivators
such as ring and prestige.
We begin by examining the existing literature and paradigms
on agency theory and managerial compensation. Next, we examine
the existing literature on employee motivation. This literature
indicates that intrinsic motivation leads to higher performance in
non-programmable tasks and that extrinsic motivators like pay very
often crowd-out the effect of intrinsic motivators on the perfor-
mance of employees, leading to poorer performance in spite of
higher pay. In the third section, we analyse how the employee moti-
vation literature might inform the current agency theory debate. We
nd that, based on the existing literature, shareholders may obtain
better performance from their managers by reducing their level of
pay, but increasing extrinsic motivators through compensation
packages. In the nal section, we suggest some areas for further
research in the eld to empirically establish connections between
intrinsic motivation and performance among senior managers. We
also note several limitations and how they might be addressed in
future studies.
Directors Remuneration and Motivation 23
Agency Theory and Managerial

Compensation
The principal-agent model is based on economic models related
to the employment relationship (Holmstrom, B., & Milgrom, P.
(1990)). The underlying concept is that the principal wants the agent
to do something on her behalf and therefore must motivate the agent
to do so. That motivation can come in two forms: extrinsic and
intrinsic. Extrinsic motivation is what we traditionally think of in
the agency theory context and it takes the form of motivators out-
side of an individual such as pay. Intrinsic motivation is inside of an
individual and usually derives from goal identication or task invol-
vement (Fuller & Jensen, 2002).
Managers do not necessarily maximise shareholder value
(Mueller, 2003). As most of them own only tiny fractions of their
companies shares (if at all), the separation between ownership and
control leads to a principal-agent problem (Bebchuk, Cremers, &
Peyer, 2011). The stockholders (principals) want their managers
(agents) to maximise the value of the company and its shares. But
managers may be better off pursuing a different strategy. We can
expect the utility-maximising manager to increase those elements in
an input vector that gives him/her personal utility (Conyon, 2006).
In other words, he/she will use some of his/her residual income to
engage in on-the-job consumption, up to a point where the marginal
utility from additional discretionary expenditures is near zero.
The managerial-discretion literature put forward some hypotheses
concerning what it is that managers consume in excess: leisure
(Edmans & Gabaix, 2009), sales (Baumol, 1967), staff and emolu-
ments (Williamson, 1979), growth (Marris, 1963, 1998) and income
(Melis, Carta, & Gaia, 2012).
One of the key elements of agency theory is opportunism, a
point stressed by Williamson (1979). If the agent has discretion
which he/she is supposed to exercise for the benet of another (the
principal), he/she may exercise it to maximise his/her own utility
instead. This is inefcient where the resulting loss to the principal
exceeds the benets to the agent. If the agent is rewarded by the
principal on a basis which does not correlate his/her effort to the
reward, the agent may not have the incentive to exercise the highest
effort. The costs resulting from this agency problem includes both
the loss of potential benets and the costs of measures designed to
reduce the loss of potential benets. Jensen and Meckling (1976)
identied these costs and termed them agency costs.
Agency theory is based on the incompleteness of contracts and
the separation of ownership and control. Though the resulting
problems were already mentioned by Adam Smith in the 18th cen-

tury, they were prominently highlighted by Berle and Means (1932).
Due to the shareholders perceived limited liability and the share-
holders inability in practice to control the management, the agency
conict is exacerbated. In academic circles, the shareholder and sta-
keholder visions of the rm have been battling for supremacy since
at least the 1930s (Coase, 1937; Dodd, 1932). In general, the share-
holder vision of the rm sees managers as being entrusted with large
amounts of ownership money and that regulation and shareholder
control through directors are the only means to stop management
from abusing this trust (Jensen & Meckling, 1976; Muth &
Donaldson, 1998). Again, generally, the stakeholder, or other-
regarding, vision of the rm sees managers and directors as
intermediaries among different groups with interest beyond just
nancial in the rm (Evan & Freeman, 1988). Shareholders are
only liable to the company to pay up their share capital. In other
words, they are sharing the companys prots, but they are not respon-
sible for all of its losses. Limited liability, so the argument goes, shifts
the risk of business failure from the companys shareholders to its
creditors. Both, the companies owners and managers, therefore may
have too much of an incentive to take risks, as the creditors would be
the party which would suffer most in case of a bankruptcy. This could
result in an inefcient use of resources (Bris & Welch, 2005).
The diversity and large number of shareholders in a typical pub-
lic company cannot or will not exert effective control over the man-
agement for various reasons such as the existence of a coordination
problem (Ingley, Mueller, & Cocks, 2011). This includes problems
of different interests of shareholders as well as bringing together
shareholders with the same beliefs.
In general, we refer to the collective action problem, where it
might be rational for each of the shareholders not to engage in con-
trol (Braendle & Noll, 2004).
Due to the consequent danger of the inefcient use of resources
there is a justication for correction. To reinforce the classical model
of the company, where the interests of the owners and managers of
the company are aligned, regulatory measures mainly in the form
of laws and codes are used.
These include strengthening shareholders voting rights, for
example bolstering minority shareholder rights (Braendle, 2006). In
addition, the accountability of the management to shareholders is
achieved by imposing penalties on managers when they behave
wrongly (Bergstresser & Philippon, 2006). Furthermore, enforced
publicity and disclosure should reduce the asymmetric information
between the parties and therefore lead to better control (Braendle &
Noll, 2005). All of these measures are reected in corporate govern-
ance reforms around the world (Mallin, 2012).
Public companies are not required to have shareholders person-

ally vote their shares because the number of shareholders is too large
and their locations too diverse. As a result, shareholders instead
often vote by proxy. Traditionally, access to the proxy ballot was
only provided to senior management and board of directors.
Recently, however, the Securities and Exchange Commission (SEC)
granted shareholders access to the proxy ballot in order to nominate
at most one director (SEC, 2010).
So-called say on pay votes are a means of giving shareholders
the ability to challenge management compensation packages. The
recently passed Dodd-Frank Financial Reform bill (2010) requires
public companies to have say on pay votes. These votes are advi-
sory in that directors are not bound by the decision of shareholders
with respect to executive compensation.
The major goals of allowing proxy access to shareholders and
say on pay votes were to increase shareholder democracy and
make management more responsive to the needs of others
whether these are shareholders or stakeholders (SEC, 2010, p. 331).
The purpose of increasing shareholder democracy and making man-
agement more responsive is presumably to reduce the amount of
excessive risk-taking and poor ethical and legal decisions made by
executives of public companies over the past decade. Yet the poor
decisions of company management and their excessive risk-taking
seem to be more directly attributed to short-termism.
Short-termism is the obsession with short-term results by inves-
tors, asset management rms and corporate managers (Krehmeyer,
Orsagh, & Schacht, 2006). Theorists of multiple persuasions see
short-termism as a major problem that might be xed through chan-
ging executive compensation structure, likely via say on pay and
proxy access rule changes (along with other proposals). Theorists
traditionally associated with the shareholder (Fuller & Jensen,
2002) and stakeholder (Evan & Freeman, 1988) visions agree not
only that short-termism is a problem, but also that it must urgently
be xed. Though law and management theorists have come up with
a variety of proposals to solve short-termism, most relate, in some
way, to simply adjusting the criteria by which senior management is
incentivised (Bebchuk et al., 2011).
Though executive compensation is certainly not the only facet
of corporate governance, it is easier to measure compensation of
executives than the relative power or prestige of being the CEO of
one company or another. So it is not surprising that much of the lit-
erature which has tested for the effects of managerial discretion has
looked at managerial compensation. Executive compensation in the
United States has risen continuously since 1970, with the bulk of the
increase stemming from granted option plans (Conyon & Murphy,
2000).
BASE SALARY
The base salaries for executive ofcers are in most cases determined
by benchmarks based on industry salary surveys. These surveys typi-
cally adjust for company size, reinforces the observed relation
between compensation and rm size. Even though base salaries only
make up a declining percentage of the total compensation, they are
key component of executive employment contracts. As these salaries
are xed, risk-averse executives will naturally prefer a dollar
increase in the base salary than in the variable bonus compensation.
BONUS
Almost any company offers an annual bonus plan based on perfor-
mance over the year, covering all of its top executives. Despite hetero-
geneity across industries and companies, executive bonus plans can be
categorised in terms of three basic components: performance measure,
performance standards and the structure of the pay-performance
relation (Murphy, 1999). Usually no bonus is paid until a minimum
performance hurdle is reached commonly 80% of a budgeted
target. Exceeding this hurdle, the manager receives a bonus, which
increases as performance mounts. Target bonuses are paid for
achieving the performance standard, and there is usually a cap on
bonuses paid 120% of the target is common. The value between
the minimum hurdle bonus and the cap is named the incentive
zone. The target is normally somewhere in the middle of this incen-
tive zone.
Companies normally use accounting elements, like revenues, net
income, EBIT (earnings before interest & tax), etc., to measure the
performance. The most common non-nancial performance mea-
sures used in annual incentive plans is to quantify the deviation
from ex-ante specied objectives, customer satisfaction or plant
security.
As long as the managers believe they can make the minimum
hurdle, they will naturally try to increase performance by legiti-
mate means or, if push comes to shove, by illegitimate ones.
According to the point on the pay line, they will do this either by
pushing expenses into the future or by shifting prots from present
to the future.
Some companies even went further. The Swiss bank UBS imple-
mented in 2008 the bonus-malus plan to remunerate its top execu-
tives (UBS, 2013). The main characteristic of the plan is that the
bonus pay out is spread over several periods and that in the case
underperformance a delayed pay out can be reduced or even set
to zero. Underperformance is mostly based on the prot and loss
results of the bank.
STOCK OPTIONS
Stock options are contracts which give the management the right
to buy a share of stock at a pre-specied exercise price for a per-
specied term. Stock options are a form of deferred compensation,
that is, an arrangement in which a portion of an employees income
is paid out at a date after which that income is actually earned.
These options normally become vested, that is exercisable,
over time: for example, 20% might become vested in each of the ve
years following grant. These options are non-tradable, and the exer-
cise price is often indexed to the industry or markets. The mechani-
cal explanation for the explosion in stock options, although
unsatisfactory to economists, is rooted in institutional details on
granting practices and exacerbated by the bull markets at the end of
the 1990s and the beginning of the 21st century. Therefore stock
options which are not indexed to the relevant industry are in the line
of re, as managers can free ride on the positive temper on stock
markets and prot from an environment where their own perfor-
mance does not matter, or the managers will try to increase the
stock price in short term to cash in instead of implementing a long-
term strategy. Agents can game the competition system when they
have multiple instruments at their control. This incentive problem
has become known as multitasking (Baker, 1992; Holmstrom &
Milgrom, 1990), where compensation on any subset of tasks will
result in a reallocation of activities towards those that are directly
compensated and away from the uncompensated activities. Using
ratios like sales margin or return on assets as performance measure
is dangerous, as it motivates gaming. That is because managers can
increase the measure in two ways: by either increasing the numera-
tor or decreasing the denominator.
As we can see, both schemes are not incentive-compatible and
therefore lead to manipulations. The only way to solve the problem
is according to Jensen (2001) to remove all the kinks from the pay-
for-performance line shown above. His solutions are linear incen-
tives and he convicts nonlinearly, especially convex incentives as
those will increase the variability.
But it is not easy to make a switch to adopt a linear compensa-
tion system. Target-based bonuses are deeply ingrained in minds of
managers. For incentive compensation to work, corporate boards
must choose both the right measures and the right levels of perfor-
mance. In principle, stock options employ the right measure of per-
formance for corporate executives, but they do not set the right
level. Shareholders expect boards to reward management for achiev-
ing superior returns that is for returns equal or better than those
earned by the companys peer group or by broader market indexes.
Stock options are often not indexed and therefore do not provide
this possibility.
In the early 1990s it was the consensus view in the literature

that the sensitivity of pay to performance in the United States was
too low (Jensen & Murphy, 1990). According to these studies,
executives did not receive enough cash after good corporate perfor-
mance and did not incur sufcient losses, through dismissal, after
poor performance. The same result was observed in other countries
like Japan (Kaplan, 1994). The change in executive wealth normal-
ised by the change in rm value appears small and falls by a factor
with rm size, but the value of the CEOs equity stake is large and
increases with rm size. But the probability of dismissal remained
unchanged between 1970 and 1995 (Murphy, 1999). The use of
equity-based compensation and pay-performance sensitivity has
risen in other countries as well, and in the United Kingdom the per-
centage of companies with an option plan has risen from 10% in
1979 to over 90% in 1985 (Main, 1999).
It is hard to see just how changing executive compensation
requirements to be more closely linked to actual performance
through say on pay votes (Bebchuk et al., 2011) will have any
effect on the vicious cycle created by short-termism (Lipton,
Lorsch, & Mirvis, 2009).
It is also hard to see why boards, shareholders and legal the-
orists alike have largely ignored the rather large body of social
psychology research that suggests that monetary rewards for per-
forming a task (e.g. achieving the highest quarterly prot for a
rm) actually decreases the effort put into a job that requires the
accomplishment of multiple tasks by a performer for example a
CEO (Deci, Koestner, & Ryan, 1999). If we accept the agency the-
ory of the rm, that is that management is simply the agent to its
principals (Jensen & Meckling, 1976), that is shareholders, then
we would also, by extension, apply the research that relates to
compensation of other employees in agency relationships. Social
science research has also produced fairly convincing evidence that
rewarding non-manual workers with explicit rewards for explicit
tasks decreases performance for any non-rewarded task (Baker,
1992; Holmstrom & Milgrom, 1990). Furthermore, incentive-
based contracts for agents specically reduce an agents motivation
to succeed in fullling their contract (Sliwka, 2003). It shouldnt
be surprising then that when management is paid largely in accor-
dance with the success or failure of a companys stock price, it
would do so to the detriment of other important needs such as
long-term shareholder wealth maximisation and the interests of
stakeholders.
This research thus suggests that management and law scholars
might be focusing on xing a system that is unable to actually cap-
ture what actually motivates senior management to act in the best
interests of shareholders or stakeholders. Employees who are intrin-

sically motivated to do their jobs well do not need extrinsic motiva-
tors to succeed in their jobs. They simply need sufcient pay. During
the 1950s and 1960s, senior management pay at public companies
was substantially less linked to performance than it is today, yet
rm growth was substantially stronger then than now (Frydman &
Saks, 2007). If we take all of the research in this context seriously,
we could easily come to a conclusion that is directly opposite
from existing proposals to re-focus senior management on better
priorities eliminate pay-for-performance entirely and simply
provide pay that is commensurate with the job.
Employee Motivation
Research on motivation within the psychology and social science
literature has been pursued since at least the 1940s (Fuller &
Jensen, 2002; Maslow, 1947). The prevailing view regarding moti-
vation is that incentives are often a great motivator. Motivators
themselves fall into two categories. Extrinsic motivation is that
which comes from outside an individual. Extrinsic motivation has
been found to sharpen focus on individuals and allow them to
accomplish manual tasks substantially faster than without incen-
tives targeting extrinsic motivation (Deci, Koestner, & Ryan,
1999). The most common incentive in the principal-agent relation-
ship is an external motivator, namely, salary. In fact, all or most
of the executive compensation and economics literature focus on
extrinsic motivators. Only recently have economists and agency
theorists had their attention drawn to the potential power of
intrinsic motivation, the second category of motivation. Intrinsic
motivation is most often based on social norms, like reciprocity
and fairness, that drive individuals to achieve some goal or task
internal to themselves, even if the perceived benets are to ones
community or society (Fehr et al., 2007).
A robust set of research in psychology and behavioural econom-
ics indicates that extrinsic motivation (i.e. pay-for-performance) is
counter-productive to success in a non-manual (i.e. thinking) task
(Deci, Koestner, & Ryan, 1999). A linked nding is that intrinsic
and extrinsic motivation crowd one another out and individuals
only have a certain pool of motivation that they can draw from
and too much of one type of motivation will force out the other. In
other words, too much extrinsic motivation, like pay, will reduce
the likelihood that individuals will be motivated intrinsically, for
instance by a desire to reciprocate goodwill.
Current Intrinsic Motivator: Takeover

Threats
Managers may behave opportunistically as we have seen above. In
addition, agents in agent-principal relationships, including corporate
executives, are often only motivated with extrinsic incentives, such
as salary and stock options. However, takeover, as one major intrin-
sic motivational tool to encourage executives to do their best work,
does not exist within current executive pay contracts.
In a zero transaction costs world even a slight deviation of a
companys market value from its potential maximum would lead
someone to purchase a controlling interest in it and remove the man-
agement, alter its policies and claim the wealth gain from bringing
the company to its maximum value (Mueller, 2003). This threat of a
takeover was the chief constraint on managerial pursuit of growth,
but sufciently loose to allow managers to deviate signicantly from
shareholders wealth-maximising policies (Marris, 1963). The term
market for corporate control was introduced later on to describe
this process, and it was argued that this market did provide suf-
cient discipline to constrain managers effectively.
When Marris discussed this process, one of the most radical
mechanisms for disciplining managers, hostile takeovers (Becht,
Bolton, & Roell, 2002), were sufciently rare. This mechanism is
highly disruptive and costly and therefore seldom used. On this
issue, the analysis by Scharfstein (1988) stands out. Building on
insights of Grossman and Hart (1986), one considers the ex-ante
nancial contracting problem between a nancier and a manager.
This contract species a state-contingent compensation scheme for
the manager to induce optimal effort provision. In addition the con-
tract allows for ex-post takeovers. The important observation made
by Scharfstein is that even if the rm can commit to an ex-ante opti-
mal contract, this contract is generally inefcient and will induce too
few hostile takeovers on average.
If hostile takeovers are a disciplining device for management,
they should predominantly affect poorly performing rms. But this
prediction is not borne out by the empirical literature. Successful US
takeover targets are smaller than other companies, but thats the
only difference from their peers (Comment & Schwert, 1995).
Furthermore, if hostile takeovers should correct managerial failure
and enhance the efciency, the value of the bidder and the target
under joint control should be larger than the value of the bidder and
the target separately. The empirical literature neither supports this
prediction (Andrade, Mitchell, & Stafford, 2001; Burkart, 1999).
Therefore, takeovers do not seem to be an efcient measure to

guarantee behaviour of the management in the sense of the
shareholders.
Well-Balanced Packages
Agency theory predicts that incentive pay and takeover threats are
substitutes (Kole, 1997). This nding matches the ndings of moti-
vation theory which suggest that intrinsic and extrinsic motivators
crowd one another out. Moreover, agency theory predicts that
incentive pay should be tied to performance relative to comparable
rms, not to absolute performance. Early studies found that changes
in the CEO cash compensation were negatively related to market
performance, but positively related to rm performance (Gibbson &
Murphy, 1990). Equity-based compensation, in contrast, is not cor-
rected most of the time for market stock index movements, conse-
quently leading to a solid rejection of the relative performance
evaluation hypothesis in all recent surveys due to accounting pro-
blems, tax considerations, difculties in obtaining performance date
from competitors (Abowd & Kaplan, 1999; Bebchuk, Fried, &
Walker, 2001; Murphy, 1999).
Agency theory can be used to determine the optimal exercise
price of granted options. The options with an exercise price equal to
the companys stock price, which are very common in practice, are a
clear contradiction of the predictions of this theory (Bebchuk et al.,
2001). Theory also predicts that incentive schemes and the adoption
of the latter should result in an increase in shareholder wealth. The
latest empirical literature generally rejects this prediction, whereas
earlier event studies generally support it (Habib & Ljungqvist, 2001).
Furthermore, rms subject to blockholder monitoring are less
likely to implement stock option plans (Kole, 1997), because more
discipline substitutes for more sensitivity of pay. Managements pro-
tected by anti-takeover laws or anti-takeover amendments provide
more incentive pay to compensate for less discipline from hostile
takeovers, while in the United Kingdom takeover threats are higher
while incentive pay and the level of pay are lower than in the United
States (Conyon & Murphy, 2000). However, this theory is not con-
sistent with what we observe. Companies in industries with more
disciplining takeovers should therefore pay less, while in fact they
pay more.
In addition to these explicit incentives, implicit incentives take
the form of executive dismissal or post-retirement board services. In
the United States, this latter point seems to be true, as 75% of the
CEOs are holding at least one directorship after retirement. This is a
point which is opposed by many corporate governance codes.
Conclusion
It has become difcult to maintain the widely held view of the 1990s
that US pay practices provide explicit and implicit incentives for
aligning the interests of managers with those of the shareholders.
On the contrary, it seems that the managers have got the possibility
and the power to set their own wage at the expense of shareholders
(Bebchuk et al., 2001). Long-standing debates all over the world
show that the opinions are controversial.
We therefore suggest a new approach with the help of penalties
for the management. Instead of designing a standard contract with
a base salary and a bonus if a certain given project is successfully
enforced, the shareholder can think about a contract with a higher
bonus for a successful project and a penalty for failure. Such a sys-
tem could go even further than the bonus-malus system of executive
compensation introduced by UBS.
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CHAPTER
Executive
3 Compensation in the
21st Century: Future
Directions
Udo C. Braendle and
Amir Hossein Rahdari
The 21st Century

It has become difcult to maintain the widely held view of the 1990s
that US pay practices provide explicit and implicit incentives for
aligning the interests of managers with those of the shareholders.
On contrary, it seems that the managers have got the possibility and
the power to set their own wage at the expense of shareholders
(Bebchuk et al., 2001). Long-standing debates all over the world
show that the opinions are controversial.
Recently, Malcolm McIntosh (McIntosh, 2015), in his book
Thinking the 21st Century: Ideas for a New Political Economy,
supported capitalism but castigated the current institutions, struc-
tures, and interpretations of neoliberal capitalism. He proposed ve
system changes necessary for the emergence of a new political econ-
omy in the 21st century. One of the fundamental changes is about
the transformation and reorganization of the current model of capit-
alism and its constituting institutions into more balanced and har-
monious ones that take into account connectivity, accountability,
transparency, networks, values, relationships, enablement, entrepre-
neurship, and rethinking the meaning of capital (economic, social,
environmental, cultural, etc.). This change is based on one funda-
mental question: how can we make enterprise a spur to ingenuity
serving all humanity and not simply a conduit for individual
greed?. Visser (2011) suggested a transformative approach to
35
corporate social responsibility (CSR) that goes beyond CSR as a

managerial strategy (strategic CSR).1
Such transformative ideas are questioning the rationale for the
theories of the rm, the place of business within society, and the rai-
son dtre behind the existence of these institutions (Piketty, 2014).
Moreover, they call for a new approach toward all managerial stra-
tegies including executive remuneration and compensation plans. At
the middle of 19th century, there were around ten laws related to
executive compensation and now there are more than a hundred
(Ellig, 2007). The ever-increasing complexity of business environ-
ment in the 21st century suggests more changes to the executive
compensation schemes to raise to the occasion.
Compensation and Motivation

As a general view, remuneration by xed salaries does not
in any class of functionaries produce the maximum amount
of zeal.
John Stuart Mill (1871)
As identied by John Stuart Mill (1873) that xed salaries are not
enough for incentivizing managers in the 19th and the 20th centu-
ries, we must reach a similar turning point in the 21st century. The
recruitment, training, and retaining process of employees need to be
aligned with the social culture and objectives of the organization.
The training processes need to motivate the employees to be socially
responsible and to enable them to put forward their innovative ideas
that have positive economic and social implications. The incentive
system should be revolutionized as the mere economic carrot and
stick and reinforcement of punishment are not effective anymore as
a series of experiments in the science of motivation, such as the can-
dle problem presented posthumously by Karl Duncker, showed that
these kinds of incentives only work for simple tasks that do not need
sophisticated cognitive skills; however, for tasks with higher cogni-
tive abilities, most of the tasks of the 21st century, that require inno-
vation, creativity, and out-of-box thinking, not only nancial
incentives do not improve performance but they have also led to
poorer performance in some cases (Ariely, Gneezy, Loewenstein, &
Mazar, 2005; Pink, 2006).
Google and a throng of other companies have utilized more
intrinsic motivators, and the higher performance of their employees
1
Epitomes of transformative CSR can be found in companies like Unilever,
Patagonia, and Interface.
Executive Compensation in the 21st Century: Future Directions 37
showed that extrinsic motivators are not any more the sole player of
the incentive game. For example, Atlassian, an Australian software
company, has a program called FEDEX days in which the company
gives its employees free days so that they can work on whatever pro-
ject they want and the results were so startling that the company is
planning to expand FEDEX days to include 20% of the employees
working hours like Google. This is also true in case of managers and
senior executives. These new models of incentivizing are taking over
in the 21st century and are expedient in providing an environment
where intrapreneurship and entrepreneurship can burgeon.
Compensation Plans: Pay-Performance

Link
Management compensation plans are policies and procedures for
compensating managers that includes one or more of the following:
salary, bonus, and benets or perks.
There are numerous compensation plans that are used to link
pay and performance. The Bonus-Malus2 system, which is preva-
lent in insurance industry, penalizes managers for poor performance
and rewards them for strong and positive performance (implemen-
ted by UBS). This system allows for bonuses to be held in escrow or
not be immediately vested and to be clawed back or reduced retroac-
tively in case of losses in the future. Phantom stock, for instance, is a
type of stock-based compensation plan and a contractual agreement
that promised to pay the grantee, at a designated time, an amount of
cash tied to the market value of an equivalent number of shares of
the corporation. This will motivate managers to put the company on
a path to better performance so when the time for their compensa-
tion come, they will be compensated at the market value.
These types of compensations attempt to resolve the hot-hand
fallacy like performance evaluations schemes in compensation plan
design, that is, better compensation for managers who were fortui-
tously successful in the past. These managers usually take tail risks
or peso risks,3 as termed by Raghuram G. Rajan, in the expense of
investors (Rajan, 2005). Compensation tied to performance also
provides incentive to manipulate earnings.
Another example can be Big BathCap earnings manipulation.
Bogey is a low-performance stage for a rm and therefore the
performance-based compensation would be also low. At this stage,
2
In Latin: Good and Bad.
3
The risk or probability of Black Swan events occurrence.
Cap
Maximize Minimize earnings
earnings
Bogey
Big Bath
Figure 1: Big Bath and Cap [The Horizontal Axis Represents Performance Measure (e.g.,
Return on Investment) and Vertical Axis Represents Compensation (e.g., Bonus)].
some managers make poor results look even worse by manipulating

companys income. This is called Big Bath. The big bath is often
implemented in a low-performing year to enhance next years earn-
ings articially (Healy, 1985). A more formal denition of big bath
accounting generally refers to accounting choices made by manage-
ment to reduce current reported earnings in order to increase future
earnings (Sthl & Appelkvist, 2014).
The imminent big rise in the subsequent years earnings may
lead to a larger compensation for executives, especially consider-
ing the low performance of the previous year. If the level of earn-
ings and performance pass a particular threshold, usually
specied in the compensation plan, then executives will try to
increase the earnings in that particular year that will lead to a
higher compensation for them. If the level of earnings and perfor-
mance reach a particular threshold on top also known as the
Cap, usually specied in the compensation plan, then executives
will try to minimize the earnings for the current year to save up
for the next year. Figure 1 depicts Big Bath and Cap earnings
manipulation strategies.
Redefining Performance Evaluation

in the Age of Sustainability
There are many instances of pay without performance. Golden
hellos, golden parachutes, gratuitous bonuses, and most of the non-
equity based compensations are epitomes of pay without perfor-
mance (Bebchuk & Fried, 2004). Even when the pay has a link with
performance, there are still some challenges that need to be
addressed. The whole body of executive compensation literature is
predicated upon nancial performance of the rm. However, com-
panies have social and environmental impact beside their economic
performance which is not accounted for in the executive compensa-

tion schemes.
A rapidly growing body of literature on sustainable develop-
ment has been developed since the 1970s and revolves around the
fact that the current trends in economic development, population
growth, resource consumption, biodiversity, social injustice, and
pollution are unsustainable and in appropriate circumstances, they
can lead to social asco and catastrophic planetary system failure
(Rockstrm, Steffen, Noone, Persson, & Chapin, 2009; Steffen
et al., 2015). The nancial scandals, such as the collapses of Enron,
WorldCom, Global Crossing, and Qwest, that resulted from corpo-
rate governance failures (Neubaum & Zahra, 2006) have also
informed the stakeholders of business social responsibility and the
demands for a stronger corporate governance system and as a result
a more comprehensive performance evaluation.
This has led to a widespread frustration that current nancial
measures (including accounting such as Return on Investments,
Return on Equity, Return on Capital Employed, and Return on
Sales and market measures such as Market Value Added and Total
Shareholder Return (Yalcin, Bayrakdaroglu, & Kahraman, 2012),
non-nancial measures (customer satisfaction) (Zeithaml, 1988,
1987), and Balanced Scorecard measures (Kaplan & Norton,
2001, 1996)) cannot offer a viable and comprehensive measure-
ment solution to the unsustainability problem (Gray, 2010). The
signicant role of management accounting information in develop-
ing and improving CSR is well established (Contrafatto & Burns,
2013). However, the literature emphasizes on the inadequacy of
accounting measures, as the ubiquitous means of performance eva-
luation, in the age of sustainable development and highlights the
signicance of looking at Environmental, Social, and Governance
performance alongside nancial performance in an organizational
context often referred to as CSR. Nonetheless, it is worth noting
that recently some measures have been taken to revitalize account-
ing and sustainability relationship (Bebbington & Larrinaga,
2014).
One important strand of literature is that of corporate social per-
formance. Since its introduction, the literature has been focused on
nding a link between corporate nancial performance and corpo-
rate social performance (Wood, 2010). By establishing this relation-
ship, beside stakeholders, shareholders will also be interested in
pursuing CSR as it will nancially pay off. Despite numerous studies
conducted to nd such a relationship, the results are still mixed. One
possible explanation is the dynamic and complex environment of a
rm that cannot be explained with the current simple models.
Another explanation can be embedded in the idea that managers
pursue social responsibility with different motivations and for differ-

ent reasons. Preston and OBannon (1997) proposed six hypotheses
that explained the relationship between CSR and corporate
nancial performance based on causal sequence and relationship
direction: Social Impact Hypothesis, Trade-off Hypothesis, Available
Funds Hypothesis, Managerial Opportunism Hypothesis, Positive
Synergy Hypothesis, and Negative Synergy Hypothesis. These
hypotheses expatiate on the rationale behind pursuing CSR.
Notwithstanding the rapid development in the scholarly eld of
CSR, there is no denition of CSR that is widely accepted (Rexhepi,
Kurtishi, & Bexheti, 2013). Dahlsrud (2008) identied ve
common dimensions in CSR denitions: the environmental dimen-
sion, the social dimension, the economic dimension, the stakeholder
dimension, and the voluntariness dimension. Moreover, CSR has
many important accompanying concepts that have helped its devel-
opment. Corporate Sustainability and Responsibility (Visser, 2010),
stakeholder theory (Freeman, 1984; Freeman, Harrison, Wicks,
Parmar, & Colle, 2010), Communicating Sequential Processes
(Wood, 1991), Corporations and citizenship (Crane, Matten, &
Moon, 2008), Shared Value (Porter & Kramer, 2011), Triple
Bottom Line (Elkington, 1994), and conscious capitalism (Mackey,
Sisodia, & George, 2013) are only some of the concepts. This has
rendered widespread confusions among professionals and aca-
demics alike.
In the past decades, especially since the 1990s, a growing num-
ber of companies around the world started reporting on the non-
nancial aspects of their business to discharge their accountability
efforts with varying levels of disclosure in contents across indus-
tries and countries (Skouloudis, Evangelinos, & Kourmousis,
2010). To do so, the majority of these companies have adopted
non-nancial reporting frameworks like Global Reporting
Initiatives sustainability reporting frameworks and International
Integrated Reporting Councils integrated reporting framework.
With the emergence of sustainability as a new paradigm in the
business world, the attempts to develop a set of indicators for com-
prehensive performance evaluation system are increasing. Puma
innovative accounting system for sustainability is an archetype of
mainstreaming non-nancial measures in accounting systems.
Puma introduced its Environmental Prot & Loss account to nan-
cially measure for its environmental impacts in terms of land use,
air pollution, waste, and Green House Gas Emissions emissions.
The results showed a staggering $125 million in environmental
impact. This trend has highlighted the need for the recognition of
other types of capitals besides nancial capital: human capital,
environmental capital, and so on and so forth (Hawken, Lovins, &
Lovins, 2008).
Conclusion
As the corporate social and environmental responsibilities are
increasingly coming to attention, the demand for the development of
new compensation schemes that evaluate executives performance
based on nancial, environmental, governance, and social perfor-
mance is rising swiftly.
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Section II
Cross-Industrial Remuneration
Practices Analysis
CHAPTER
Financial Companies
4 Regina W. Schroder
Introduction
Ever since corporate governance crossed the Atlantic Ocean, it
has been broadly and multifacetedly discussed. Amongst other
governance-related subjects its implementation in various elds has
been an issue. As a remedy, different forms of corporate governance
(such as industrial and the social governance) were developed.
Financial governance, which is not part of industrial, or social
governance, became a topic of discussion later. However, since the
recent nancial crisis, the literature has paid particular attention to
it, as the number of publications dealing with nancial governance
shows (Hopt, 2011, 2013; Kirton, 2005; OECD, 2009; Underhill &
Zhang, 2008). In their analysis of nancial rms that experienced
the nancial crisis in 2007 and 2008, Erkens, Hung, and Matos
(2012) found, for example, that companies with more independent
boards and higher institutional ownership suffered worse stock
returns.
The interplay between nancial governance and remuneration
has so far received little attention. This chapter contributes to clos-
ing this gap, at least in part. In particular, the chapter focuses on the
question of how to evaluate remuneration over time, and how to
discount payments received in different time periods.
The chapter is structured into ve sections. Following this intro-
duction, the second section rst highlights the elements of corporate
governance in nancial institutions, focusing on stakeholders inter-
ests. The following section then elaborates on European initiatives
for enhanced governance and remuneration and is split into two
47
48 REGINA W. SCHRODER
subsections, dealing with (a) corporate governance and (b) remu-

neration. The fourth section is concerned with the chapters leading
question and is structured into two subsections, of which the second
is itself divided into four sections. The chapter nally ends with a
conclusion and the highlighting of further research opportunities.
The Crisis and Its Effects on

Remuneration Governance in Financial
Institutions
Corporate governance practices started to receive increased interest
due to corporate scandals such as that involving Enron. The nan-
cial crisis strengthened this interest. This is true for companies but
also for nancial institutions, with responsibilities for the implemen-
tation or oversight of corporate governance practices in companies.
In the rst subsection, the elements of corporate governance will be
explained, before the following subsections focus on remuneration
governance before and after the crisis.
ELEMENTS OF THE CORPORATE GOVERNANCE OF FINANCIAL

INSTITUTIONS
As Gillans (2006) search of Social Science Research Network
abstracts containing the term corporate governance reveals,
research in corporate governance dramatically increased in the 10
years up to 2006. Corporate governance is, however, an ambivalent
concept, as can be seen by the diversity of existing denitions for it.
Turnbull (1997), for example, understands corporate governance as
all the inuences affecting the institutional processes.
Moreover, Gillan proposes distinguishing between internal and
external corporate governance. While the former encompasses the
board of directors, the management and a balance sheet model, con-
sisting on the one hand of the assets, and on the other hand of the
debts and the equity, with all three elements subsequently aligned,
the external view relates to creditors and the shareholders, that is,
integrates more stakeholders, who inuence the two stakeholder
groups and the balance sheet model mentioned. This chapter con-
cerns itself with internal corporate governance.
In addition, the focus here is not on corporate governance in
general, but on governance in nancial institutions, which to Hopts
(2011, 2013) mind differs considerably from general corporate gov-
ernance. The differences are twofold: the stakeholders, considered
together with their interests; and the policies, methods, and other
Financial Companies 49
instruments integrated into governance practice. The following sec-

tion primarily explores the interests of the stakeholders involved in
the corporate governance of nancial institutions.
As illustrated in Figure 1, there are nine stakeholder groups: cor-
porate employees; board members; community; creditors; share-
holders; customers; suppliers; governments; and managers. Each of
these stakeholder groups strives for its own interests and focuses on
different topics. The board, for example, is amongst those interested
in institutional corporate governance.
Hopt (2012, 2013) nds that a banks scope of corporate gov-
ernance goes beyond equity governance, that is, shareholders, and
includes debt governance, that is, debt holders. Hopt formulates the-
ses on (a) the corporate governance of rms and its relevance for
banks, (b) the corporate governance of banks, and (c) the banks
internal corporate governance, for which Hopt makes proposals for
corporate and supervisory reform. Surely, these theses can be read
as challenges, the biggest challenge however how a nancial insti-
tution should design the remuneration of its employees, managers,
and the board remains disregarded.
Firm
Share-
holders
Dividends
Capital growth
Safe investment
Figure 1: Stakeholders Interests. Source: Doyle (1994).

Two corporate governance forms which are of importance in

particular for nancial institutions have been mentioned before, that
is, the equity and the debt governance. Due to the subject of this
book and this chapter, the following focuses on another governance
form, the remuneration governance.
PRE- AND POST-CRISIS REMUNERATION GOVERNANCE

A key element of corporate governance is how remuneration is dealt
with, which has been discussed in numerous publications in the last
(Ungureanu, 2013; Lloyds, 2013).
Barontini et al. analyzed directors remuneration before and after
the crisis and concluded that the remuneration received by board
members of nancial institutions reduced markedly after the crisis. In
non-nancial corporations, however, the reverse was true.
Moreover, for the pre-crisis period the authors observed little or only
minor variations regarding the remuneration disclosures between
nancial and non-nancial rms. Yet after the crisis the disclosure in
nancial rms increased, and, thus, exceeded the remuneration
reporting and management of such issues in non-nancial rms.
While the remuneration structure has changed in terms of its
weighting of xed and variable payment elements and in the
amounts of these, no attention has been paid to the present value of
the remuneration or on the discounting method to be applied.
European Initiatives for Enhanced

Governance and Remuneration
Though the crisis cannot be said to have been caused by deciencies
in corporate governance practices or by mistakes in the design of
remuneration systems, the European Union considers some improve-
ments in corporate governance to be essential. These initiatives,
together with discussion on the design of remuneration systems, will
be presented in the following.
CORPORATE GOVERNANCE
This section focuses on the changes made in corporate governance
between 2010 and 2013 as illustrated in Figure 2.
In June 2010, the European Commission published a Green
Paper on corporate governance in nancial institutions and remu-
neration policies. This paper examined multiple aspects of corporate
governance and sought out stakeholders opinions on several issues,
for example, on the functioning of boards of directors,
2010 2011 2012 2013 2014
t
June: April: December: Over the year: -not yet
Green Paper Release of a Release of an Several known-
on Corporate new action plan for additions to
governance in consultation enhancement and changes
financial paper on and in the codes
institutions Corporate modernization database (e.g.,
and Governance of the EU France
remuneration Framework Corporate released in
policies Governance June a revised
framework version of the
September: corporate
Submission of governance
comments on code of listed
the papter by corporations)
Lloyds
November:
Release of
responses and
a feedback
statement
Figure 2: Changes in Corporate Governance within Financial Institutions from 2010

till 2013.
remuneration, and co-operation with supervisory institutions and

auditors. In response to the comments made by individuals, public
authorities, and registered organizations, the commission released a
feedback statement in November, 2010.
Just one year after the release of the Green Paper, in April 2011,
another consultation paper on the corporate governance framework
was published. In addition, in May a conference on European
Company Law: the way forward took place, focusing on the mod-
ernization of company law.
In December 2012, an action plan for an EU Corporate
Governance framework was released. Since then, several changes in
the corporate governance codes of European countries have been
made, and the European discussion on corporate governance is still
in progress.
Remuneration
After the nancial crisis, not only has overall corporate governance
attracted debate, but also remuneration practices, which the green
paper on corporate governance also dealt with.
Due to the experiences in the crisis, the European Commission

adopted a recommendation on the remuneration in the nancial ser-
vice sector in the second quarter of 2009. This recommendation
urged nancial institutions to establish remuneration policies for all
responsible employees involved in risk management, and declared
guidelines for the design and implementation of remuneration poli-
cies and for the review of remuneration policies of nancial institu-
tions by supervisory authorities. Though a subsequent report on the
application of the recommendation revealed that some progress had
already been made, much more needed to be done.
One year later, in June 2010, the European Parliament released
a report on the remuneration of directors of listed companies and on
remuneration policies, in which it demanded binding principles for
remuneration policies in the nancial sector.
In the following year, amendments to the Capital Requirements
Directive III took effect, with which the European Commission
implemented rules on the relationship between executive pay and
corporate risk management. These should ensure that the interests
of all the nancial institutions stakeholders are aligned.
While advances regarding the regulation of remuneration and
its relationship to risk management have been made, questions
regarding the design of incentive schemes remain. For instance, the
question of how variable bonuses one important element of the
boards and top managers remuneration should be structured
over time remains unanswered.
STRUCTURING VARIABLE BONUSES OVER TIME

As the remuneration report of Deloitte (2013) illustrates, employees,
chief ofcers, and directors, who are not explicitly named, receive
annual and long-term variable payments. Little or nothing is said
about the net value of such incentives, though this information is
essential to evaluate the present value of the entire remuneration.
Thus, I now deal with the different discounting forms, before next
focusing on the effects of the chosen discounting method on remu-
neration and on corporate governance more generally.
DISCOUNTING
To evaluate the sum of (potential) payments their net present value
(NPV) is calculated. This value represents the sum of all payments
(here the remuneration) at a specic point in time. Normally, the
value is either calculated for the initial point in time, that is, when
the present period started, or for the periods end. The use of the
NPV is subject to several conditions. For instance, the capital market
needs to be perfect, and the discounting rate has to be consistent.
To decide on the total remuneration offered, any payment is

multiplied by the reciprocal of the discounting factor. This factor
can assume different forms. Three of these forms are characterized
and considered below.
ALTERNATIVE DISCOUNTING FUNCTIONS

As explained before, various discounting functions exist: the expo-
nential, the hyperbolic, and the quasi-hyperbolic discounting meth-
ods. After their short presentation, they are compared and evaluated
regarding their contribution to good corporate governance.
EXPONENTIAL DISCOUNTING
The exponential discounting method is based on Samuelsons model
of discounted benet and is the most commonly referred to in the lit-
erature. The models idea is that the total value of all future cash
ows is equivalent to the sum of all discounted revenues (R) and
payments (P), if an over-the-time constant discounting rate dr (with
dr = 1 + i) is assumed. The following equation for the NPV illus-
trates this discounting form.
X
T
NPV = Rt Pt dr t 1
t=0
This formula attributes a smaller value to differences between reven-

ues and payments that was incurred later than cash differences that
are realized closer to the date, for which the NPV is calculated. Cash
differences which are realized at time t** (with t* < t**) conse-
quently contribute less to the NPV than an earlier-occurring rev-
enue-payment difference, because it is discounted over a longer time.
Although many methods and applications resort to exponential
discounting, which is indicative of this models acceptance, the
method possesses many deciencies:
For example, the discounting rates are diminished over time, as

the mathematical formulation shows (drt).
Moreover, losses are discounted with a smaller rate than prots
(sign effect).
Often greater amounts are discounted with smaller discount
rates than higher differences between revenues and payments.
If values are discounted single-handedly, that is, just one dif-
ference is taken into account, the discount rates applied vary less
than in the case of an analysis of the entire difference
progression.
As an answer to the rst deciency hyperbolic discounting was

developed and proposed.
HYPERBOLIC DISCOUNTING
According to Frederick, Loewenstein and ODonoghue (2002) the
best documented deciency of the exponential discounting is its
assumption of an over-the-time unchanged discount rate. As an
answer thereto the hyperbolic discounting assumes an over-the-time
decreasing discount rate which is more in accord with multiple
empirical analyses:
There is [...] strong empirical evidence that people discount
the future hyperbolically, applying larger annual discount
rates to near-term returns than to returns in the distant
future. (Cropper and Laibson, 1998, p.1)
For shorter time periods, consequently, a smaller discount rate

is applied than for longer periods.
Rasmusen (2008) also calls hyperbolic discounting, non-expo-
nential discounting, to focus on the differences between this and the
formerly illustrated discounting. Hyperbolic discounting, however,
does not assume a hyperbolic function (like the sinus hyperbolicus).
Rather, it applies to a discounting function (dfh) as illustrated
in Eq. (2).

df h = 2
1 t
This formula encompasses three variables, namely two coefcients

( and ) and the time factor t. It is valid for any points in time
except for the starting point in time (t = 0).
QUASI-HYPERBOLIC DISCOUNTING
Often the hyperbolic discounting function is not applied, but just
approximated. In many cases then a quasi-hyperbolic discounting
function (dfqh) is used, because it reproduces some of the qualitative
characteristics of a hyperbolic discounting function and regarding its
structure is similar to an exponential discounting function, at least,
as long as the coefcient is equal to or even larger than zero and at
the same time not larger than one. The discounting function then
has the following form:
df qh = t 3
Exponential Discounting Quasi-hyperbolic Discounting Hyperbolic Discounting
1.0
0.9
Value of the discounting function
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0.0
0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50
Time
Figure 3: Comparative Illustration of the three Discounting Functions

Considered.
For the rst time span (t = 0) no discounting is necessary, because

the value of the discounting function is assumed to be equal to one.
EVALUATION
Due to the three discounting functions presented above, the question
arises how these functions are related. Surely it is possible to nd an
example, that is, assume values for all variables and coefcients
used, and then make the necessary calculations. But a comparison of
calculated values is difcult, as the time frame assumed in all func-
tions supposedly varies. Figure 3, however, illustrates the three func-
tions assuming a comparable time frame for all three discounting
functions.
As this gure shows, none of the discounting functions consid-
ered always lead to the highest present value of all revenues and
payments considered. Thus, it is essential to declare which function
is used in order to correctly anticipate the consequences of any
reward offered and remuneration paid. This information should be
integrated in the governance concept and report. It then constitutes
an element of the governance concept that might be integrated in
Figure 1 in the form of a surrounding frame.
Conclusion and Prospects

As the former elaborations revealed, the nancial crisis has affected
corporate governance not only in non-nancial rms, but even more
importantly in the nancial sector. However, so far no attention has

been paid to the present value of remunerations and by which dis-
counting method this value should be calculated.
To contribute to a closure of this gap, this chapter reviewed
three discounting practices, that is, exponential, hyperbolic, and
quasi-hyperbolic discounting. As none of these approaches always
leads to an exemplary high value, it has to be chosen by the rm
and the remunerations receiver and/or disclosed in corporate
reports. Then, all stakeholders are able to anticipate the amount of
the incentives and rewards paid, and the nancial institutions with a
relationship to the company are better able to evaluate any encoun-
tered risk.
Accordingly, the discounting method used and its disclosure are
important elements of corporate governance. As such, the presented
discounting approaches should also be critically considered regard-
ing all other governance methods, for example, risk governance and
total risk.
References
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nies. Cambridge: Cambridge University Press. Retrieved from http://papers.ssrn.com/
sol3/papers.cfm?abstract_id=2250677
Cropper, M., & Laibson, D. (1998). The implications of hyperbolic discounting for
project evaluation. Retrieved from http://elibrary.worldbank.org/doi/book/10.1596/
1813-9450-1943
Deloitte. (2013). Directors remuneration report: Overview of new Disclosure
Requirements. Retrieved from http://www.deloitte.com/assets/Dcom-United
Kingdom/Local%20Assets/Documents/Services/Tax/uk-tax-overview-new-disclosure-
requirements.pdf
Doyle, P. (1994). Setting business objectives and measuring performance. European
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Erkens, D. H., Hung, M., & Matos, P. (2012). Corporate governance in the
20072008 crisis: Evidence from nancial institutions worldwide. Journal of
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Frederick, S., Loewenstein, G., & ODonoghue, T. (2002). Time discounting and time
preference: A critical review. Journal of Economic Literature, 40(2), 351401.
Gillan, S. L. (2006). Recent developments in corporate governance. An overview.
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International Affairs, 84(3), 535554.
CHAPTER
Industrial Companies
5 Yusuf Mohammed Nulla
Introduction
This chapter will explore the industrys effects on Directors remu-
neration, particularly focusing on the effect of energy, metal, mining,
and health industries on CEO compensation in Canada and United
States. In the beginning of this chapter, the background and the role
of principal-agent problems in CEO compensation will be discussed.
The core of the chapter presentation will be based on discussing the
impact of primary benchmarks, variables used in CEO contract,
rm size, rm performance, and CEO power (corporate governance)
on CEO compensation. It will be a comparative study which
includes Canadian and United States public companies traded on
the Toronto Stock Exchange (TSX/S&P) and New York Stock
Exchange (NYSE) indexes. The later parts of the chapter will discuss
the impact of policy, design, factors, boards role in directors remu-
neration, and accounting regulation on directors remuneration.
This chapter will then conclude with a summary.
Background
The CEO compensation system has been greatly misunderstood by
the public for some time but it has emerged as a concern during the
period of the global credit crunch from 2007 to 2009. The general,
social, ethical belief is that CEOs should be rewarded based on
accounting performance and should be penalized if companies per-
form below market expectations. This belief resulted in numerous
single studies conducted in the United States and United Kingdom,
59
60 YUSUF MOHAMMED NULLA
yet these studies have failed to arrive at robust conclusions on the

relationship between CEO pay and performance. As such, great
scholars in the eld of executive compensation, such as Gomez-
Mejia, Eugene F. Fama, Michael Jensen, and Kevin Murphy, have
expressed concerns: why are robust conclusions not achieved; why
these studies have arrived at divergent or inconsistent results; and
why it has failed to establish dening factors that inuenced CEO
compensation system. Tosi, Werner, Katz, and Gomez-Mejia
(2000) have blamed these concerns to different methods of collec-
tion, different statistical techniques, different samples, different
moderator variables, and differences in how constructs of interest
have been used in various studies. As such, these reasons have
hampered to reach denite and consistent conclusions among pre-
vious studies. In addition, CEO compensation has rarely been stu-
died as a separate study despite it is believed to be a strong proxy
toward determining CEOs total compensation. That is, CEO com-
pensation which includes salary and bonus is sufcient to represent
CEO total compensation which comprised of salary, bonus, stock
options, pensions, and other long-term benets. Agarwal (1999),
Finkelstein and Boyd (1998), and Finkelstein and Hambrick (1989,
1996) concluded that simple measures of cash compensation are an
excellent proxy for CEO total pay. Similarly, Mehran (1995)
reported that CEOs took 67 percent of total pay in the form of sal-
ary and bonus and 22 percent in the form of equity-based
incentives.
The literature indicated that most of the previous studies have
either focused on the particular industry, or sample sizes that have
ranged from fty to eight hundred,or use of different proxy for the
rm size, rm performance, and CEO power. Therefore,the results
are incomparable or inconsistent. In addition, from a timing per-
spective, previous studies have ranged from one to ten year period,
therefore, has affected the quality and consistency of the statistical
results.
Literature on CEO Compensation

Agency theory deals with the relationship between a principal
(shareholder) and an agent (companys CEO or managers). It tries
to resolve problems arising from conict of goals and desires
between them. It tries to resolve a problem of a principals inability
to verify an agents output. It tries to resolve a problem of risk
sharing which arises when a principal and an agent have different
attitudes toward risk. In addition, it points to the fact of minimiz-
ing the moral hazard problem between owners and managers by
Industrial Companies 61
way of control. However, since the monitoring is costly, the own-

ers then try to develop incentive contracts to align their interest
with those of employee managers. According to Jensen and
Meckling (1976), agency theory is directed at the ubiquitous
agency relationship, in which one party, the principal, delegates
work to another party, the agent, who performs that work. Thus,
it attempts to describe this relationship using the metaphor of a
contract.
The compensation plans are a form of contract designed to link
the goals of shareholders with those of the CEO or other key execu-
tives. According to agency theory, compensation plans should be
designed so that managers have sufcient incentives to make deci-
sions that maximize shareholder wealth and thus, reduce manager
shareholder agency problem. Watts and Zimmerman (1978) pointed
out that CEO compensation contract may be viewed as an impor-
tant means of resolving this conict; in particular, compensation
plans may be designed to maximize shareholder returns by tying pay
to performance. However, Dalton, Hitt, Certo, and Dalton (2007)
argued that there is a potential for managerial mischief when the
interests of the rms owners (principals) and managers (agents)
diverge. This is explained in the earlier study conducted by Jensen
and Meckling (1976), who believed that the conict between them
may arise because the shareholders primary goal is to receive maxi-
mum returns for their investments, while managers may have a
wider set of preferences. According to Eisenhardt (1989), CEO com-
pensation is inuenced by agency theory in the form of governance
structure whereby a weaker governance structure leads to relatively
greater CEO compensation. That is, it is believed that CEO will act
on his best interest by adopting a maximum power approach
through controlling board and taking advantage of operational
expertise than rely on the rms performance. Similarly, Pratt and
Zeckhauser (1985) argued that because agents control organiza-
tional resources and are likely to know more about the tasks that
they perform for the principal, information asymmetry that exists
could give advantage to agents. On the other hand, principal usually
wishes to counter this asymmetry and seeks to devise ways to pre-
vent agents from making decisions to divert resources away from
the principals interests. This is supported by Jensen and Ruback,
(1983), who believed that principals dene the rule of the game for
senior management team including a system for monitoring and
reward structure which includes the degree to which managerial
incentives are aligned with the interests of the owners. Jensen and
Meckling (1976), and Hart (1983) believed that agency problems
are controlled by the market for corporate control, managerial labor
market, and product market control.
Finkelstein and Boyd (1998) argued that the balance of power

between the board and CEO is a major determinant of CEO com-
pensation. This is explained by Core, Holthausen, and Larcker
(1999), who believed that weaker governance structures have
greater agency problems, CEOs at rms with greater agency pro-
blems receive greater compensation, and rms with greater agency
problems perform worse. This is supported by Bebchuk, Fried,
and Walker, (2002), who stated that executive compensation is
consistent with executives who control their own boards and maxi-
mize their own compensation subject to an outrage constraint.
Similarly, Weisbach (2007) stated that contracts that are nego-
tiated between CEO and board are not likely to be those that maxi-
mize shareholder prots subject to the usual constraints in
principal-agent problems; rather contracts are likely to reect opti-
mal rent grabbing by the CEO. Thus, focus of agency theory is on
determining the most efcient contract governing principal-agent
relationship.
Research Design
The qualitative study was conducted based on two hundred and
forty companies from TSX/S&P and NYSE indexes focusing on
energy, metal, mining, and health sectors. The duration of the
study was from 2005 to 2010. The longitudinal study approach,
random sample, and survey methods were selected. The linear
regression equation was adopted for statistical calculations. The
CEO compensation was assigned as the dependent variable. The
rm size, rm performance, and CEO power were assigned as inde-
pendent variables. The subvariables of CEO compensation where
CEO salary, bonus, and total compensation. The subvariables of
rm size were total sales and total number of employees. The sub-
variables of rm performance were return on assets, return on
equity, net prot margin, earnings per share, cash ow per share,
common stocks outstanding, book and market values of common
stocks. The subvariables of CEO power were CEO age, CEO
shares outstanding, CEO shares value, CEO tenure, CEO turnover,
5 percent management ownership, and 5 percent individual/institu-
tional ownership. The 5 percent condence interval was assumed
in this study.
Results
The results found that among energy, metal, mining, and health
industries there was a relationship between CEO compensation, rm
size, rm performance, and CEO power, indicating that all these

variables have inuenced the statistical models or toward model t-
ness. The TSX/S&P energy, metal, and mining index companies
results1 indicated that regression was ranged from weak to strong
ratios.2 The NYSE energy index companies results3 also have indi-
cated that regression was ranged from weak to strong ratios.
However, the NYSE index health companies results indicated that
regression was ranged from weak to good ratios. It was therefore
demonstrated that, in all these industries, model tness was inu-
enced by short- and long-term compensation structures, indicated
that CEO contracts clearly outlined its benchmarks on time-frame
basis. That is, in the TSX/S&P index companies, relative to NYSE
index companies, the short-term CEO compensation models found
to have high statistical model ratios. In contrary, in the NYSE index
companies, relative to TSX/S&P index companies, the long-term
CEO compensation models were found to have high statistical
ratios. These interesting differences were perhaps due to the inu-
ence of respective market cultures in Canada and the United States.
That is, CEO contracts in Canada are characterized as balanced
between short- and long-term compensation systems. On the other
hand, CEO contracts in the United States tended to promote retire-
ment reward system in terms of pension, insurance, stock, medical,
and other long-term benets in the CEO contracts.
In the TSX/S&P index energy, metal, and mining companies,
the correlations between CEO compensation and rm size were
characterized as good to strong positive ratios. In the NYSE index
energy companies, the correlations between CEO compensation and
rm size were characterized as moderate to good positive ratios. In
the NYSE index health companies, the correlations between CEO
compensation and rm size were characterized as weak to strong
positive ratios. Although, in all these industries, the ratios were posi-
tive between CEO compensation and rm size, yet the ranges were
different. For example, in TSX/S&P energy, metal, and mining com-
panies, CEO salary, bonus, long-term benets, and rm size have
good to strong positive ratios. However, in the NYSE index energy
and health companies, CEO salary and rm size have ranged from
good to strong positive ratios yet CEO bonus and rm size have
weak to moderate positive ratios. All these differences in correla-
tions demonstrated that industry and market culture4 have an effect
1
Nulla (2013e).
2
Weak ratio = 0.000.25; moderate ratio = 0.260.50; moderate ratio =
0.510.75; and strong ratio = 0.761.00.
3
Nulla (2013d).
4
Canada and United States.
on the design of CEO contract in terms of linking between CEO sal-

ary, bonus, long-term benets, and rm size.
In the TSX/S&P companies, the correlations between the CEO
compensation and rm performance were characterized as weak to
strong positive ratios. Similarly, in the NYSE index companies, the
correlations between CEO compensation and rm performance
were also characterized as weak to strong positive ratios. However,
in the NYSE index health companies, the correlations between CEO
compensation and rm performance were characterized as weak
negative to good positive ratios. It therefore demonstrated that the
ratio ranges were different. For example, in the NYSE and TSX/
S&P energy, metal, and mining companies, the CEO salary, bonus,
long-term benets, and rm performance were ranged from weak to
strong positive ratios. In the NYSE index health companies, the cor-
relations between CEO compensation and rm performance were
characterized as weak negative to good positive ratios.
In the TSX/S&P and NYSE companies, the correlations between
the CEO compensation and CEO power were characterized as weak
negative to moderate positive ratios. That is, in the NYSE and TSX/
S&P energy, metal, mining, and health companies, the correlations
between the CEO salary, bonus, long-term benets, CEO age, CEO
shares outstanding, CEO shares value, CEO tenure, CEO turnover,
ve percent management ownership, and ve percent individual/
institutional ownership were ranged from weak negative to
moderate positive ratios. Thisindicated the weak inuence of the
non-nancial factors,such as, corporate governance, CEO stock
ownership, market price, the impact of management and owner-
controlled criteria, and CEO tenure (duration of the service), to the
compensation models. Overall, CEO power had a weak inuence
on the CEO compensation, perhaps due to the strong inuence of
rm size and accounting performance to CEO compensation.
Directors Remuneration Policy

Salaries are determined with reference to market practice and mar-
ket data, and reect individual experience and role. The purpose is
to reward skills and experience and provide the basis for a competi-
tive remuneration package. Salaries are reviewed annually and
increases are made to reect market movements and change in job
responsibilities. The compensation committee notes and manages
the potential for salary increases to have a ratchet effect on total
remuneration because of the linkage between salary and other ele-
ments of the remuneration package such as cash in lieu of pension,
bonus, and long-term incentive awards.
Individual bonus decisions are based on executive directors per-

formance in the year, measured against group and personal objec-
tives. Performance measures are both quantitative and qualitative,
and nancial and non-nancial. Bonus awards are made by the com-
mittee following discussion of recommendations made by the chair
of the remuneration committee. The purpose is to reward the
delivery of the near-term business targets set each year; the indivi-
dual performance of the executive directors in achieving those tar-
gets; and contribution to the delivering company with strategic
objectives.
The executive directors receive an annual cash allowance in lieu
of participation in a pension arrangement. The purpose is to enable
executive directors to build long-term retirement savings. This is a
common arrangement in executive remuneration, reecting recent
and continuing changes in respective Canadian and the US taxation
of pension contributions. The rates of these allowances for executive
directors exceed pension contribution rates for the broader employee
population. This reects market practice for senior executives. The
rate of cash allowance in lieu of pension for any new executive
director is appropriately benchmarked at the time of appointment.
Executive directors benets provision usually includes private
medical cover, life and ill-health income protection, tax advice, the
use of a company vehicle or the cash equivalent, and use of a com-
pany vehicle and driver when required for business purposes. The
purpose is to protect against risks and provide other benets.
The long-term performance measurement, holding periods, and
the malus conditions discourage excessive risk-taking and inap-
propriate behaviors, encourage a long-term view, and align execu-
tive directors interests with those of shareholders. The purpose is to
reward execution of company strategy and growth in shareholder
value over a multi-year period.
Directors Remuneration Design

The directors contract design is based on short- and long-term com-
pensation factors. It varies with industry and market culture in terms
of duration focus in the directors contract. In Canada, based on
recent research study,5 the CEO compensation contracts are charac-
terized as balanced between short- and long-term compensation.
On the other hand, in the United States, the CEO contracts tend to
5
Nulla (2013b).
favor on long-term compensation such as pensions, stock options,

insurance, and other benets. As such, CEO cash compensation is
higher in Canada relative to the United States.
Directors Remuneration Factors

From the analyses provided in previous sections, it has now been
cleared that directors remuneration packages vary from industry to
industry and perhaps company to company and rm size. The
benchmark used in evaluating performance in particular accounting
performance varies, perhaps based on implementation of the strate-
gic plan and its successes and the milestones to be achieved by the
CEO. The growing or emerging technology companies evaluate
CEO compensation based on sales, research and development, and
project successes rather than on net prot margin; retail and distri-
bution industries evaluate CEO compensation based on sales and
net prot margin; energy, metal, and mining companies, the highest
paid CEO compensation among all industries, evaluate CEO com-
pensation on the resource drilling and production successes, and
market price of the stock; health and pharmaceutical companies
CEO compensation is mostly based on sales, net prot margin, and
research successes such as regulatory approval to manufacture new
products. Other industries like nancial and manufacturing, rely on
accounting performance as a major benchmark in compensating
CEOs.
According to previous research,6 rm size has inuenced CEO
compensation. It is true from previous research ndings conducted
by scholars that the large rm size CEO received high compensation
relative to CEOs in small and medium rm sizes. The primary ratio-
nales provided were that large rm size CEOs have to deal with
high risk projects, manage large departments, have complex organi-
zational structures, face more competition in the market especially
globally, highly accountable for strategic results, and compliance
with complex policies and procedures both domestically and inter-
nationally. However, recent research7 also has demonstrated that in
small-size companies the correlations between CEO cash compensa-
tion and rm size were higher relative to other rm sizes. That is,
CEOs increments (in terms of ratio) are higher in small-size compa-
nies than in large-size companies, perhaps due to quantum business
growth and industry demand for services or products.
6
Nulla (2013a) and Nulla (2012).
7
Nulla (2013b).
The ownership structure has an inuence on the design of direc-

tors remuneration.8 For example, the nature and extent of inuence
of accounting performance to CEO compensation are depended on
the selection of predictor variables and the ownership structure. It
was found that accounting performance is more appreciated in
owner-managed companies wherein owners demand more factual
performance than qualitative assessment. In addition, it was found
that rm size and CEO compensation have a good correlation; how-
ever, in management-controlled companies the correlations are
stronger, indicates more qualitative criteria in the CEO contract.
On the other hand, it was found that CEO power factors have a
weak inuence on CEO compensation under both owner and
management-controlled scenarios perhaps due to the CEO
contracts emphasis on accounting performance and strategic goals
accomplishments.
Other factors, in particular qualitative, have inuenced direc-
tors compensation. For example, board members recruited or
appointed by CEO, executive compensation consultant negotiating
CEO contract on behalf of CEO with board, CEO/Chairman dual
role status, CEOs operational experience, outside CEO recruitment,
organizations that have international subsidiaries, and compliance
with management internal policies and procedures.
Boards Role in Directors Remuneration

The board and the directors play a vital role in advancing the com-
panys strategic priorities and objectives and in providing oversight
and supervision of the management of the business and affairs of
the company. Appropriate remuneration for services performed by
directors is part of good governance practices. Remuneration must
reect the importance and professional nature of board work, and
attract and retain qualied individuals.
Accounting Regulation
Due to global expansion of North American companies, one unied
accounting standard is demanded for nancial reporting and analy-
sis by investors, stockholders, and government. The emergence of
International Financial Reporting Standards (IFRS) globally has cre-
ated a viable option to adopt in North America. As such, Canada
has decided to adopt IFRS in 2011 from Canadian GAAP. Similarly,
8
Nulla (2013c).
the United States will soon (over the next several years) adopt IFRS
from US GAAP. By adopting IFRS in North America, the nancial
reporting indeed has and will become more informative and market
valued. The empirical research on directors compensation is in early
stage under IFRS nancial reporting. Through the adoption of IFRS
in North America, indeed directors compensation will be more
volatile if accounting performance criteria are weighted in the CEO
contract, such as in owner-managed companies, and nancial and
manufacturing industries.
Conclusion
This chapter has explored the energy, metal, mining, and health
industrys effects on directors remuneration in Canada and United
States. In addition, it has discussed the impact of policy, design,
factors, boards role in directors remuneration, and accounting
regulation on directors remuneration. The results found that
among energy, metal, mining, and health industries, there was a
relationship between CEO compensation, rm size, rm perfor-
mance, and CEO power. However, CEO contracts in Canada are
characterized as balanced between short- and long-term compensa-
tion systems. On the other hand, CEO contracts in the United
States tended to promote the retirement reward system in terms of
pension, insurance, stock, medical, and other long-term benets in
the CEO contracts. The correlation results demonstrated that
industry and market culture have an effect on the design of CEO
contract in terms of linking between CEO salary, bonus, long-term
benets, and rm size. The correlation between CEO compensation
and rm performance, although it was mostly positive, varies with
industry due to different variables used in the CEO contract. As
such, the correlations were ranged from weak negative to strong
positive ratios. However, consistently, in all these industries,
accounting net income/net prot margin has a positive inuence on
the CEO compensation in particular, CEO salary and bonus. In
addition, it was found that CEO power has a weak inuence on
CEO compensation perhaps due to the strong inuence of rm size
and accounting performance as prime criteria toward determining
CEO compensation.
Despite the six decades of research in the area of executive com-
pensation by many scholars, I came to the conclusion that the execu-
tive compensation research should be continuous, to improve the
understanding the framework, and educate the public towards how
the executives are evaluated to entitle mammoth amount of bonuses
and pensions, far superior from the average worker lifetime
combined remunerations. Therefore, I highly encouraged to conduct

new research to fulll the zeal of obtaining robust results. For exam-
ple, the new research may focus on the nature and extent of the mar-
ket culture and IFRS on the executive compensation framework.
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Section III
Cross-Country Remuneration
Practices Analysis
CHAPTER
Directors
6 Remuneration in the
United States
Andrew J. Felo
Introduction
Although executive compensation in the United States has received
tremendous attention from politicians, investors, and regulators
over the last several years, less attention has been paid to how rms
remunerate members of their boards of directors. However, both
types of remuneration confront similar issues. For example, how
should rms structure (forms of compensation and amounts of each
form of compensation) remuneration so that directors are encour-
aged to work on shareholders behalf and not on the behalf of
executives or on their own personal behalf? Also, how do rms use
remuneration to attract and retain experienced directors? In addi-
tion, both types of remuneration are regulated in similar ways in the
United States, although director remuneration is not as highly regu-
lated as is executive compensation. This chapter discusses various
issues related to the remuneration of board of director members in
the United States.
One unique aspect of director remuneration is that directors
essentially establish their own compensation, with little to no over-
sight. That is because director remuneration is typically established
by the compensation committee (or its equivalent) of a rms board
of directors. Any stock options paid to directors must come from a
plan adopted by the board of directors and approved by share-
holders, but shareholders rarely reject plans adopted by boards.
Director elections also provide a potential check on director remu-
neration as shareholders can vote directors out of their positions if
they are unhappy with the compensation they award themselves.
73
74 ANDREW J. FELO
However, this is probably not much of a realistic threat, given that

most directors run unopposed for their board seats in the United
States. Therefore, shareholders must rely on the integrity of directors
as well as rules and laws established by regulators and stock
exchanges to ensure that director remuneration is in their best inter-
ests. Although regulators and stock exchanges do not tell rms how
to structure director remuneration, they do establish rules concern-
ing how compensation committees operate (including compensation
committee composition and use of compensation consultants) and
what kinds of information concerning director remuneration rms
must disclose to their shareholders.
In 1995, a Blue Ribbon Commission of the National
Association of Corporate Directors (NACD) produced a report
recommending that board of director members of rms listed in the
United States should be paid in cash and stock only, with equity
being the bigger component of total remuneration (NACD, 1995).
In addition, it recommended that rms establish targets for how
much company stock directors should own and that they should
eliminate pension plans for directors. The reason for recommending
that equity make up the majority of director remuneration is that
compensating directors with equity does a better job of aligning the
interests of directors with shareholders interests than other forms of
compensation do. This is because as shareholder wealth increases,
the value of equity remuneration increases. More importantly, direc-
tor remuneration decreases if shareholder wealth decreases. Cash
compensation may not provide such motivation to directors as they
receive the same amount of compensation regardless of what hap-
pens to the rms stock price. While director remuneration may not
increase if the stock price increases, there is no penalty to the direc-
tor if the stock price decreases. Setting targets for stock ownership is
another way to align the interests of directors and shareholders as it
helps to ensure that directors will have some skin in the game.
Last, a pension plan may give a director the incentive to not rock
the boat so as to remain on the board long enough to qualify for
the pension. This tendency is more than likely not in the best inter-
ests of shareholders. According to a recent survey jointly conducted
by The Conference Board, NASDAQ OMX (owner of the
NASDAQ stock market), and NYSE Euronext (owner of the New
York Stock Exchange stock market), rms seemed to have generally
taken these recommendations to heart. In the 2011 scal year (the
most recent survey available), director remuneration packages
included cash retainers, meeting attendance fees, shares of stock,
and stock options (Tonello, 2013). I give more details on each of
these components of director remuneration below.
Directors Remuneration in the United States 75
Remuneration Regulation and Reporting

In the United States, corporate governance rules and regulations are
determined in multiple ways. Bills that are passed by Congress and
signed into law by the President impact public companies. For exam-
ple, the Dodd-Frank Wall Street Reform and Consumer Protection
Act of 2010 (hereafter referred to as the Dodd-Frank Act) contains
several provisions related to corporate governance, including execu-
tive and director remuneration. In addition, the Securities and
Exchange Commission (SEC) has the legal authority and responsibil-
ity to regulate public capital markets (e.g., stock and debt markets).
It does this by issuing rules and regulations that public rms must
follow. Last, the exchanges where securities are traded (e.g., NYSE
and NASDAQ) have rules that listed rms must abide by as a condi-
tion of having their securities traded on those exchanges. This sec-
tion of the chapter will discuss how laws, rules, and regulations
issued by these groups address corporate director remuneration in
the United States.
The NYSE and NASDAQ do not mandate that listed rms fol-
low any particular compensation rules. That is, they do not tell rms
how much compensation to offer or what forms of compensation
they should offer to directors. What they do is promulgate general
guidelines and principles that they believe rms should follow when
determining appropriate director compensation. For example, the
following statement is from Section 303A.09 of the NYSE (2013)
Company listing requirements:
Director compensation guidelines should include general

principles for determining the form and amount of director
compensation (and for reviewing those principles, as appro-
priate). The board should be aware that questions as to
directors independence may be raised when directors fees
and emoluments exceed what is customary. Similar con-
cerns may be raised when the listed company makes sub-
stantial charitable contributions to organizations in which a
director is afliated, or enters into consulting contracts with
(or provides other indirect forms of compensation to) a
director. The board should critically evaluate each of these
matters when determining the form and amount of director
compensation, and the independence of a director.
On July 26, 2006, the SEC passed new rules concerning execu-
tive and director compensation. Although these rules relate primarily
to executive compensation, they also relate to director compensa-
tion. These rules require that rms provide information on all com-
ponents of executive and director compensation in a single table in
76 ANDREW J. FELO
their proxy statements. In addition, rms have to include a

Compensation Discussion and Analysis (CD&A) in their proxy
statements. Much like the Management Discussion and Analysis
included in 10-K reports, the CD&A must include a discussion and
analysis of the factors used in determining the gures presented in
the compensation table, including the outcomes the rm is trying to
reward. Firms must provide information in the table and CD&A
related to compensation for the current scal year and two prior s-
cal years, equity-related compensation that is at-risk and had been
awarded in prior years, and retirement and change-in-control com-
pensation. In 2009, these rules were modied to change how rms
value stock and option grants made to directors. Notably, director
compensation plans are not subject to the same say on pay share-
holder votes that executive compensation plans are subject to. As
with the stock exchanges, the SEC does not tell rms how they are
to compensate their directors. Rather, the SEC directs rms to tell
their shareholders how they decide on director remuneration plans.
The SEC classies directors as corporate insiders (similar to
how rm executives are classied) with respect to insider trading
regulations. In addition to prohibitions on trading on material
non-public information (insider trading), insiders must report their
stock holdings and transactions to the SEC when they rst are
classied as insiders and when these holdings change. When a per-
son rst becomes an insider (e.g., when rst elected as a director),
he or she must report stock holdings to the SEC on Form 3. Any
subsequent transactions must be reported to the SEC within two
business days on Form 4. If an insider fails to le Form 4 on time,
he or she must report the transaction on Form 5 within 45 days
of the end of the rms scal year. In addition, Section 955 of the
Dodd-Frank Act requires the SEC to develop and propose rules
mandating that rms disclose whether they allow directors (and
executives) to hedge any risk related to owning company equity.
As of the writing of this chapter, the SEC has not proposed any
such rules.
Director remuneration is typically determined by a boards com-
pensation committee (or its equivalent). Similar to audit committees,
much attention has been placed recently on the independence of
compensation committees. The logic is that independent compensa-
tion committee members are more likely to establish compensation
that is in the best interests of shareholders, not in the best interests
of executives and directors. Section 952 of the Dodd-Frank Act
requires the SEC to direct the NYSE and NASDAQ to issue rules
mandating that compensation committee members be independent.
In implementing this requirement, the NYSE passed a rule that all
compensation committee members be independent of management
while NASDAQ requires that rms have compensation committees
made up of at least two independent members. NASDAQ allows a

rm to have one non-independent member on the committee under
extraordinary circumstances. To qualify for this exception, the com-
pensation committee must have at least three members and the non-
independent member cannot be a current executive or employee of
the rm or a family member of a current executive of the rm. (I
review evidence on compensation committee independence below.)
In addition to independence requirements, both the NYSE and
NASDAQ require that compensation committees adopt formal char-
ters outlining committee responsibilities, membership requirements,
and committee operating procedures. Both Exchanges require that
the charter be reviewed for adequacy at least once per year.
Compensation committees often use consultants to help them
design appropriate remuneration plans for executives and directors.
Although these consultants bring valuable expertise to the process,
there is some concern that these consultants may be biased toward
management or the board. That is, in order to continue being hired
by the rm and compensation committee, the consultants may
recommend remuneration packages that favor executives and direc-
tors at the expense of shareholders. This is similar to the issue raised
when external auditors perform non-audit services for their audit cli-
ents. Under rules issued by the NYSE and NASDAQ in accordance
with Section 952 of the Dodd-Frank Act, compensation committees
have the sole authority to retain compensation consultants. If the
committee chooses to retain a consultant, the committee decides
what rm to retain, how much to pay the consultant, and the dura-
tion of the engagement. In other words, executive management has
no say in whether a consultant is retained or how much the consul-
tant is paid. This is similar to the requirement under the Sarbanes-
Oxley Act of 2002 that audit committees hire, re, and decide the
compensation for external auditors. However, in deciding to hire a
compensation consultant, the compensation committee is required
to explicitly consider whether a particular rm may not provide
independent or unbiased advice. For example, if a consulting rm
has been hired by management to help design compensation plans
for employees, it may not be appropriate for the compensation com-
mittee to also hire that consulting rm. The SEC requires that rms
disclose fees paid to compensation consultants if the consultant or
its afliates received in excess of $120,000 from the rm for addi-
tional services. It is important to stress that the SEC and Exchanges
do not prohibit the compensation committee from hiring a rm that
is retained by management. The SEC and Exchanges only require
that the compensation committee considers whether this compensa-
tion consultant can provide independent and unbiased advice. This
is consistent with the SEC and Exchanges not telling rms how to
compensate their executives and directors. I present empirical
78 ANDREW J. FELO
evidence concerning the use of compensation consultants and com-

pensation below.
Remuneration Design
A recent survey of rms on the Standard and Poors 500 Index
shows that average remuneration for directors in 2013 was approxi-
mately $251,000 (Green & Suzuki, 2013). This represents the sixth
consecutive year that average director compensation increased at
these rms. Although the $251,000 is a 15 percent increase since
2007, average CEO compensation for these rms increased 33 per-
cent over the same period. The same survey indicates that directors
spent approximately 250 hours on board matters during the year at
these rms.
In a survey of rms listed on the NASDAQ and NYSE markets
published by The Conference Board (a much broader sample of
rms than the Standard and Poors 500), Tonello (2013) reports the
median total director remuneration ranges from $53,300 in the
smallest rms (based on revenue) to $240,000 in the largest rms
(based on revenue). When classifying rms based on industry,
energy rms report the highest median total remuneration
($202,555) and commercial banks report the lowest median total
remuneration ($47,200). The survey also reports that director remu-
neration continues to increase. The author attributes the increase in
remuneration to an increase in time directors spend on rm business,
an increase in personal liability for directors, and a decrease in sup-
ply of potential directors due to increased independence and exper-
tise requirements for board service.
According to the survey, rms listed on the NYSE and
NASDAQ typically compensate their directors with a combination
of a cash retainer, meeting fees, full value shares of stock, and stock
options (Tonello, 2013). Stock and stock options are used to incenti-
vize directors to look out for the best interests of shareholders, while
meeting fees are used to motivate directors to attend board and com-
mittee meetings. The cash retainer is the only component that is
guaranteed to directors regardless of rm performance or meeting
attendance. I expand on each component below.
Survey results indicate that the median cash retainer in the 2011
scal year ranges from a low of $27,250 for commercial banks to
$75,000 in the industrial and transportation equipment industry. As
expected, larger rms (based on revenues or total assets) pay signi-
cantly higher cash retainers than do smaller rms. The median retai-
ner for the smallest rms (based on revenues) is $30,000 while the
median retainer for the largest rms is $90,000. The other percen-
tiles (10, 25, 75, and 90 percent) show similar spreads, as do the
results when measuring rm size based on total assets. A large

majority of rms (approximately 75 percent) award additional cash
retainers to directors chairing board committees (audit, compensa-
tion, nominating, etc.). In addition, 40.7 percent of rms award
additional cash retainers to the chairman of the board and 50.8 per-
cent award additional cash retainers to the lead director. Larger
rms are less likely to pay the additional retainer to the chairman
but more likely to pay it to the lead director (Tonello, 2013).
Meeting fees are payments for attending board and board com-
mittee (audit, compensation, nominating, etc.) meetings. Some rms
pay these fees whether directors attend meetings in person or elec-
tronically, depending on rm policy. Of the four components, meet-
ing fees are paid by the least number of rms. For example, more
than half of the manufacturing and non-nancial services rms in
the survey do not pay meeting fees. Median total meeting fees range
from a low of $8,175 (business services industry) to a high of
$26,000 (energy industry). Across all industries, median fees for
individual meetings range from $500 to $2,000. In the retail trade
industry, a rm at the 90th percentile paid meeting fees of $14,000
per meeting.
A large majority of the rms in the survey compensate their
directors with some form of equity. Approximately 95 percent of
sample rms in the manufacturing and non-nancial services indus-
tries and 88 percent of sample rms in nancial services include
equity in their director remuneration plans. The reason is obvious:
By directly tying director remuneration to the price of the rms
equity, directors will be motivated to work toward maximizing the
rms share price.
Equity compensation comes in two forms: full value shares and
stock options. Stock options will be discussed in the following para-
graph. Full value shares are forms of compensation where the recipi-
ent (the director in this case) receives the full value of the stock as
compensation. Examples include unrestricted and restricted stock,
deferred stock units, restricted stock units, performance shares, and
performance units. If the stock price goes up, then the value received
goes up. Likewise, the value received decreases as the stock price
decreases. This differs from other forms of equity where value is
received only if the stock price increases (e.g., stock options and
stock-appreciation rights). As expected, the value of these full value
shares is larger for larger rms. For rms having revenues below
$100 million, the median value of these shares is $20,000, while the
median is $145,000 in rms with revenues above $20 billion.
Median award values range from $32,500 (commercial banks) to
$125,000 (computer services).
The second form of equity compensation includes stock options
and stock-appreciation rights. Both of these compensation forms
80 ANDREW J. FELO
allow holders to benet from an increase in the rms stock price

from a pre-determined level. For options, the pre-determined level is
called the strike price. If the stock price does not increase beyond
the pre-determined level before the instrument expires, then it
becomes worthless. The rationale for this form of remuneration is
that recipients only benet if the rms stock price increases.
Although this form of compensation was quite popular in the past,
the evidence in the survey indicates that they are falling out of favor
with most rms. Only about 36 percent of manufacturing rms, 27
percent of nancial services rms, and 25 percent of non-nancial
services rms report including options or stock-appreciation rights
in their director remuneration plans (Tonello, 2013). One possible
reason for the decline in use is that they give managers an incentive
to take actions that may increase a rms stock price in the short
term but may decrease it in the long term (e.g., by cutting R&D or
marketing spending or by committing nancial statement fraud).
Another possible reason is that when stock prices fall as a result of
uncontrollable circumstances, these instruments provide little to no
motivation to managers and directors. Actual stock grants still pro-
vide motivation if this happens as they retain some value, even if the
stock price decreases. The only exception to the trend of less use of
options is in relatively small manufacturing and non-nancial ser-
vices rms. Option use is still quite popular in these rms. This may
be related to the fact that using options allows these small rms to
conserve much needed and scarce cash while providing something of
value to attract and retain directors.
As mentioned above, the 1995 NACD Blue Ribbon
Commission on Director Compensation recommends that rms
establish targets for the minimum of amount the rm stock directors
should own (NACD, 1995). The Conference Board survey shows
that approximately 75 percent of rms have done this (Tonello,
2013). The targets are typically stated as a minimum number of
shares, a minimum dollar amount of shares, or as a multiple of the
annual cash retainer received (this is the most common form used).
However, small rms are much less likely to have adopted minimum
levels of stock ownership. For example, only 10.3 percent of rms
with revenues of less than $100 million have adopted such targets.
According to the survey, the most common perquisite for board
members is for the rm to match personal contributions made to
charitable organizations (approximately 24 percent of all rms offer
this). Other perquisites include providing life, travel, or accident
insurance to directors (approximately 11 percent), providing medi-
cal and dental benets (approximately 3 percent), reimbursing direc-
tors for taxes incurred on compensation and benets (approximately
2 percent), allowing directors to use corporate aircraft for personal
purposes (approximately 2 percent), and providing tickets to
sporting and other entertainment events (approximately 2 percent).

Overall, not offering any perquisites to directors is the norm as 62
percent of rms in the survey do not provide any of these perquisites
to directors. In addition to these benets, virtually all rms (95 per-
cent) reimburse directors for costs associated with attending meet-
ings. Some rms put limits on reimbursements, but a large majority
of rms have no such limits (Tonello, 2013).
Empirical Evidence on Director

Remuneration
Although not as extensive as the literature on executive compensa-
tion, there has been a fair amount of empirical research on director
remuneration practices in the United States. Past research on direc-
tor remuneration has generally fallen into two categories. The rst
category involves the determinants of director remuneration. One
topic in this area is the characteristics for rms adopting stock-
option plans for outside directors. Other topics in this area include
the relationship between director remuneration and compensation
committee characteristics, the use of compensation consultants,
board overlaps, and board independence from the CEO. The second
category concerns the impact of director remuneration on the rm
and its stakeholders. Topics in this category include market reac-
tions to the adoption of equity compensation plans for directors, the
link between director remuneration and nancial reporting, the link
between director remuneration and a rms dividend policy, the rela-
tionship between director remuneration and shareholder lawsuits,
and the link between director remuneration and corporate social
performance. I discuss research in both categories in this section of
the chapter.
The Determinants of Director

Remuneration
CHARACTERISTICS OF FIRMS ADOPTING OUTSIDE DIRECTOR
STOCK-OPTION PLANS
Fich and Shivdasani (2005) investigate the characteristics of rms
adopting stock-option plans for outside directors for the rst time.
They nd that the probability that a rm will adopt such a plan is
positively related to the percentage of independent directors on the
board and the percentage of equity owned by institutions. Since
both of these are considered indicators of strong corporate
82 ANDREW J. FELO
governance, they conclude that rms with strong corporate govern-

ance systems are more likely to compensate their outside directors
with stock options. They also nd that high-growth rms are more
likely to adopt stock-option plans for outside directors than are low-
growth rms. They speculate that by tying directors remuneration
to stock price, outside directors are incentivized to ensure the rm
realizes its high-growth potential. Last, they nd that as the percen-
tage of equity owned by outside directors increases, the less likely a
rm is to adopt a stock-option plan for outside directors. This indi-
cates that when outside directors own a relatively large amount of
equity, a stock-option plan is not needed to incentivize outside direc-
tors to act in shareholders best interests.
DIRECTOR REMUNERATION AND COMPENSATION COMMITTEES

Compensation committees are generally responsible for setting
executive and director remuneration, although shareholders do need
to approve stock-option plans. As noted above, the NYSE requires
that all compensation committee members be independent of man-
agement while NASDAQ requires that rms have compensation
committees made up of at least two independent members. These
requirements are designed to increase the likelihood that executive
compensation plans will be in shareholders best interest by having
directors who are less likely to be biased toward company executives
determine compensation plans. A compensation plan is in share-
holders best interests if it strengthens the link between compensa-
tion and rm performance. Although the requirements relate
primarily to executive compensation plans, it is possible that more
independent compensation committees will also develop director
remuneration plans that are in shareholders best interests.
I am not aware of any published empirical studies investigating
the relationship between compensation committee independence and
director remuneration plans. There are, however, studies on execu-
tive compensation and compensation committee independence.
Unfortunately, these studies provide contradictory evidence. While
Vafeas (2003) reports that non-independent compensation commit-
tee members are associated with a weaker link between executive
compensation and rm performance, Daily, Johnson, Ellstrand, and
Dalton (1998) and Anderson and Bizjag (2003) fail to nd evidence
that non-independent compensation committees award more gener-
ous compensation packages to executives. Based on this equivocal
evidence concerning executive compensation and compensation
committee independence, it is difcult to imagine that there would
be unequivocal results when considering director remuneration and
compensation committee independence. However, the fact that it
looks more appropriate for a rm to have an independent
compensation committee, it is unlikely that regulators will change

this requirement.
DIRECTOR REMUNERATION AND COMPENSATION CONSULTANTS

Some critics of compensation consultants have argued that they
have enabled rms to hide and justify exorbitant executive compen-
sation contracts (Bebchuk & Fried, 2006). Others have argued that
if a compensation consultant provides other services to the rm, the
consultants independence could be impaired to the point that direc-
tors would not be protected from legal liability under the Business
Judgment Rule (Brancato & Rudnick, 2006).
As noted above, the SEC requires that boards or compensation
committees using compensation consultants disclose the fees paid to
such consultants if the rm paid the consultant in excess of
$120,000 for services other than aiding the compensation commit-
tee. The Conference Board survey indicates that a large percentage
of rms (approximately 70 percent across all industries) report the
name or names of consultants used, with larger rms more likely to
make such disclosures. However, the vast majority of rms do not
meet the threshold for disclosing fees paid to compensation consul-
tants. When disclosures are made, the highest median for compensa-
tion services is $155,831 in non-nancial services and $650,000 for
non-compensation services in the manufacturing industry.
There is little published empirical evidence concerning the use of
compensation consultants in US rms. (There are a number of
unpublished working papers on the topic.) In addition, virtually
there exists evidence involving executive, not director, remuneration.
In a published study on the use of compensation consultants,
Cadman, Carter, and Hillegeist (2010), report that rms using com-
pensation consultants pay their executives more than do other rms.
However, they do not nd a weaker link between compensation and
performance at these rms. In addition, they do not nd evidence
that non-independent consultants are associated with more lucrative
pay packages. If we extrapolate this limited evidence on executive
compensation to director remuneration, it does not appear that com-
pensation consultants enrich directors at the expense of
shareholders.
DIRECTOR REMUNERATION AND BOARD INDEPENDENCE FROM CEO

Ryan and Wiggins (2004) investigate how board independence from
the CEO impacts independent director remuneration. As mentioned
above, directors are in the fairly unique position of having signi-
cant discretion in determining their own compensation. The authors
hypothesize that directors can be more or less involved in
84 ANDREW J. FELO
determining their compensation, depending on their power relative

to the CEO. For example, relatively independent boards are more
likely to rigorously monitor management because they do not feel
beholden to management (especially the CEO) and they want to pro-
tect their reputations as board members. If this is the case, directors
will be actively involved in setting their compensation in such a way
that they have incentives to monitor management. In this situation,
equity (stock and stock options) would be a relatively large compo-
nent of director remuneration. On the other hand, non-independent
directors may defer to the CEO on compensation issues. To keep
directors from monitoring his or her activities, the CEO would insist
on making equity a relatively small component of director remu-
neration. Their evidence supports this argument. Specically, direc-
tors on boards with more outsiders (indicating higher director
independence) receive more compensation in the form of equity,
while rms where the CEO is more entrenched and also serves as
the chairman of the board (indicating lower director independence)
receive less compensation in the form of equity. If one accepts the
idea that compensating directors with equity benets shareholders
by aligning the interests of directors and shareholders, this evidence
supports the notion that board independence benets shareholders
through director remuneration.
DIRECTOR REMUNERATION AND BOARD OVERLAPS

Farrell and Hersch (2012) analyze director compensation where two
rms share an independent director. They refer to this situation as a
board overlap. If all boards value a directors expertise equally,
then one would expect that a director would receive the same com-
pensation for all boards he or she serves on. However, this is not the
case. In fact, there are substantial differences in compensation for an
independent director serving on multiple boards, although the
difference in compensation for overlap rms is less than for non-
overlap rms. The authors speculate that boards nd it more
important to compensate all directors on the board similarly than to
match the compensation a director receives from another board.
SUMMARY OF DETERMINANTS OF DIRECTOR REMUNERATION

What are the traits of rms that adopt stock-option plans for direc-
tors? Evidence shows that rms having relatively strong corporate
governance mechanisms in place (higher percentage of independent
directors on the board and a higher percentage of equity owned by
institutions) and rms with high-growth expectations are more likely
to compensate their outside directors with stock options than are
other rms. In addition, stock-option grants appear to be a
substitute for stock ownership because director stock-option plans

are less likely as the percentage of equity owned by outside directors
increases.
Recent regulations issued by the SEC and Stock Exchanges
require rms to have compensation committees that are comprised
of only independent directors and to disclose if the committee uses a
compensation consultant that also provides at least $120,000 in
other services to the rm. Although the rules most likely target
executive compensation, they also are related to director remunera-
tion. Unfortunately, there is little empirical research on the impact
of the rules on director remuneration. Although there are no pub-
lished studies that I am aware of that investigate the relationship
between the independence of compensation committees and director
remuneration or the relationship between the use of compensation
consultants and director remuneration, there are studies published
about how these two factors relate to executive compensation. The
evidence concerning executive compensation and independent com-
pensation committees is mixed. Therefore, one cannot say with any
condence that the link between director compensation and rm
performance will be stronger with independent compensation com-
mittees. The one published study on the use of compensation consul-
tants and executive compensation indicates that although rms
using consultants (whether the consultants are independent or not)
tend to pay their executives more, the link between compensation
and rm performance is not weaker when consultants are used. As
shareholders and regulators tend to focus on strengthening the link
between compensation and performance, it does not appear from
this limited evidence that compensation consultants enrich directors
at shareholders expense. Existing evidence does seem to indicate
that more powerful CEOs use their power to reduce directors incen-
tive to monitor their activities by inuencing director remuneration
plans. Last, it appears that rms look to compensate all their outside
directors similarly, regardless of whether the director serves on
another rms board.
The Impact of Director Remuneration

on the Firm and Its Stakeholders
MARKET REACTION TO ADDING EQUITY TO DIRECTOR
REMUNERATION PLANS
Gerety, Hoi, and Robin (2001) investigate the stock markets reac-
tion when a rm adopts a plan to include equity in its remuneration
86 ANDREW J. FELO
package for directors. They nd that there is no statistically or eco-

nomically signicant impact to stock returns at the time of the adop-
tion of the plan is announced. The authors investigate the strength
of rms corporate governance for additional insights into these
results. They focus on the role the CEO plays in nominating people
to serve as directors. If the CEO is involved in the nominating pro-
cess, then corporate governance is relatively weak, as directors may
not be truly independent of the CEO. If they are not truly indepen-
dent, they may be less likely to adequately monitor the CEO. They
speculate that in this scenario, equity plans may not properly align
the interests of shareholders and directors. This is similar to the gen-
eral notion of the Ryan and Wiggins (2004) paper discussed above.
The empirical results support this contention. Specically, when the
rm does not have a nominating committee, the stock market reac-
tion to the announcement is signicantly negative, but when there is
a nominating committee, the reaction is insignicant. This evidence
indicates the importance of corporate governance (specically, direc-
tor independence from the CEO) in determining whether equity
remuneration for directors is in shareholders best interests.
In addition to studying the characteristics of rms adopting
stock-option plans for outside directors, Fich and Shivdasani
(2005) also study the markets reaction and analysts reaction to a
rm adopting a stock-option plan for outside directors for the rst
time. If market participants believe that stock-option plans align
the interests of shareholders and outside directors, then there
should be a positive impact on rm value when rms adopt these
plans. Similarly, if analysts believe these plans align the interests of
shareholders and outside directors, then analysts may increase
their earnings forecasts to reect that they expect the board will
do a more effective job of monitoring management. Using various
measures of rm value (market-to-book ratio, stock returns, return
on assets, return on sales, and asset turnover), they report evidence
that adopting a stock-option plan for outside directors increases
rm value. In addition, although the market reaction to the
announcement that a rm is adding an independent director to the
board is not signicantly different from zero in this study, they
nd that the impact is signicantly negative when the rm does
not have a stock-option plan for directors. This is consistent with
the notion that having a stock-option plan for outside directors is
viewed as a positive development for shareholders. The authors
also report that analysts revise earnings forecasts up when rms
adopt a stock-option for outside directors, indicating that analysts
expect these plans to improve rm performance. Taken together,
evidence from this chapter indicates that the adoption of stock-
option plans for outside directors is good news for shareholders.
DIRECTOR REMUNERATION AND FINANCIAL REPORTING

Persons (2012) investigates the relationship between two forms of
independent director compensation (cash and stock options) and
fraudulent nancial reporting. Evidence indicates a positive relation-
ship between the inclusion of stock-option grants in independent
director remuneration plans and the likelihood of fraudulent nan-
cial reporting. In fact, fraud rms are more likely to compensate
independent directors exclusively with stock options than are non-
fraud rms. There is no relationship between independent director
cash compensation and the likelihood of fraudulent nancial report-
ing. In addition, there is no relationship between stock ownership
and fraudulent nancial reporting. These results hold after control-
ling for audit committee characteristics, board characteristics, and
CEO compensation. These results are consistent with the notion
that compensating independent directors with stock options pro-
vides them with the incentive to look the other way concerning
fraudulent nancial reporting, while cash compensation and stock
holdings do not provide these incentives. This may be the case as
independent directors benet (at least in the short term) when a
rms stock price increases as a result of fraudulent nancial
reporting.
Lynch and Williams (2012) study the relationship between the
form of audit committee compensation and earnings management.
An effective audit committee should reduce earnings management.
Using discretionary accruals to measure earnings management, they
nd a positive relationship between earnings management and
stock-option compensation (consistent with the results from
Persons, 2012, discussed above) and a negative relationship
between earnings management and compensation in the form of
restricted stock. These results are consistent with the notion that
stock options provide incentives to permit earnings management
(as a way to increase the value of option grants by increasing the
likelihood that the rms stock price will increase above the strike
price prior to the expiration of the option) and that restricted
stock reduces this incentive because audit committee members can-
not benet from short-term increases in the value of restricted
stock.
Using a sample of rms that are using equity to compensate
directors for the rst time, McClain (2012b) investigates whether
compensating outside directors with stock options improves their
monitoring of a rms nancial reporting process. The rationale is
that by tying at least part of a directors remuneration to future
stock performance, the director will pay closer attention to man-
agement than if his or her remuneration is guaranteed (in the form
88 ANDREW J. FELO
of cash payments). He shows that three years after the introduc-

tion of equity remuneration, discretionary accruals (a measure of
earnings management) are negatively related to the percentage of
director remuneration paid in equity. Over the same period, stock
returns are positively related to the percentage of director remu-
neration paid in equity. These results support the notion that
equity remuneration, in the form of stock options, is related to
higher stock returns, less earnings management, and more effective
monitoring of management.
How do we reconcile the seemingly contradictory results
between Lynch and Williams (2012) and McClain (2012b)? After
all, they both investigate the relationship between discretionary
accruals and the use of equity to compensate outside directors.
There are a few important differences between the studies. First,
Lynch and Williams (2012) analyze audit committee compensa-
tion, while McClain (2012b) looks at compensation for all outside
board members. Since the audit committee is directly responsible
for overseeing a rms nancial reporting process, the results of
Lynch and Williams (2012) are probably more representative of
overseeing nancial reporting than are McClains (2012b) results.
Second, McClain (2012b) only studies rms that adopt equity as
part of their outside director remuneration packages for the rst
time. There may be something unique about rms adopting such
plans for the rst time that makes generalizing results to rms as a
whole inaccurate. In addition, he does not observe his negative
relationship between discretionary accruals and the use of equity
to compensate outside directors until the third year after equity is
added to the compensation package. In the rst year, the relation-
ship is statistically insignicant. Taken together, it seems that
Lynch and Williams (2012) provide more persuasive evidence than
does McClain (2012b).
Jeong and Kim (2013) investigate whether compensating
independent board members with equity is related to more conser-
vative accounting. The logic is that compensating board members
with equity provides them incentives to more closely monitor
management, and the closer monitoring manifests itself in the
form of more conservative accounting. Results show that the
higher the proportion of director compensation paid in equity
the more conservative is the rms accounting. In addition, the
results are the same using the percentage of compensation paid in
equity to audit committee members instead of to all independent
board members. This evidence supports the notion that using
equity to compensate independent board members provides them
with incentives to more closely monitor a rms nancial report-
ing process.
DIRECTOR REMUNERATION AND DIVIDEND PAYING

McClain (2012a) investigates the dividend-paying behavior of rms
that adopt equity compensation for directors for the rst time. He
nds that as the percentage of director remuneration paid in equity
increases, rms are less likely to pay dividends. The amount of divi-
dends paid is negatively related to equity compensation percentage.
In addition, more protable rms pay a lower amount of dividends.
Since the paying of dividends tends to decrease stock price (since
cash is removed from the business), this evidence supports the
notion that directors with a nancial stake in the company (in the
form of equity compensation) tend to support policies that are
expected to lead to future stock price growth.
Boumosleh (2012) investigates the relationship between includ-
ing stock options in the compensation for outside directors and a
rms dividend-paying behavior. The author uses dividend-paying
behavior to assess a rms appetite for risk. Specically, rms paying
relatively low dividends have a higher appetite for risk as they use
funds to pay for risky items such as research and development
expenditures. Evidence indicates that rms paying directors a rela-
tively high amount of stock options have lower dividend payout
ratios. This supports the notion that stock options encourage direc-
tors to approve more risky projects. Accepting more risky projects
may or may not benet shareholders. For example, directors could
forgo dividend payments to fund projects with negative net present
values but that personally benet the director. Results indicate that
the use of stock options encourages directors to more closely moni-
tor management such that dividends are not forgone in order to
fund projects with negative net present values. Taken together, this
evidence indicates that compensating directors with stock options
encourages less dividends (more risk), but the increase in risk-taking
benets shareholders.
DIRECTOR REMUNERATION AND SHAREHOLDER LAWSUITS

Crutchley and Minnick (2012) study the relationship between direc-
tor remuneration and shareholder lawsuits where the board of direc-
tors is named as a defendant. If equity compensation aligns
directors interests with shareholders interests, increasing equity
compensation could reduce shareholder lawsuits against the board
of directors. Contrary to this expectation, though, the evidence from
this paper indicates that shareholder lawsuits against directors are
more likely as equity compensation increases and less likely as cash
compensation increases. The authors speculate that equity compen-
sation makes directors less independent as they focus more on
their personal wealth than on the shareholders best interests. The
90 ANDREW J. FELO
reduced independence then manifests itself as a lawsuit against the

board as shareholders become displeased with the boards
performance.
DIRECTOR REMUNERATION AND CORPORATE SOCIAL PERFORMANCE

Deutsch and Valente (2013) investigate the impact that paying direc-
tors with equity has on corporate social performance. Even though
equity is expected to more closely align the interests of shareholders
and directors, the authors argue, it may also result in directors
ignoring other stakeholders. Their empirical results support this
idea. Although the amount of director compensation paid in equity
is positively related to future nancial performance, it is negatively
related to various measures of future corporate social performance.
These results indicate that if rms want directors to consider social
issues when advising and evaluating management, then it will be
necessary to include more than equity in their compensation
packages.
SUMMARY OF THE IMPACT OF DIRECTOR REMUNERATION

ON STAKEHOLDERS
Research reviewed in this section of the chapter investigates the
results of director remuneration choices. One stream of research
addresses whether using equity to compensate outside directors is
good for shareholders. The evidence on this is mixed. While some
researchers nd that using equity is benecial to shareholders (in the
form of higher stock returns, higher accounting returns, and less
earnings management), others nd that using equity is not benecial
to shareholders (lower stock returns, more earnings management,
and even greater likelihood of nancial statement fraud). There
seems to be two important issues to consider when looking at this
contradictory evidence. One, there seems to be different results
when equity is measured as stock options or as shares of stock
(restricted or unrestricted). When stock options are considered, the
results for shareholders tend to be negative, while the results tend to
be positive when shares of stock are considered. One possible expla-
nation is that stock options give an incentive to rms to increase
their stock prices in the short term, which may not be good for
shareholders in the long run. This may be why The Conference
Board survey shows that stock options have become less popular at
many relatively large rms. The second factor is the strength of a
rms corporate governance system. It appears that when a rm has
relatively weak corporate governance system, using equity to com-
pensate outside directors is a negative for shareholders. When cor-
porate governance is relatively strong, the impact of using equity is
statistically insignicant. While insignicant may not increase a

shareholders wealth, it is better than a negative impact.
Another stream of research reviewed in this section addresses
the relationship between compensating directors with equity and a
rms dividend-paying activity. The results consistently show a nega-
tive relationship between using equity to pay outside directors and
paying dividends. This relationship is consistent with directors who
own equity in a company wanting to encourage behavior that can
lead to an increase in stock price. Somewhat related to this is evi-
dence that shareholder lawsuits against directors are more likely as
equity compensation increases. Higher amounts of equity compensa-
tion could encourage directors to sanction greater risk-taking by
management. If these riskier projects do not work out, though,
shareholders may believe that the high amount of equity compensa-
tion encourages excessive risk-taking. Last, there is evidence that
using equity to compensate outside directors encourages directors to
pay less attention to corporate social performance. A possible expla-
nation for this is that although equity aligns the interests of share-
holders and directors, this alignment may result in directors
encouraging management to ignore corporate social performance
because focusing on corporate social performance may cost the rm
money, at least in the short term.
Remuneration Challenges
There are a number of challenges rms in the United States face
when attempting to determine director remuneration packages. One
challenge is that directors have a large amount of input into their
own pay packages. Therefore, they are subject to substantial criti-
cism if people believe that their pay is excessive or unwarranted
based on rm performance.
A second challenge is to make the remuneration package attrac-
tive enough to enable the rm to attract quality directors to the
board, but not so high that people nd it excessive. As the responsi-
bilities and workload of board members has increased, the number
of board candidates has tended to decrease. There are at least three
reasons why fewer people are candidates for board seats. First, the
increased workload makes it difcult for current executives to serve
on boards of other rms and for one director to serve on multiple
boards. In fact, some rms do not allow their executives to serve on
other boards because they fear board service may take up too much
of their time. Second, individuals may be reluctant to serve on
boards out of fear of legal liability issues. Even if a director is not
successfully sued, it could be embarrassing and time consuming to
be named in a lawsuit. Third, independence requirements for board
92 ANDREW J. FELO
and committee membership (e.g., audit and compensation commit-

tees) reduce the pool of available directors. The bottom line is that
most rms are probably competing for fewer and fewer independent
board candidates. This makes it imperative that rms offer attractive
director remuneration packages.
At the same time, rms do not want to overpay their directors.
In addition, director remuneration should provide incentives to
monitor management and offer strategic advice to management.
When discussing director remuneration, we tend to focus on the
monitoring role of outside directors. In order to motivate directors
to monitor management, it is probably necessary to pay directors at
least partially in equity. As noted above, the NACD recommended
in 1995 that the majority of director remuneration should be in
stock (NACD, 1995). By doing this, directors benet when share-
holders benet. This can at least partially address the challenge
about how much pay is too much pay. If shareholders earn high
returns, they are probably less likely to be concerned with
director pay.
The extant research reviewed above generally nds that paying
directors in equity benets shareholders. However, using stock
options may not be as benecial to shareholders as is using stock
shares (restricted and unrestricted). As the recent survey by The
Conference Board indicates that stock options are becoming less
popular as a director remuneration tool (Tonello, 2013), possibly
because of the potentially negative incentives stock options seem to
provide to directors. The only exception to this trend is that stock
options continue to be a signicant component of director remu-
neration at small rms.
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accounting conservatism. The Journal of Applied Business Research, 29(3), 885900.
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CHAPTER
Directors
7 Remuneration in the
United Kingdom
Jean J. Chen and Zhen Zhu
Remuneration Regulation
The UK is widely recognised as a world leader in corporate govern-
ance reform. In the wake of a series of corporate failures (e.g. the
BCCI and Maxwell cases) in the early 1990s, the publication of the
Cadbury Report (Cadbury Report, 1992) in the United Kingodm
represents the rst attempt to set out a specic set of recommenda-
tions on good corporate governance practices, which has signi-
cantly inuenced the development of corporate governance codes
around the world. Furthermore, the Cadbury Report has set the
agenda for corporate governance reform in the United Kingodm, fol-
lowing which, more subsequent policy documents, principles, guide-
lines and codes of practices have been published in the United
Kingodm, keeping Britain as front runner in this eld (FRC, 2011;
Keasey, Short, & Wright, 2005; Tricker, 2009).
Specically, regulatory framework for directors remuneration
in the United Kingodm are mainly set out in two places: The
Greenbury Report in 1995 (note that the Greenbury recommenda-
tions have been incorporated into the Combined Code and its new
version of the UK Corporate Governance Code 2012 with a few
amendments, which will be discussed in more detail later), and
the Directors Remuneration Report Regulations in 2002 (issued by
the Department of Trade and Investment, DTI, and contained in the
95
96 JEAN J. CHEN AND ZHEN ZHU
relevant sections of Companies Act 2001) which will be discussed

separately in section Remuneration Reporting.1 In line with the
comply or explain approach adopted by the UK corporate govern-
ance system, the regulatory framework is complemented by market
Listing Rules2 and good practice principles issued by investor asso-
ciations3 (BIS, 2012b).
THE GREENBURY REPORT 1995

In response to growing concern about the excessive executive pay
packages, especially in relation to share options and other additional
sources of remuneration, the Greenbury Committee was set up in
January 1995 to identify good practice in determining and accounting
for directors remuneration. The committee reported in July 1995 (The
Greenbury Report in 1995), calling for establishing a balance between
executives rewards and their performance (Solomon, 2010). In parti-
cular, the Greenbury Report strengthened the role of independent
non-executive directors in the pay-setting process, and signicantly
increases the amount of required disclosure on directors remuneration
(Keasey & Watson 1991). The main recommendations of the
Greenbury Report were as follows (Bruce & Buck, 2005; Keasey &
Watson 1991; Tricker, 2009):
Remuneration committees should consist solely of independent

non-executive directors.
The remuneration committee should report to shareholders
annually.
The remuneration report should include:
I. The companys policy regarding the setting of executive
remuneration.
1
For rms in nancial sector, there are additional rules including FSA (the
Financial Service Authority) Remuneration Code (2009, revised in 2010)
and Remuneration Disclosure Requirements 2010. The revisions seek to
align the Codes provisions with recent international work on remuneration
principles. In particular, the remuneration principles in the Third Capital
Requirement Directive (known as CRD3), and the Committee of European
Banking Supervisors (CEBS) Guidelines on Remuneration Policies and
Practices (CEBS guidelines), provide guidance on the implementation and
interpretation of the remuneration principles in CRD3, while Remuneration
Disclosure Requirements 2010 is relating to the implementation of remu-
neration disclosure requirements based on those set out in the CRD3.
2
The Listing Rules 2004, issued by FSA (the Financial Service Authority).
3
For example, ABI Principles of Remuneration 2011, issued by the
Association of British Insurers.
Directors Remuneration in the United Kingdom 97
II. Full details of all elements of the remuneration package

(including share options and pension entitlements) of each
named individual director.
III. Details and reasons for directors contracts exceeding one
year, aimed at avoiding excessive golden handshakes (sever-
ance pay).
Shareholders approval is required for the adoption of long-term
incentive plans (LTIPs), which should be linked to long-term per-
formance criteria.
Share options should never be issued at a discount, should be
phased in rather than issued in one large block and should not
be exercisable in less than three years.
Firms might compare the merits of executive share options
(ESOs) with alternative forms of long-term performance-
contingent pay component.
As it can be seen, the Greenbury Report focused solely on the

process of determining directors remuneration. It reemphasised
the importance of independent non-executive directors (INEDs) in
the governance of this process by recommending that remunera-
tion committees should consist solely of INEDs. It also went
further and prescribed the inclusion of three INEDs on the board
in contrast to a minimum of two INEDs recommended by Cadbury
Report (Cadbury Report, 1992; Keasey & Watson 1991). In addi-
tion to the emphasis on the role of INEDs in the remuneration
committee, the Greenbury Report signicantly increased the amount
of required disclosures on directors remuneration (Keasey &
Watson 1991). Specically, an annual remuneration report made
by the remuneration committee on behalf of the board should
be provided, as part of companys annual report, accounting to
shareholders for companys compensation policy, including: levels,
comparator groups of companies, individual components, perfor-
mance criteria and measurement, pension provision, contracts of
service, and compensation commitments on early termination (The
Greenbury Report in 1995). Finally, it echoed concerns over levels
of ESOs by addressing the potential drawbacks of ESOs, and
highlighted a clear preference for LTIPs (Bruce & Buck, 2005;
Conyon, Peck, Read, & Sadler, 2000), which have resulted in
a parallel decline in the relative signicance of ESO schemes and
increase in the uptake of LTIP schemes in large UK companies
executive pay packages (Bruce & Buck, 2005). In general terms,
these recommendations have seen widespread approval and rapid
implementation among large UK listed companies.
THE COMBINED CODE ON CORPORATE GOVERNANCE 1998

AND ITS SUBSEQUENT REVISIONS
Following the publication of the Hampel Report (1998), the
Hampel committee issued the Combined Code (1998), consolidating
the Cadbury, Greenbury and Hampel recommendations into a series
of principles of good governance practice. Under each main princi-
ple, there was a list of code provisions, giving details of how the
principles may be attained. Specically, the 1998 Code consisted of
18 principles and 48 code provisions, setting out standards of good
practice in relation to board leadership and effectiveness, remunera-
tion, accountability and audit, and relations with shareholders.
Requirements relating to directors remuneration were set out in the
1998 Code by three principles, including the level and composition
of remuneration, procedure and disclosure, The 1998 Code retained
all the recommendations made by the Greenbury Report (see the dis-
cussion above) except that it stated the board (rather than the remu-
neration committee should report to shareholders on remuneration;
Keasey & Watson 1991). Therefore, the 1998 Code increased the
disclosure requirement for remuneration and addressed that it was
the responsibility of the board who should report to shareholders.
Importantly, the Combined Code (from its 1998 version to the
current 2012 version), which is incorporated into the London Stock
Exchanges Listing Rules, maintains the apply or explain approach
proposed by the Cadbury Report. As the Code (2012) stated, the
apply or explain approach is the trademark of corporate govern-
ance in the United Kingodm (the UK Corporate Governance Code
2012). All companies with a premium listing of equity shares on
the Main Market4 are required under the Listing Rules to make a
statement in their annual report, explaining how they have applied
the main principles, and conrming that they have complied with
the code provisions or providing explanation where they do not.
This includes provisions on the make-up and the role of remunera-
tion committees, the pay-setting process and the structure of pay.
Additionally, the Listing Rules also require shareholders to approve
any new share-based reward schemes, for all employees and not just
for directors. Companies typically seek approval every ve to ten
years for the broad structure of these schemes. This is done by
means of a binding shareholder resolution at the AGM (BIS, 2012a,
2012b). Following the 1998 Combined Code, a series of revisions to
the Code was subsequently issued by the Financial Reporting
4
The listing regime of London Stock Exchange includes two types of listing:
a premium listing and a standard listing refer to LSE website for more
details.
Council (FRC), which undertakes regular review of the impact and

implementation of the Code and its associated guidance to ensure
that it continues to work effectively. The last signicant revisions to
the Combined Code was made in 2003 when it was updated to
incorporate recommendations from the Higgs Report (2003) on the
role of non-executive directors and the Smith Report (2003) on
audit committees. Further minor amendments were made in 2006
and 2008 following the reviews by the FRC. In particular, in the
2003 edition of the Code, the standard expectations of corporate
governance had once again been sharpened including the increasing
monitoring roles of remuneration committees. Specically, the 2003
Code readdressed remuneration issue, aiming to avoid excessive
remuneration which displays little relation to corporate perfor-
mance, including new supporting principle relating to pay compari-
son (benchmarking), and the working procedures for remuneration
committee; new provisions relating to remuneration committee com-
position, non-executive directors remuneration, and restriction for
executive director to serve as non-executive director elsewhere;
revised provisions relating to remuneration committee responsibil-
ities, reducing compensation commitments in the event of early ter-
mination, and notice periods which should not be beyond one year
(Keasey & Watson 1991; Tricker, 2009).
THE UK CORPORATE GOVERNANCE CODE 2010

Following a review and consultation process undertaken in 2009,
the FRC issued a new edition of the Code in June 2010, now
renamed as the UK Corporate Governance Code (the 2010 Code)5
under the background of the global nancial crisis and consequent
decline in economic conditions since the publication of the previous
2008 Code. The changes involved two aspects: rst, some structural
changes to the Code were made to promote better board behaviour
by focusing attention on the code principles rather than more
detailed code provisions.6 Second, adopting those recommendations
5
The 2010 Code applies to accounting period beginning on or after 29 June
2010.
6
Refer to the appendix A of May 2010 consultation document of FRC for
specic structural changes to the 2010 code. In particular, Section E in the
2008 Code, which was addressed to institutional investors, has been moved
to Schedule C in the 2010 Code and then been removed entirely when the
new Stewardship Code 2010 for institutional investors came into effect
from July 2010. The Stewardship Code 2010 and its revised version of
2012, set out good practice for institutional investors on monitoring and
engaging with investee companies and reporting to clients and beneciaries.
of the Walker Review (2009)7 that the FRC considered should apply
to all listed companies. As a consequence, the corporate governance
standard in the United Kingodm has once again been improved
signicantly.
The major changes to the content of the 2010 Code included
(refer to the May 2010 consultation document of FRC):
To encourage boards to be well balanced and avoid group

think, there are new principles on the composition and selection
of the board, including the need for appointing members based
on their merit, against objective criteria, and with due regard for
the benets of diversity, including gender diversity.
To promote proper debate in the boardroom, there are new
principles on the leadership of the chairman, the responsibility
of the non-executive directors to provide constructive challenge,
and the time commitment expected of all directors.
To help enhance the boards performance and awareness of its
strengths and weaknesses, the chairman should hold regular
development reviews with each director and board evaluation
reviews in FTSE 350 companies should be externally facilitated
at least every three years.
To increase accountability to shareholders, all directors of FTSE
350 companies should be re-elected annually and chairmen are
encouraged to report personally on how the principles relating
to the leadership and effectiveness of the board have been
applied.
To improve risk management, the companys business model
should be explained and the board should be responsible for
7
The Walker Review is an independent review of governance in banking sec-
tor with specic focus on executive remuneration and the role of the board
of directors carried out in early 2009 in reaction to the latest international
nancial crisis which came to a head in 20082009 in the UK. After a pub-
lic consultation, the nal version was published in November 2009, reach-
ing a number of important conclusions that seem equally appropriate for
other types of organisation: (i) addressing the effectiveness of the combined
code and the comply or explain approach; (ii) weaknesses in board effective-
ness and improvement measures; (iii) risk management role of the board;
(iv) the role of core institutional investors; (v) improvements in the structur-
ing of remuneration policy including more power for remuneration commit-
tees to scrutinise rm-wide pay; Remuneration committee to oversee pay of
high-paid executives not on the board; Signicant deferred element in bonus
schemes for all high-paid executives; Increased public disclosure about pay
of high-paid executives; Chairman of remuneration committee to face re-
election if report gets less than 75% approval (Solomon, 2010, p. 62, The
Telegraph, 16/07/2009).
determining the nature and extent of the signicant risks it is

willing to take.
Performance-related pay should be aligned to the long-term
interests of the company and its risk policies and systems.
In terms of compensation polices, they remained largely

unchanged. There were only a few minor additional requirements as
highlighted below (KPMG, 2010, p. 13, May 2010 consultation
document of FRC):
It explicitly states as a principle that performance measures

should be designed to support the long-term success of the
company.
Non-nancial performance measures should be used in incentive
plans where appropriate. It is not suggested that this will always
or generally be the case.
The proposal that bonuses should be linked to risk-adjusted per-
formance measures is not included in the Code. However, incen-
tives should be compatible with risk policies and systems.
Consideration should be given to the use of clawback provisions
which permit the company to reclaim variable remuneration in
exceptional circumstances of misstatement or misconduct.
The 2010 Code adopted the recommendations from the 2009

Walker Review where appropriate, and emphasised the need for
performance-related pay to be aligned with the long-term interest of
the company and with the companys risk policies and control sys-
tems, and the use of clawback arrangement to enable the company
to reclaim performance-related payments in certain circumstances.
THE UK CORPORATE GOVERNANCE CODE 2012

In September 2012, the updated edition of the Code was published
by FRC (the UK Corporate Governance Code 2012)8 following a
consultation seeking views on whether to amend the 2010 Code and
the associated Guidance on Audit Committees. Only limited
changes were made to the 2010 Code (refer to the September 2012
consultation document of FRC, FRC news, reported on 28/09/2012
on FRC website). They included:
FTSE 350 companies are to put the external audit contract out
to tender at least every ten years with the aim of ensuring a
8
The 2012 Code applies to reporting periods beginning on or 1 October
2012.
high-quality and effective audit, whether from the incumbent

auditor or from a different rm;
Audit Committees are to provide shareholders information on
how they carry out their responsibilities, including how they
assess the effectiveness of the external audit process;
Boards are to conrm that the annual report and accounts taken
as a whole are fair, balanced and understandable, to ensure
that the narrative sections of the report are consistent with
the nancial statements and accurately reect the companys
performance;
Companies are to disclose their policy on boardroom diversity,
including gender, any measurable objectives that have been set
for implementing the policy, and report the progress on achiev-
ing the objectives. This change was rst announced in October
2011, also came into effect from 1 October 2012;
Companies are to provide fuller explanations to shareholders as
to why they choose not to follow a provision of the Code. The
characteristics of an informative explanation are set out in the
introductory section of the Code on the operation of comply or
explain as non-binding guidance for companies and investors in
order to help companies understand what are expected of them
when they choose to deviate from the provisions of the Code,
and to provide shareholders with a benchmark against which to
judge explanations;
Companies are to disclose the use of board advisors including
executive search consultancies, board reviewers and remunera-
tion consultants. Companies that have made use of board advi-
sors are required to disclose the identity of these advisors, and
whether they have any other connections with the company.
With regard to directors remuneration, as outlined above, con-

sistent disclosure requirements in relation to the use of board advi-
sors including executive search consultancies, board reviewers and
remuneration consultants have been introduced to the 2012 Code.
Specically, it is now clear that where remuneration consultants are
appointed, they should be identied in the annual report (newly
added) and a statement made as to whether they have any other
connection with the company. Same disclosure requirements apply
to executive search consultancies and board reviewers as well
(September 2012 consultation document of FRC: 14). Accordingly,
transparency in the use of remuneration consultants has been
improved. It is consistent with the overall purpose of the 2012 revi-
sion which are improved information disclosure and strengthened
role of audit committees so as to give investors greater insight into
what company boards and audit committees are doing to promote
their interests (chairman of the FRC Baroness Hogg, reported by
FRC on 28/12/2012). Looking ahead, the FRC will carry out further
consultation on whether changes are needed to those parts of the
Code dealing with remuneration when the governments legislation
on remuneration reporting and voting has been nalised. Any
changes following this consultation will be effected in the next edi-
tion of the Code.
Remuneration Design (Schemes)

Leaving aside perquisites, pension rights,9 and other additional ben-
ets,10 executive directors pay packages in most of the large UK
companies contain three basic elements: (i) base salary, (ii) bonus
and (iii) long-term performance-contingent pay, that is equity-based
compensation, principally ESOs and LTIPs (Bruce, 2005; Conyon &
Murphy, 2000; Jenson, Murphy, & Wruck, 2004; Murphy,
1999).11 The key components of UK executive directors remunera-
tion are discussed below:
(1) Base salary

Base salary is received by an executive in accordance with the
terms of his contract (Mallin, 2007). That is, it is the xed
component in executive compensation contract, not related to
any performance conditions. Base salary is usually determined
through competitive benchmarking, based primarily on general
industry and peer group salary surveys, typically adjusted for
company size. Such method used in determining base salaries
formalizes and reinforces the observed relation between com-
pensation and size, and moreover, contributes to a ratchet
effect in executive base salary levels. Base salary is essential as
most other components such as target bonus, option grants are
measured relative to base salary levels (Murphy, 1999).
(2) Annual Bonus
An annual bonus plan typically ties to a rms single-year
(usually the previous nancial year) accounting performance.
The payments may be made in cash or shares or a combina-
tion. While companies use a range of performance measures,
almost all companies rely on some measure of accounting
9
Pension rights refer to both compulsory and voluntary company contribu-
tions to pension plans.
10
Sometimes executive compensation contract contains provision for sever-
ance pay as well, which is not considered in our discussion.
11
Among those pay components, base salary is also called xed pay, and
other components called variable pay or contingent pay.
prots, for example EBIT, ROE, EPS growth (Murphy, 1999).

There is a trend that an increasing number of companies use
multiple performance measures rather than a single measure in
their annual incentive plan. Meanwhile, non-nancial perfor-
mance measures, such as individual performance, and broad
strategic and operational targets, are increasingly adopted by
companies as complements to nancial measures. For instance,
it is reported that in 2010, more than 60% of FTSE 100 com-
panies use three or more measures for their annual bonus
plans, while about 80% of FTSE 250 companies use either two
or three measures, and the most common combination of per-
formance measures is some form of prot measure in conjunc-
tion with personal performance and corporate/strategic targets
(KPMG, 2010).
For large UK companies, many of them may also have
deferred annual bonus (DAB) plans, which involve deferral of
part of the annual bonus into company shares (deferred
shares), restricted for a period of time (most commonly three
years). Some (but not all of) DAB plans provide for matching
shares, which typically vested to the extent that performance
conditions are met over the performance period, with EPS,
TSR, or some forms of combination the most common perfor-
mance measures (KPMG, 2010).
(3) Share Option Plans
Share option plans (ESOs) are contracts which give the recipient
the right to buy shares of stock at a pre-specied exercise price
over a pre-specied time period, and therefore provide a direct
link between executive pay and share-price performance (more
specically, a direct link between managerial rewards and share-
price appreciation) (Conyon & Murphy, 2000; Murphy, 1999).
ESOs typically become vested (exercisable) over time, that is
restricted share options (e.g. 25% might become exercisable
in each of the four years following grant). In the United
Kingodm, the structure of share option contract may be more
complex because the vesting of the option often depends on
meeting a specic performance condition (performance criteria)
with real EPS growth the most common measurement
(KPMG, 2010, p. 57). As Conyon et al. (2000) commented
that unlike US CEO option contract, the stock options
received by UK CEOs are often subject to performance criteria
prior to vesting. That is, the right to exercise the executive
option is contingent upon the achievement of company perfor-
mance targets, and not simply elapsed time.
Interestingly, it is revealed in the United Kingodm, there is
little cross-sectional variation in the practice of option grant-
ing. Most options expire in 10 years and are granted with
exercise prices equal to the fair market price on date of grant.

Consequently, in terms of the form of ESO schemes, there is a
tendency towards standardization (Bruce, 2005; KPMG,
2010; Murphy, 1999), which may be explained in part by
favourable tax and accounting treatments (Murphy, 1999).
The most widely used method for calculating the companys
cost of granting an executive option is the Black-Scholes for-
mula 1973, which demonstrates that under the assumption of
risk-neutrality, option values can be estimated by computing
the expected value of the option upon exercise and discounting
this expected value to the grand date using the risk free-rate
(Conyon & Murphy, 2000; Murphy, 1999).
ESO plans now constitute the single largest component (on a
Black-Scholes basis) of executive pay in the US owning to the
explosion in stock option grants during the period of 1980s
and 1990s, which was driven by a combination of political,
economic, institutional and cultural factors (Murphy, 1999).
By contrast, in the United Kingodm, the 1990s witnessed a sig-
nicant decline in the relative importance of ESO schemes
within executive pay packages due to institutional and cultural
constrains imposed. This trend has been continuing and it is
reported that by year 2010, less than 20% of the FTSE top
350 companies used ESO schemes to reward their executives
(KPMG, 2010).
(4) Long-Term Incentive Plans
In the United Kingodm, LTIPs are typically grants of shares
that become vested (ownership is transferred to the execu-
tives) upon achievement of certain performance criteria (also
known as LTIP share grants or performance share grants).
In particular, for the performance-contingent UK grants,
LTIPs may be regarded as a conditional ESO scheme with a
zero exercise price, whereby it is shares rather than a right to
purchase shares which are rewarded to eligible executives
(Bruce, 2005). Awards under LTIPs are contingent on the
achievement of a level of relative performance evaluated
against comparator groups over a specied period of time,
commonly three years (there are essentially three bases for
comparison, which may be employed individually or in combi-
nation: a given real growth in the chosen performance yard-
stick, e.g. RPI + n% growth in TSR, a published market/sector
index, e.g. the FTSE 250 index, or a peer group, with peer
groups the most common benchmark against which to evaluate
performance) (Bruce, 2005; KPMG, 2010).
There is a remarkable phenomenon that the decline in the
relative signicance of the ESO schemes within executive pay
package has been matched by the parallel increase in the role
100%
90%
80%
70%
60%
2002
50%
2009
40%
2010
30%
20%
10%
0%
LTIPs ESOs
Figure 1: Percentage of Using LTIPs in FTSE 100 Companies 20022010. Source: The
High Pay Commission (2011).
of LTIPs since 1990s. The shift towards LTIPs in large UK

companies has become signicant after the Greenbury Report
in 1995 (Bruce, 2005). By 2010, around 80% of the FTSE top
350 companies used LTIPs to make rewards to their executives
(KPMG, 2010). And for FTSE 100 companies, this gure was
even over 90%, while the proportion of using share options in
FTSE 100 companies has declined to only around 30%, as
shown in Figure 1.
Interestingly, it is argued that the remarkable movement
away from ESOs towards LTIPs raises a signicant governance
issue in the sense that ESOs may automatically guarantee
rewards in a rising market irrespective of corresponding
increased executive effort, whereas by focusing on relative per-
formance conditions, LTIPs are relatively insensitive to broad
market trends but critically, it may also have the potential to
reward executives even when share-price performance is declin-
ing. Therefore, compared with ESOs, more complex, less
standardised and transparent LTIP plans (partially owning to
relatively less regulatory constrains) may be potentially more
susceptible to abuse by self-serving executives (Bruce,
2005; Bruce & Buck, 2005).
Finally, we look into the executive directors remuneration in

the UK-listed companies based on a sample of FTSE All-Share non-
nancial companies over the period of 20022011. The remunera-
tion data is collected from BoardEx database. Table 1 presents the
descriptive statistics on CEO annual compensation, and the average
Table 1: Executive Directors Compensation in UK Listed Companies.
Variable N Mean S.D. Min 0.25 Median 0.75 Max
Panel A. Descriptive statistics on CEO compensation (20022011) (000s)

Salary 2733 449.56 265.47 0.00 270.00 393.00 568.00 2671.00
Bonus 2679 361.81 506.24 0.00 67.00 205.00 454.00 5137.00
Total Salary + Bonus 2739 802.46 680.28 0.00 378.00 600.00 985.00 5430.00
Total Equity Compensation 2179 1414.61 3332.41 0.00 236.00 541.00 1372.00 87901.00
Total Annual Compensation 2722 1939.88 3362.00 11.00 558.00 1018.00 2097.00 90151.00
Directors Remuneration in the United Kingdom

Panel B. Descriptive statistics on executive average compensation (20022011) (000s)
Salary 2764 331.51 196.16 0.00 203.50 287.00 411.17 2671.00
Bonus 2728 240.84 301.70 0.00 54.50 147.04 317.38 3333.33
Total Salary + Bonus 2770 566.57 440.54 0.00 282.75 440.88 706.25 3447.67
Total Equity Compensation 2366 895.20 1904.35 0.00 160.50 378.38 918.50 41203.50
Total Annual Compensation 2757 1297.44 1815.91 8.00 416.00 748.00 1457.00 33988.80
Source: Original data are collected from BoardEx database.

Notes:
1. The sample consists of all the non-nancial companies from FTSE All-Share Index over nancial year 20022011.
2. The valuation of salary and bonus is the amount that is actually paid during the period.
3. The total value of equity-based compensation is the sum of value of shares awarded, value of LTIPs awarded and estimated value of options awarded (using
Black-Scholes option pricing model).
4. The total annual compensation is the sum of the value of cash compensation (salary plus bonus) and equity-based compensation.
107
Total Equity Compensation Bonus Salary
Figure 2: CEO Compensation in UK Listed Companies Over 20022011 (000s).

Notes:
1. The sample consists of all the non-financial companies from FTSE All-Share Index over
financial year 20022011.
3. The total value of equity-based compensation is the sum of value of shares awarded,
value of LTIPs awarded and estimated value of options awarded (using Black-Scholes
option pricing model).
4. The total annual compensation is the sum of the value of cash compensation (salary
plus bonus) and equity-based compensation.
annual compensation of all the companys executive directors

(including the CEO), supported by Figures 2 and 3, demonstrating
the historical trend of the mean value of CEO compensation and
executive average compensation over the sample period.
Panel A of Table 1 illustrates CEO total annual compensation
and its components for the whole sample period. On average, a
CEO receives 1,939,880 total annual compensation each year,
which includes 1,414,610 equity compensation (accounting for
63.81% of the total remuneration), 449,560 salary (accounting for
20.28% of the total compensation), and 361,810 bonus (account-
ing for 16.32% of the total compensation). Thus, the equity-based
compensation (the sum of share options, current share rewards and
LTIPs) emerges as the largest component of CEO compensation in
UK listed companies. Figure 2 demonstrates the evolution of CEO
compensation over the sample period. Firstly, there appears an over-
all persistent rise in CEO total compensation level with an average
of more than twofold growth from 1134,560 in year 2002 to
2,378,900 in year 2011. The total annual compensation increased
at an average rate of 12.8% per annum that has gone much beyond
Total Equity Compensation Bonus Salary
Figure 3: Executive Average Compensation in UK Listed Companies Over 20022011

(000s).
Notes:
1. The sample consists of all the non-financial companies from FTSE All-Share Index over
financial year 20022011.
3. The total value of equity-based compensation is the sum of value of shares awarded,
value of LTIPs awarded and estimated value of options awarded (using Black-Scholes
option pricing model).
4. The total annual compensation is the sum of the value of cash compensation (salary
plus bonus) and equity-based compensation.
the annual performance of the FTSE All-Share Index (the Index)

during the same period (the 10-year annualised total return of the
Index) which is only 4.8%,12 indicating that there is hardly a link
between executive pay and rm performance in UK listed compa-
nies. Meanwhile, accompanying the strong upward trend, there also
appears some volatility in the level of CEO total compensation.
Three temporary declines in CEO total compensation appeared in
year 2006, 2008 and 2011, coinciding with the Index performance
uctuations which decreased signicantly in year 2006, 2008 and
201113 (the biggest drop in year 2008 is in connection with the glo-
bal nancial crisis during 20082009). Moreover, the rise of
equity-based compensation contributes the most to the increase of
CEO total compensation over the sample period, which makes up
12
FTSE All-Share Index factsheet, as at 30 June, 2011, from FTSE website.
13
The year-on-year performance (total return) of FTSE All-Share was
16.8% in 2006 (dropped from 22.0% in 2005), 29.9% in 2008, 3.5% in
2011 respectively (FTSE All-Share Index factsheet, as at 31 December,
2012, from FTSE website).
more than 60% of CEO total compensation in the sample rms (an
average of 59.34% of the total compensation in year 2002 to
62.98% in year 2011).
The executive compensation (see Panel B of Table 1 and
Figure 3) shows the same patterns with CEO compensation as dis-
cussed above (in terms of the pay structure and the historical trend),
but the average pay level of executive directors is signicantly lower
than the CEOs. Specically, on average, an executive receives
1,297,440 total annual compensation each year (compared with
GBP 1,939,880 of the CEOs), including an average of 331,510 sal-
ary (accounting for 22.68% of the total compensation), 240,840
bonus (accounting for 16.48% of the total compensation), and
895,200 equity-based compensation (accounting for 61.24% of the
total compensation).
Remuneration Reporting
DIRECTORS REMUNERATION REPORT REGULATIONS 2002
Following a consultation document on directors remuneration
the UK government announced that further reform on remunera-
tion disclosure would be required, and as a result, the Directors
Remuneration Report Regulations 2002 (the Regulations14), speci-
fying the content of directors remuneration reports, came into
force for all UK incorporated quoted companies from 31
December 2002, which are contained in the relevant sections of
the Companies Act 2006.15 As stated by the DTI, the purpose
of the legislation is to: enhance transparency in setting directors
pay; improve accountability; and provide for a more effective
performance linkage.
The Regulations require listed companies to produce a detailed
annual directors remuneration report, which should include the fol-
lowing information (Ferrarini, Moloney, & Vespro, 2003, p. 17):
(i) Remuneration committee. The report must name each director

who was a member of the committee; The report also must
name any person who provided the committee with advice or
service;
(ii) Remuneration policy. The report must include a statement of
the companys remuneration policy for the following nancial
year and for subsequent nancial years. The statement must
14
Schedule 8 of the Large and Medium-sized Companies and Groups
(Accounts and Reports) Regulations 2008.
15
Sections 420422, 439 Companies Act 2006.
include, for each director, detailed summary of any perfor-

mance conditions chosen to which any entitlement to share
options or LTIPs is subject, the reason for using of the perfor-
mance conditions and the performance assessment methods;
other terms and conditions for each director s remuneration,
and contract duration, notice period and termination pay-
ments under such contracts; the report much also contains a
performance graph which sets out the total shareholder return
of the company;
(iii) Detailed audit nancial information. This should include for
each director during the nancial year, emoluments, share
options, LTIPs, pensions, sums paid to third parties in respect
of directors duties.
Moreover, the Regulations require listed companies to hold a

shareholder vote on that report. It is required that either share-
holders should be allowed to vote on the remuneration report at the
AGM (annual general meeting), or that special procedures are created
to allow shareholders to move a resolution on remuneration at the
AGM, which is known as say on pay (Keasey & Watson 1991).
In sum, the key requirements of the Regulations involve the fol-
lowing two aspects:
First, it sets out the legal requirement prescribing the form and
content of the directors remuneration report.
Second, it sets out the mandatory requirement that companies
must submit their remuneration report to an annual advisory
vote at their AGM, separately from votes on any other matters
(According to the Regulations, Section 7, the existing directors
must ensure the resolution is put to the vote of the AGM. If they
fail to do so, each existing director is guilty of an offence and
liable to a ne).
Taken together, the regulations represent the largest step

towards full disclosure to date (Roach, 2002) which have greatly
improved the transparency on executive remuneration in the United
Kingodm by enforcing detailed disclosure of executive remuneration
in the UK-listed companies. Moreover, the regulations emphasise
the role of shareholders in executive pay setting and encourage
shareholders to engage in companies pay-setting process by giving
them (advisory) voting right on remuneration reports.
THE 2012 DIRECTORS REMUNERATION REPORTING REFORM

Following the publication of a discussion paper on executive remu-
neration (BIS, 2011) seeking views on how to improve remuneration
policies in the United Kingodm, in June 2012, the UK government

announced that further reforms are needed to tackle the failings in
the corporate governance framework for executive remuneration
that have been exposed during the latest global nancial crisis. This
included (i) Giving shareholders more power through binding votes,
so they can hold companies to account; (ii) Boosting transparency
so that what people are paid is clear and easily understood; (iii)
Working with responsible business and investors to promote good
practice and ensure reforms have a lasting impact (BIS, 2012a).
These reforms will impact all UK incorporated quoted companies.16
The purpose of these reforms is to help restore the link between pay
and performance by giving shareholders the power to hold the com-
panies they own to account. They come in the context of a drive to
encourage stronger working relationships between company boards
and shareholders (Policy paper of BIS January 2013).
As such, the Department for Business, Innovation and Skills
(BIS) published a consultation paper of the new reporting regula-
tions for directors remuneration, which will replace rather than add
to the current reporting regulations. The new regulations are
expected to come into force from October 2013,17 alongside the
relevant sections of the Enterprise and Regulatory Reform Bill
2012,18 which will amend the relevant provisions of Companies Act
2006 and set out the shareholder voting requirements.
The draft regulations specify that the directors remuneration
report should be split into two distinct parts in order to ensure
greater transparency and facilitate the new shareholder voting
regime (BIS, 2012a):
(i) A policy report setting out a forward-looking (future) policy

on remuneration, including exit payments, and disclosure of
material factors taken into account when setting pay policy.
This part of the report will be subject to a binding vote and it
will only be legally required when there is a shareholder vote
(at a minimum this will happen every three years).
(ii) An implementation report on how the policy was implemented
in the past (reported) nancial year. This part of the report will
set out how the policy has been implemented in the reporting
16
Quoted companies, as dened by the Companies Act 2006. This means
companies registered in the UK and with equity listed on the main market in
the UK, in another state in the European Economic Area or on the New
York Stock Exchange or NASDAQ. There are around 900 such companies.
17
The regulations will replace Schedule 8 of the Large and Medium-sized
Companies and Groups (Accounts and Reports) Regulations 2008.
18
The Bill was introduced to the House of Commons on 23 May 2012, and
completed its passage on 24 April 2013.
year, including actual payments made to directors set out as a

single gure, exit payments made and disclosure of the link
between company performance and pay. It will be required on
an annual basis and will be subject to an advisory vote.
To sum up, the proposed legislation and regulations will

require:
A two-part structure to the directors remuneration report com-

prising a forward-looking statement relating to the companys
future pay policy (the Policy Statement) and an implementation
report disclosing pay received or earned and termination pay-
ments made with respect to the reported nancial year (the
Implementation Report);
A binding shareholder vote on the Policy Statement, every three
years or sooner if there are changes made to it; and a non-
binding annual shareholder vote on the Implementation Report;
The new regime therefore will provide a more robust framework
within which companies and shareholders can set, agree and
implement pay policy so as to restore a stronger, clearer link
between pay and performance in UK companies.
PROBLEMS IN UK EXECUTIVE REMUNERATION
As we mentioned earlier, the recent nancial crisis and the subse-
quent economic downturn in western economies have once again
provoked the debate on directors compensation especially in terms
of the highly controversial executive pay-setting issue. In particular,
in the United Kingodm, the concern has focused on the problems
that the link between pay and performance has grown weak; and
the constant, ratcheting up of executive pay is unsustainable
(Business Secretary Vince Cable; BIS, 2012a). There has emerged a
consensus among business leaders, investors, academics and govern-
ance experts that the rising executive pay is not linked to rm per-
formance (BIS, 2012a).
It is revealed that the average total remuneration19 of FTSE 100
CEOs had a fourfold increase from an average of 1m to 4.2m
(13.6% a year) for the period 19982010. This is faster than the
increase in the FTSE 100 index, retail prices or average remunera-
tion levels across all employees for the same period (BIS, 2012b),
19
This gure includes salary, bonus, deferred bonus, other benets, long-
term incentives, share options and pensions.
Executive remuneration in FTSE 250 companies has also risen fast,

although at a slower rate, while growth in average CEO salaries in
Small Cap and AIM companies has been more modest (Hutton
Review, 2010, cited in BIS, 2012b, p. 6). Consistent with the above
ndings, our statistic data on executive directors remuneration in
FTSE All-Share companies over years 20022011 also suggest that
there is hardly a link between executive pay and rm performance in
UK listed companies (see the discussion in section Remuneration
Design (Schemes)). Moreover, there is compelling evidence of a
disconnection between pay and performance in UK companies.
Researchers have studied the relationship between executive
directors pay and long-term performance in the United Kingodm,
whereas little evidence of the link between pay and performance has
been found (refer to the recent evidence of Bell & Reenen, 2011;
Gregg et al., 2010; BIS, 2012b). In particular, research also revealed
that there is an asymmetric sensitivity of pay to performance. That
is, top executive pay appears to go up when performance is
good, but there is comparatively less elasticity downwards when
performance is average or poor. As a result, average levels of execu-
tive pay have ratcheted upwards (Bell & Reenen, 2011, cited in BIS,
2012a).
Meanwhile, the increasingly complex pay structure moving
towards incentive payments (LTIPs, share options, and bonus) over
the last decade (BIS, 2012b) has led to increasing length and com-
plexity of company reports, which make it more difcult for report
users to identify the main facts and gures amongst lots of other
detailed information in the current Directors Remuneration Report.
It is clear that regulations for pay reporting have not kept up with
developments in market practice (BIS, 2012b). In particular, despite
companies already being required to give full disclosure of remunera-
tion under the Directors Remuneration Regulations (2002), compa-
nies do not give a clear gure for total remuneration for each
individual director nor do they seem to provide a clear line of sight
between levels and structure of remuneration and directors perfor-
mance in meeting the companys strategic objectives. It is also high-
lighted that in some areas the Regulations themselves add to some of
this complexity as it can be difcult to understand and that clarica-
tion of what is expected could improve compliance in these areas
(BIS, 2012b). Feedback to the consultation on company reporting led
by BIS also suggests that without access to better and more concise
information about pay, particularly on the link to performance,
shareholders nd it difcult to hold companies to account (BIS,
2012b).
Therefore, two problems in UK remuneration practices have
been highlighted in recent scrutiny which are the divergence of
executive pay from rm performance and decreased transparency
caused by increasingly complex remuneration report, indicating the

failings in the corporate governance framework for executive remu-
neration (BIS, 2012a).
CHALLENGES FOR REMUNERATION POLICY

In response to the failure in the governance of directors remunera-
tion, in June 2012, the government has announced a comprehensive
package of reforms to address these failures, including binding
shareholder votes and greater transparency (see detailed discussion
in previous section). On 25 April 2013, the Enterprise and
Regulatory Reform Bill 2013 received Royal Assent and has become
a law which includes new rules relating to quoted companies disclo-
sure of directors remuneration and shareholder approval of direc-
tors remuneration reports. It gives effect to the new regime from
1 October 2013. The nal regulations remain unchanged from the
draft published in June. Once in force, directors remuneration
reports will be split into two parts: a forward-looking pay policy
report, which will be subject to the binding shareholder vote; and
a report on how that policy was implemented over the previous
year, which will be subject to an advisory vote. The new regulations
will apply to UK incorporated quoted companies with nancial
years commencing on or after that date.
However, there are limitations to how effective these legislations
will be alone. In particular, shareholders and remuneration commit-
tees, as currently constituted, arguably lack the will to curb execu-
tive pay. Since most remuneration committee members are current/
former lead executives themselves, they have strong sympathies with
the executives whose pay levels they are deciding, and operate on
the understanding that if their pay award is generous, they will bene-
t from decisions made by other committee members, as part of a
general upward trend in pay awards. In recent years, the prolifera-
tion of international investors and short-term shareholdings on UK
equity market (FRC, 2011, 2012a, 2012b) means that it is increas-
ingly unlikely that shareholders are actually in a position to hold the
executive to account. Therefore, to instil these changes in compa-
nies governance culture and behaviour will require the complement
of corporate governance codes and guidelines (FRC, 2012a, 2012b).
Acknowledgements
The authors are grateful for the nancial supported provided by the
National Social Science Foundation of China (ID: 10ZD&035), the
National Natural Science Foundation of China (ID: 71132001) and
the Programme for Changjiang Scholars and Innovative Research

Team in Nankai University (PCSIRT).
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CHAPTER
Directors
8 Remuneration
in Germany
Markus Stiglbauer, Julia Wittek and
Sven Thalmann
THE GERMAN TWO-TIER SYSTEM
In general, there are two common sets of rules when it comes to cor-
porate governance systems: one-tier board systems and two-tier
board systems. Whereas the one-tier board system is primarily found
in Anglo-Saxon countries, Germany is one among other countries
like Finland, Austria or Denmark that are well-known for their two-
tier system. The main difference between these two systems is that in
the one-tier system both executive and non-executive directors form
one board, the board of directors, while the two-tier system follows
the concept of an organizational separation of management and
supervision implemented through the management board (Vorstand)
and the supervisory board (Aufsichtsrat). This principle of separa-
tion which applies for all stock corporations regardless of their size
and workforce is granted by the German Stock Corporation Act
(GSCA Aktiengesetz) which prohibits a simultaneous membership
on both boards of the same company ( 105 GSCA).
According to 76 GSCA the management board is in charge of
the management of the rm and its representation in and out of
court ( 78 GSCA). The duties of the supervisory board include the
appointment and dismissal of board directors ( 84 GSCA), moni-
toring the management board as well as approving fundamental
business decisions ( 111 GSCA; Stiglbauer, Fischer, & Velte,
2012). The members of the supervisory board are elected by the
shareholders at the general meeting ( 101 GSCA), as referenced in
119
120 MARKUS STIGLBAUER ET AL.
Figure 1: German Two-Tier System. Source: Stiglbauer (2010).
Figure 1. In Germany the supervisory board consists of at least three

up to a maximum of 21 members depending on the companys share
capital but the board number has to be divisible by three ( 95
GSCA).
Major stock corporations are subject to employee representa-
tives on the supervisory board (co-determination). This means
that depending on the size of the company the supervisory board
must comprise two thirds of shareholder representatives and one
third of employee representatives for companies with more than
500 employees ( 4 One-third Participation Act) or one half of
shareholder and the other half of employee representatives for
companies with more than 2,000 employees, respectively ( 7
Co-Determination Act). For major stock corporations, in the event
of a tie vote, the chairman of the supervisory board has a casting
vote according to 29 Co-Determination Act. In order to prepare
its deliberations and resolutions or for supervision purposes, the
supervisory board is recommended to appoint one or more commit-
tees from among its members ( 107 GSCA). This includes an audit
committee of which the main tasks are the supervision of accounting
processes, the efciency of risk management, and internal control
systems as well as external audit ( 107 GSCA). Unlike committees
in Anglo-Saxon countries, German committees are very restricted in
their authorities and act in a more preparatory way (Ziemons,
2000). The main idea behind that limitation is that decisions should
only be made with the consent of the supervisory board and cannot
be delegated to single board members ( 107 GSCA).
REMUNERATION REGULATION OF THE MANAGEMENT BOARD

AND SUPERVISORY BOARD
In general, the remuneration of the management board and the
supervisory board is regulated in the GSCA ( 87, 113 GSCA). As
the GSCA does not dene a specic structure of the remuneration of
management and supervisory board members in German listed
Directors Remuneration in Germany 121
companies, the German Government commission introduced the

German Code of Corporate Governance (GCCG) in 2002 (Schaller,
2011). The GCCG affects the structure of the remuneration, as
German listed companies have to submit a declaration of conformity
with the GCCG and have to explain every departure from the Code
(Schaller, 2011). The guidelines regarding the remuneration of the
management board are to be found in the article 4.2 and for the
supervisory board in the article 5.4 of the GCCG. Due to the ever-
rising quest for sustainability and transparency, the German
Government has increasingly concerned itself with the remuneration
of managers in the past years.
Besides the already existing GCCG since 2002, the German
Government passed the Management Board Remuneration
Disclosure Act (VorstOG Vorstandsvergtungs Offenlegungs-
gesetz) in 2006. The law forces publicly traded corporations
to provide detailed disclosure of both performance and non-
performance-based compensation as well as long-term incentives of
each board member in the notes. Originally, the law was introduced
to give companies an incentive to establish appropriate, perfor-
mance-based management compensation due to increased transpar-
ency (Stiglbauer et al., 2012).
Unfortunately the plan failed to succeed. Due to a lack of bind-
ing standardized presentation in the annual reports like, for exam-
ple, in the UK, companies used this loophole to report management
salary gures in such a circumstantial way that it was almost impos-
sible to comprehend or compare (Ribaudo, 2006). Against all expec-
tations, salaries even increased and it was argued that one cannot
separately evaluate the performance of individual board members
(Mller, 2009). With this and the nancial crisis taking its toll in
2008, the Act Regarding the Appropriateness of Management
Boards Remuneration (VorstAG Gesetz zur Angemessenheit der
Vorstandsvergtung) came into force on August 5, 2009 (Klhn,
2012). The basic idea of this law is to link the variable compensa-
tion of the management board to the companys development on the
basis of several years assessment data. The criteria for the assess-
ment of the management boards remuneration have been tightened
and are more specic than before.
Thus, the supervisory board can reduce the remuneration if the
companys business situation deteriorates to such an extent that
such remuneration could not be justied (GSCA 87; Klhn, 2012).
For example, before this regulation, the supervisory board was
entitled to reduce the managements compensation in case of great
unfairness for the company. Now, after the introduction of the
VorstAG, the supervisory board is expected to cut down manage-
ment compensation to a reasonable level (Klhn, 2012). Due to the
new regulation the supervisory board is not only given a stricter
responsibility in judging the appropriateness of the management

boards compensation, it is also held liable for agreeing to unreason-
able high management remuneration (GSCA 116).

REMUNERATION OF THE MANAGEMENT BOARD
In exchange for their know-how and managing abilities, the man-
agement board has to be granted an appropriate remuneration sys-
tem which is set by the full supervisory board. As mentioned before,
the GSCA is quite general when it comes to board remuneration
which is why it is also very useful to look at the German Code of
Governance. According to the GCCG, the supervisory board is
responsible for the determination of the total compensation of each
board member which includes monetary compensation components,
retirement benets, other benets, especially in the event of termina-
tion of employment, fringe benets, and benets by third parties,
which were promised or granted with regard to the work of the
management board (GCCG 4.2.3).
Moreover, the supervisory board has to ensure proportionality
between the approved compensation and the duties and perfor-
mance of such member as well as the company situation and that
the remuneration does not exceed standard remuneration without
any special reasons. Furthermore, the remuneration structure of
listed companies should be aimed at a sustainable corporate devel-
opment ( 87 para. 1 GSCA; Ringleb, Kremer, Lutter, & Werder,
2014). In order to achieve this 87 GCSA and the GCCG 4.2.3 also
recommend a variable next to a xed remuneration (Stiglbauer
et al., 2012; Velte, Weber, & Stiglbauer, 2013).
The GCCG further recommends that the monetary compensa-
tion components should comprise xed and variable components
(GCCG 4.2.3). The xed components are not performance-related
and are usually paid monthly (Rapp & Wolff, 2012). The GSCA
and the GCCG state that the supervisory board has to make sure
that variable components are based on a multi-year assessment
which considers both, positive and negative developments (GSCA
87, GCCG 4.2.3).
The variable components are performance-related and comprise
variable cash compensation and share-based compensation. The
variable cash compensation includes royalties and bonuses and is
usually paid annually. The amount of the variable cash compensa-
tion depends on the achievement of pre-dened objectives, which
may differ signicantly between companies (Rapp & Wolff, 2012).
For example, the amount of variable cash compensation may
depend on the revenues or the prot of the company. In addition,

companies may also use more than one objective for the determina-
tion of the variable cash compensation. In Germany, absolute
accounting performance measures such as EBIT (Earnings before
Interest and Taxes) are most commonly used (Gtz & Friese, 2013).
However, relative accounting performance measures such as ROA
(Return on Assets) or RONA (Return on Net Assets) and value-
based measures such as EVA (Economic Value Added) are rarely
applied. From the perspective of the value-based management, the
use of such performance measures is preferable, as they are signi-
cantly more meaningful than absolute accounting performance mea-
sures (Rapp & Wolff, 2012). In their study on board remuneration
of companies listed in the German DAX and MDAX, Gtz and
Friese (2013) found that on the average 2.6 key gures are used in
the practice for the calculation of short-term variable remuneration
and 2.2 key gures for the measurement of long-term variable remu-
neration in DAX companies. Next to personal, individual objectives,
the calculation is mainly based on accounting performance measures
as well as share-based performance measures. Moreover, the focus
on a sustainable corporate development has also become an impor-
tant issue for companies when it comes to remuneration systems.
The average long-term assessment period for variable remuneration
is 3.4 years among management boards of companies listed in the
DAX and MDAX (Gtz & Friese, 2013).
The annual general meeting often authorizes the supervisory
board to grant the management board shares or options (share-
based compensation). Regarding the design of the share-based com-
pensation, the supervisory board has numerous options. In addition
to real shares or real options, the supervisory board can grant the
members of the management board virtual shares or virtual options.
Furthermore, caps, exercise barriers, or vesting periods can be imple-
mented. In order to avoid extremely high payouts due to an excep-
tional unforeseen performance of the share price, caps are often
installed. Exercise barriers dene when the respective management
board members may sell a share or exercise an option. For example,
the share price or the prot of the company has to rise by 20 percent
before a share can be sold or an option can be granted. Within the
vesting period, the respective management board members may not
sell a share or exercise an option. The Act on the Appropriateness of
Management Board Remuneration (VorstAG) calls for a vesting
period of at least four years. Gtz and Friese (2013) found that 57
out of 80 corporations listed in the DAX and MDAX participated in
stock option programs which are implemented in order to create an
optimum mix of risk and opportunity awareness among managers.
Pension awards are payments by the company that are made
after the termination of employment to a former member of the
management board. For pension awards, the supervisory board

should determine the level of provision aimed in each case and con-
sider the resulting annual and long-term expense for the company.
In determining the level, the length of time for which the individual
has been a member of the management board is another important
factor to take into account (GCCG 4.2.3).
It is standard practice and also recommended in the German
Corporate Governance Code that in the event of premature termi-
nation of activity without good cause, management board con-
tracts determine that severance payments made to the resigning
board member do not exceed two years compensation including
fringe benets (severance payment cap) and compensate no more
than the remaining term of the contract (GCCG 4.2.3). If the con-
tract of employment is terminated for a serious cause for which
the management board member is responsible, no payments are
made to the management board member. The severance payment
cap should be calculated on the basis of the total compensation
for the past year and if appropriate the expected total compensa-
tion for the current year. Payments promised in the event of pre-
mature termination of a contract of employment due to a change
of control are not to exceed 150 percent of the severance payment
cap (GCCG 4.2.3). In addition to the structure of the remunera-
tion, criteria for the appropriateness of the compensation are men-
tioned in the German Corporate Governance Code. According to
which, the criteria are the tasks and performance of an individual
management board member, the economic situation, the perfor-
mance and outlook of the company, and the common level of
compensation taking into account the peer companies and the
structure of the remuneration in place in other areas of the com-
pany (GCCG 4.2.2).
Among others, ndings of a study by the Institute of
Management Accounting at the Philipps-University Marburg and
the Institute of Management and Control at the Georg-August-
University Gttingen on the status quo of the remuneration of man-
agement boards in the German Prime Standard (DAX, MDAX,
TecDAX, and SDAX) are presented (Rapp & Wolff, 2012). In the
study, only the monetary compensation components were consid-
ered. Pension awards, other awards, especially in the event of termi-
nation of employment, fringe benets, and benets by third parties
which were promised or granted with regard to the work of the
management board, were not taken into account.
The study showed that the effects of the nancial crisis in
2007 as well as the following economic recovery of many compa-
nies are clearly reected in the remuneration of the management
board over the years. After a signicant drop in 2008 and 2009,
from h904 tsd. per capita in 2007 to h761 tsd. per capita in 2009,
the total compensation rose to h951 tsd. per capita, in 2010,

which equals an increase by 25 percent compared to the prior
year. Thus, the average management board compensation per
capita of all the companies listed in the German Prime Standard
reached the pre-crisis level (Rapp & Wolff, 2012). In 2011, it
further increased and exceeded the one million mark for the very
rst time (Rapp & Wolff, 2012). However, the level of compensa-
tion varies signicantly between indices which can be seen in
another study of Gtz and Friese from 2013 that only looked at
larger corporations and correspondingly higher management sal-
aries listed in indices like the DAX and MDAX. With an average
total salary of around h2.9 million a member of the management
board of a company listed in the DAX averagely received about
three times the amount of a management board member listed in
the SDAX or TecDAX and approximately twice as much as a
board member in the MDAX with around 1.5 million euros
(Gtz & Friese, 2013).
In the same period the xed board remuneration for MDAX
companies was about 0.6 million euros on average compared to 0.8
million euros for the DAX. It is very interesting to nd that the main
difference in board remuneration between these two indices is the
proportion of variable and share-based components of the total
compensation. In short, 70 percent of the total salary of DAX
board members and 60 percent of MDAX board members are
performance-based. Although their salaries almost rose throughout
the years since the economic crisis, the management boards of both
DAX and MDAX still do not meet the remuneration levels from the
boom year of 2007 (Gtz & Friese, 2013), in contrast to the ndings
from the previous study by Rapp and Wolff (2012). In general, the
inconsistencies between the two studies are only due to the inclusion
of the board remunerations of companies listed in the TecDax and
SDAX (Rapp & Wolff, 2012).
In 2012, the range of board remuneration of companies listed
in the DAX varied between 6.3 million euros per capita
(Volkswagen AG) and 1.4 million euros (Commerzbank AG), and
between 4.5 million euros (Axel Springer AG) and 0.5 million
euros (GAGFAH S.A.) in the MDAX. When we look at the Prime
Standard again, the proportion of xed remuneration per head
increased continuously from 55 percent in 2007 to 63 percent
until 2009. Due to the rising importance of variable remuneration
components, the proportion of xed remuneration fell in 2010 and
2011. However, the proportion of xed remuneration never fell
below 50 percent which allows the conclusion that the proportion
of xed remuneration in companies listed in the MDAX, TecDAX,
and SDAX (and relatively smaller revenue) are comparatively
much higher than in the DAX. The economic recovery of many
companies after the crisis period of 2008 and 2009 is also reected
in the increase of the proportion of the variable cash compensation
in 2010 and 2011. During the crisis in 2008 and 2009 the propor-
tion of xed remuneration rose, while the variable cash compensa-
tion diminished from 36 percent in 2007 to 30 percent in 2009
and regained its level of 36 percent in 2010 and 2011 (Rapp &
Wolff, 2012).
About half of the companies of the German Prime Standard use
share-based compensation. Overall, the share-based compensation
still plays a minor role regarding the total compensation which, in
many cases, can be explained by the long-term alignment of the vari-
able cash compensation (Rapp & Wolff, 2012).
REMUNERATION OF THE SUPERVISORY BOARD

According to 113 GSCA, the remuneration of the supervisory
board is determined in the articles of the company or set by the
general meeting. The German Corporate Governance Code com-
plements the article of the GSCA and contains guidance for the
structure and the appropriateness of the remuneration (Lazar,
Metzner, Rapp, & Wolff, 2011). Like the management board, the
supervisory boards remuneration depends on the duties and
responsibilities of each member, the membership in committees,
and of course the companys success or business situation (GCCG
5.4.6; GSCA 124; Ringleb et al., 2014). The general meeting can
resolve on an amendment of the articles, for example, to reduce
such remuneration, if the supervisory board compensation is deter-
mined in the articles. Usually, the remuneration consists of mone-
tary compensation components and fringe as well as retirement
benets, but the latter only applies to full-time chairmen of the
supervisory board (Emmerich & Habersack, 2008; Ringleb et al.,
2014). Furthermore and again similar to the management board,
the chairman of the supervisory board is usually granted a two to
four times and the deputy chairman a 1.5 times higher salary than
ordinary supervisory board members due to their higher responsi-
bilities and duties (Ringleb et al., 2014). Usually, the remuneration
of members of the supervisory board is composed of a xed com-
ponent, a function-related component and a variable component
depending on the success of the company (Lazar et al., 2011). In
case of performance-based pay it has to be made sure that the
compensation is oriented towards sustainable corporate develop-
ment (GCCG 5.4.6). However, there is a clear trend towards xed
remuneration and fringe benets instead of performance-based
pay, as the supervisory boards monitoring function should be
independent from a companys success (Lazar et al., 2011; Ringleb
et al., 2014).
As previously stated, since the introduction of the VorstOG in 2006,
publicly traded corporations have to disclose detailed information
on the remuneration of each member of the management and super-
visory board, former members of these boards as well as the com-
pensation of members in advisory boards in the notes ( 285 GCC).
Moreover, according to 289 GCC the management report should
provide information on the remuneration system of publicly traded
companies. As corporations often disclose their remuneration
system and corresponding detailed information in a separate
compensation report (as a part of the management report), the
German Commercial Code states that the disclosure in the notes can
be omitted if the remuneration report fullls the requirements of
285 GCC.
However, the disclosure can also be circumvented if the annual
general meeting passes a resolution for a maximum of ve years but
only with a majority of at least 75 percent of the represented share
capital (GCC 286). Thus, only the total compensation of the man-
agement and supervisory board has to be disclosed, as the already
existent transparency rules remain in force.
In their study of companies listed in the German Prime Standard
from 2005 to 2011, Rapp and Wolff (2012) found that since the
regulatory changes in 2006 the proportion of companies that dis-
close individualized compensation increased from 43 percent to 81
percent until 2011. The highest increase was from 2005 to 2006,
where the proportion of companies with individualized disclosures
rose by 27 percent to 73 percent. In the following years, the propor-
tion increased steadily (Rapp & Wolff, 2012).
As mentioned earlier, a lot of companies, especially big corpora-
tions summarize the details of the management board members
remuneration in a separate compensation report. Next to the remu-
neration itself, it has become increasingly common to give detailed
information on their objectives, long-term and mid-term incentive
(LTI and MTI) plans in order to achieve those targets, the term of
the LTIs and MTIs, the corresponding performance measurements,
the payout, and of course the renewal of such incentive plans.
Moreover, many corporations provide a clear calculation table to
make the remuneration structure more comprehensible for other sta-
keholders. As many corporations use different key gures and incen-
tive plans for the calculation of management remuneration, the
GCCG recommends that as of 2014 corporations should use remu-
neration model tables provided by the GCCG in order to increase
transparency due to this constantly rising complexity of (variable)
board remuneration systems (GCCG 4.2.5; Gtz & Friese, 2013).
Also, the use of uniform remuneration tables would make a positive

contribution to the comparability of board remuneration structures
between different corporations.
The last pages gave an overview of the current remuneration situa-
tion in Germany and its development over the last few years. Of
course, there are still many challenges that need to be faced and
discussed.
As mentioned before, the variable remuneration component of
the management board is usually performance-related. Since there is
no specic determination on what key gure to use for performance
measurement or simply which remuneration instruments (cash, real
or virtual stocks or options, uncertied securities, etc.), there will
always be signicant differences in variable board remuneration
between companies (Prinz & Schwalbach, 2013). For example, prof-
its heavily depend on German or international nancial reporting
standards and with no specic, uniform method of determination,
the management board is given the opportunity to manipulate the
amount of reported prots due to a large scope of assessment possi-
bilities. In order to report higher prots in the short or medium run,
the management board can, for example, neglect necessary invest-
ments which would eventually cause a serious drop in revenue or
lead to signicantly higher costs in the mid- or long term (Schmig,
2013). One could argue that this problem has been solved with the
implementation of taking LTI and MTI plans into account but this
also bears the risk of greater non-transparency. It is very difcult for
stakeholders to understand the effective (variable) remuneration of
board members over several years due to the persisting individual
and highly complex variable remuneration systems. The long-term
character of these remuneration instruments causes time-delayed
success and nal payments that comply neither with the value at the
grant date nor with the original success expectations (Gtz & Friese,
2013). Moreover, it was found that not a single of the DAX30 cor-
porations retroactively informs about achieving targets of mid- or
long-term performance indicators quantitatively or accumulated
over the years in their compensation reports and followed by a
proper goal achievement analysis (Prinz & Schwalbach, 2013).
Especially, the still remaining lack of transparency when it
comes to, for example, the consideration of individual and task-
related criteria of board members other than the chairman, salaries
of former board members, selection, measurement, and weighting of
non-nancial criteria are just a few more crucial points that will
have to be improved or need special attention in the future (Prinz &

Schwalbach, 2013).
However, substantial changes are about to come in the next
years. In 2013, the German Government planned to pass the Act to
Improve the Supervision of Board Remuneration and Amendment
of Further Stock Corporation Law Provisions (VorstKoG Gesetz
zur Verbesserung der Kontrolle der Vorstandsvergtung und
nderung weiterer aktienrechtlicher Vorschriften) which legitimates
the annual general meeting to decide on management board remu-
neration at the proposal of the supervisory board ( 120 GSCA
Say on Pay). The Law did not come into force as the German
Federal Council dropped the passing immediately prior to the parlia-
mentary elections (Peters & Hecker, 2013). The Federal Council jus-
tied their decision with the resulting imbalance of power between
the three company bodies: management board, supervisory board,
and general meeting. If the supervisory board was only able to make
restricted decisions on management board remuneration, it would
fail to have an important leverage for the implementation of their
supervisory functions. Due to the strengthening of the general meet-
ing there would also be a shift from employee to equity interests.
Furthermore, it could be difcult for the supervisory board to estab-
lish a sustainable and long-term remuneration policy when depend-
ing on the annual stockholder vote (Deutscher Bundestag, 2013).
However, it turns out that the coalition agreement of the new gov-
ernment coalition between the Christian Democratic Party and the
Social Democratic Party stipulates the passing of the VorstKoG in
order to reinforce the general meeting and thus to indirectly regulate
inated management salaries. The second passage regarding the
determination of a maximum ratio between the total remuneration
of management board members and the average employee salary of
the company has been removed from the coalition agreement
(Hoppe, Kersting, & Hofmann, 2013). However, the future will
show if this is the right path to go. In their study, Gtz and Friese
(2013) criticize the limitation of board remuneration to absolute
amounts as board remuneration should be set in relation to the rev-
enues they generate. For example, the excessive remuneration of the
management board of the Volkswagen AG has often been criticized
in the past years. But if the remuneration is put in relation to the
EBIT of the business year, with a ratio of 0.50 percent VW is far
below the DAX average of 0.80 percent (Gtz & Friese, 2013).
Thus, it remains questionable if general meetings are really able to
properly estimate the value of management boards remuneration.
When it comes to the remuneration system of supervisory
boards, it is interesting to nd that opinions differ widely on the
market. On the one hand there is a growing tendency toward a
solely xed remuneration on the grounds that members of the
supervisory board should be paid well in both good times and bad
in order to fulll their monitoring functions independently from the
expected amount of compensation. On the other hand, it is argued
that unlike external consultants, the supervisory board is also
responsible for the long-term strategy of a company and therefore
should benet from long-term and sustained corporate success, too
(Fockenbrock, 2013). Moreover, the growing gap between highly
(e.g., Volkswagen AG) and poorly paid supervisory board members
who claim for a better compensation adapted to their greater
responsibilities will require a lot of attention in the next years.
Although one could see that much has been done to regulate
board remuneration in the past years, there still remain serious
issues that need to be dealt with and eventually be solved. It is up to
the German Government and the economy to nd solutions through
binding regulations or voluntary rules (e.g., GCCG) in order to
reduce these current problems and minimize prospective challenges.
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CHAPTER
Directors
9 Remuneration in Italy
Marco Artiaco
Introduction
Remuneration systems are a key element of corporate governance.
Their purpose is to acquire the management and cater its choices to
align the goals of the members of the board with those of the
shareholders using motivational levers. Regarding the capacity of
remuneration systems to inuence the board of directors, the main
reference is the agency theory, according to which a subject, the
agent (the board) is acting in favor of, or as a representative to a
second subject, the principal (the shareholder). This theory shows
problems in the relationship between the agent (the board) and the
principal (shareholder) in the presence of uncertainty and information
asymmetry. In fact, in this case the agent will most likely be motivated
to maximize their goals at the expense of the shareholder (Jensen &
Meckling, 1976). The studies on this issue have tried to verify whether
the system of remuneration may be a tool of alignment between the
objectives of the agent and those of the shareholder. The empirical
analysis which allows this approach to reach different solutions is
done by relating the nancial size of the system (amounts and struc-
ture), with variables such as ownership, and the separation between
ownership and control. On one hand, executive compensation is just a
matter of contract, it is only necessary to identify, previously, the opti-
mal compensation model that aligns the objectives of the board with
those of the shareholders (Core, Guay & Larcker, 2002; Jensen &
Meckling, 1976). On the other hand, the system of remuneration is
only partly inuenced by the need to align the boards objectives to
those of the partners. This will also depend on other variables, such as
133
134 MARCO ARTIACO
the ability of the board to inuence the extent of compensation to the

executives, making it an annuity of the board of directors (Bertrand &
Mullainathan, 2001; Aghion, Philippe, Blanchard, Olivier-Jean, 1994;
Yermack, 1997). Remuneration levels grow due to the introduction of
incentive systems and weak corporate governance.
The Italian context was dened by a large amount of state-
owned companies, a Catholic rich-blaming culture, for this reason,
executive compensations were signicantly lower than in the United
States and compensation design schemes were also simpler than
American ones. Since the 1990s, Italian remuneration standards
have aligned with capitalistic countries remuneration levels.
In Italy, the exponential growth in directors compensation over
the last few decades can be explained by different causes: shareholder
ownership, corporate governance, and regulatory framework.
The Italian economic system was dened by a substantial het-
erogeneity in companies dimensions and a geographical fragmenta-
tion (Artiaco, 2013). Italian peculiarities are explained by a clear
separation between productive and non-productive areas and a
niche-market-oriented production. Moreover, the Italian stock
market is characterized by inefciency and companies undercapita-
lization. The Italian ownership structure is characterized by a
separation between ownership and control, in which shareholders
such as families, nancial institutions, or banks are able to control
and manage the business with less than 51% ownership through
specic nancial instruments such as pyramidal ownership or juridi-
cal instruments such as shareholder agreements. In this context, it is
more convenient for majority shareholders to get an annual compen-
sation, than to be entitled to receive prots (Barca, 1995). In this
context, high remuneration packages have been allotted despite
poor managerial performance. This phenomenon can be ascribable
to a poor regulation system as well as weak governance. The eco-
nomic and nancial crisis has called into question remuneration and
incentive schemes; regulators have started setting rules for listed
nancial companies with the intention of regulating remuneration
and incentive plans.
In the following sections, an in-depth analysis of the Italian
remuneration system has been developed. It includes key factors and
peculiar characteristics of Italian companies. Our aim is to give a syn-
thetic explanation of the Italian regulation system, remuneration design
schemes, remuneration reporting, and Italian remuneration guidelines.
The Italian response to the crisis has been characterized by tighter
regulation and re-regulation of the corporate governance
Directors Remuneration in Italy 135
remuneration policies rules. Corporate governance rules vary,

depending on company peculiarities. Unlisted companies are subject
to civil law rules. Listed companies, in contrast, are subject to much
more detailed rules. Some companies are subject to peculiar rules
due to their core business. Listed nancial companies, for example,
are subject to a self-disciplinary code for listed companies and the
Bank of Italys rules for nancial companies.
The Italian compensation discipline sets out different rules and
compensation schemes for:
(1) Listed companies

(2) Banks and bank holding companies
(3) Government-owned unlisted companies
(4) Unlisted companies.
As described in the following paragraphs, different regulatory

levels imply differences between remuneration models.
LISTED COMPANIES
Italian listed companies may also adopt the Code of Self-Discipline
of Listed Companies published by Borsa Italiana1 (the Italian Stock
Exchange) in 1999.
According to article 2389 of the Italian Civil Code, the board of
directors compensation must be established by the board meeting.
This is clearly a good example of a say-on-pay tool.
According to article 2389, 3rd comma, of Civil Code the board
of directors, upon examination of proposals from the committee for
remuneration and having heard the board of auditors, determines
the salary compensation and contract terms of the managing direc-
tor, through the committee for remuneration, to which the specic
duty has been assigned, and of other administrators who fulll parti-
cular roles, including the participation on committees instituted by
the board of directors.
In companies with a supervisory board, the shareholders ordin-
ary meeting xes the remuneration of the members of the supervi-
sory board, if not set out in the articles of association (Civil Code
new art. 2364-bis).
As stated before, Italian listed companies may also adopt the
Self Disciplinary Code for Listed Companies, which integrates the
Civil Code provisions.
1
Italian Stock Exchange or Borsa Italiana: Borsa Italiana S.p.A. is the com-
pany responsible in Italy for the organization, management, and develop-
ment of markets for the trading of nancial instruments.
136 MARCO ARTIACO
In accordance with the comply or explain principle, rather

than setting out binding laws Borsa Italian set out a Self-
Disciplinary Code, which listed companies may either comply with,
or if they do not comply, explain publicly why they do not. Self-
Disciplinary Code Peculiarities will be discussed below in CONSOB
legislative decree no. 58 of 24 February 1998 (CONSOB, 1998).
CONSOB LEGISLATIVE DECREE No. 58 OF 24 FEBRUARY
1998 Consolidated Law on Finance pursuant to Articles 8 and 21 of
Law no. 52 of 6 February 1996. (see art. 123-ter) Text updated
with amendments introduced by Italian Legislative Decree no. 69 of
21.6.2013, converted with amendments from Law no. 98 of
9.8.2013 and by Law no. 97 of 6.8.2013.
Consob Legislative Decree n. 58/1998 sets out rules on remu-
neration disclosure for Listed Companies
Article123-ter
Report on remuneration
1. At least twenty-one days prior to the date of the shareholders

meeting established by article 2364, paragraph two, or the
shareholders meeting established by article 2364-bis second
paragraph of the Italian Civil Code, companies with listed
shares shall make a report on remuneration available to the
public at the company registered ofces, on its internet website
or in any of the other ways established by Consob regulation.
2. The report on remuneration shall be laid out in the two sections
established by paragraphs 3 and 4 and is approved by the
Board of Directors. In companies adopting the dualism system,
the report is approved by the supervisory board, upon proposal,
limited to the section established by paragraph 4, letter b), of
the management board.
3. The rst section of the report on remuneration explains:
a) the companys policy on the remuneration of the members
of the administrative bodies, general managers and executive
with strategic responsibilities with reference to at least the
following year;
b) the procedures used to adopt and implement this policy.
4. The second section, which is intended for the members of the
administrative and auditing bodies, general managers and, in
aggregate form, without prejudice to the provisions of the regu-
lation issued in accordance with paragraph 8, for executives
with strategic responsibilities:
a) provides a suitable representation of each of the items com-
prising remuneration, including treatment provided for in
the event of cessation of ofce or termination of employ-
ment, highlighting the coherence with the companys policy
in terms of remuneration approved the previous year;
b) analytically illustrates the fees paid during the nancial year

of reference, for any title and in any form by the company
and by subsidiaries or associates, noting any components of
said fees that refer to activities performed in years prior to
that of reference, in addition to highlighting the fees to be
paid in one or more subsequent years in exchange for the
work performed in the year of reference, potentially specify-
ing an estimated value for components that cannot objec-
tively be quantied in the year of reference.
5. Fee plans established by article 114-bis are attached to the
report, or the report species the section of the companys web-
site where these documents can be viewed.
6. Without prejudice to the provisions of articles 2389 and 2409-
terdecies, rst paragraph, letter a) of the Italian Civil Code and
article 114-bis, the shareholders meeting called in accordance
with article 2364, paragraph two or article 2364-bis, paragraph
two, of the Italian Civil Code, resolves in favour or against the
section of the report on remuneration established by paragraph 3.
The resolution is not binding. The outcome of voting is made
available to the public in accordance with article 125-quater,
paragraph 2.
7. By regulation, adopted having rst consulted with the Bank of
Italy and Isvap as concerns the parties respectively supervised
and considering sector Community regulations, Consob
indicates the information to be included in the section of the
remuneration report established by paragraph 3, including all
information aiming to highlight the coherence of the remunera-
tion policy with the pursuit of the companys long-term interests
and with the risk management policy, in accordance with the
provisions of paragraph 3 of Recommendation 2004/913/EC
and paragraph 5 of Recommendation 2006/385/EC.
8. By regulation adopted in accordance with paragraph 7, Consob
also indicates the information to be included in the section of the
remuneration report envisaged by paragraph 4. Consob may:
a) identify the managers with strategic responsibilities for
which information is supplied in nominative form;
b) differentiate the level of information detail according to
company dimension.
Source: Legislative decree. (CONSOB). No. 58 of 24 February

1998. (It.)
The comply-or-explain principle is a central element of EU cor-

porate governance: listed companies should state in the report and
accounts whether they comply with the Code and give reasons for
any areas of non-compliance. The same as to the remuneration.
138 MARCO ARTIACO
Article 6 Remuneration of directors

Principles
6.P.1. The remuneration of directors and key management
personnel shall be established in a sufcient amount to
attract, retain and motivate people with the professional
skills necessary to successfully manage the issuer.
6.P.2. The remuneration of executive directors and key
management personnel shall be dened in such a way as to
align their interests with pursuing the priority objective of
the creation of value for the shareholders in a medium-long
term timeframe. With regard to directors with managerial
powers or performing, also de-facto, functions related to
business management, as well as with regard to key man-
agement personnel, a signicant part of the remuneration
shall be linked to achieving specic performance objectives,
possibly including non-economic objectives, identied in
advance and determined consistently with the guidelines
contained in the policy described in principle 6.P.4.
The remuneration of non-executive directors shall be pro-
portionate to the commitment required from each of them,
also taking into account their possible participation in one
or more committees.
6.P.3. The Board of Directors shall establish among its
members a remuneration committee, made up of indepen-
dent directors. Alternatively, the committee may be made
up of non-executive directors, the majority of which to be
independent; in this case, the chairman of the committee is
selected among the independent directors. At least one com-
mittee member shall have an adequate knowledge and
experience in nance or remuneration policies, to be
assessed by the Board of Directors at the time of his/her
appointment.
6.P.4. The Board of Directors shall, upon proposal of the
remuneration committee, establish a policy for the remu-
neration of directors and key management personnel.
Source: Legislative decree. (CONSOB). No. 58 of 24
February 1998. (It.)
Remuneration policy establishes guidelines and directions
according to which remunerations shall be determined by the board
of directors, with reference to the remuneration of inside directors
and other directors covering particular ofces, and by the managing
directors with reference to the key management personnel.
In expressing the opinion pursuant to article 2389, paragraph 3,

of the Italian Civil Code, statutory auditors shall also verify the con-
sistency of the proposals with the policy on remuneration.
The complexity of the remuneration issue requires that related
board decisions must be supported by some preliminary activities
and proposals of the remuneration committee.
In carrying out its tasks, the remuneration committee shall
ensure appropriate links with all relevant functional and operational
departments of the issuer. It is also appropriate that the chairman of
the board of statutory auditors or another statutory auditor desig-
nated by the board chairman participates in the works of the com-
mittee; the remaining statutory auditors are allowed to attend.
In performing its duties, remuneration committee should use
external consultants with an expertise in compensation policies.
Such consultants must not simultaneously provide the human
resources department, directors, or key management personnel, with
signicant services which might compromise their independence.
The remuneration committee shall report to the shareholders
on the exercise of its functions; for this purpose the chairman or
another committee member should be present at the annual share-
holders meeting.
BANK AND BANKING HOLDINGS

In the nancial services sector, corporate governance should take
account of stakeholders interests (e.g. depositors, savers, life insur-
ance policy holders, etc.), as well as the stability of the nancial
system, due to the systemic nature of many players.
The aim of the following paragraph is to describe the main
legislative responses of the Italian regulators to the nancial crisis
with reference to nancial intermediaries:
(1) On March 30, 2011, the Bank of Italy published a set of super-
visory provisions concerning banks remuneration and incen-
tive policies and practices (known as New Regulations) with
the purpose of implementing the European Directive 2010/76/
EC of 24 November 2010 (Capital Requirements Directive
III or CRD III Directive). CRD III Directive, together with
the guidelines approved by the Committee of European
Banking Supervisors (CEBS), are construed in the context of
the measures applied to face up to the nancial crisis that
struck global markets over the last few years. In line with
European regulation standards, the New Regulations lay down
the fundamental principles whereby credit institutions are
required to ensure that their remuneration policies and prac-
tices are consistent with their organizational structure and
140 MARCO ARTIACO
promote sound and effective risk management. In particular,

the New Regulations strengthen the following principles:
(a) transparency and disclosure of information on remunera-
tion policies and practices: relevant information is required
to be distributed, analyzed and further checked by the
competent corporate bodies;
(b) structure of variable remuneration: variable remuneration
(especially with regard to selected categories of employees)
has a full set of provisions well separated from those
applicable to the xed remuneration;
(c) risk alignment: in this respect, the employees remunera-
tion, to a given extent, may be paid out in shares (or other
nancial instruments); furthermore, deferred payments are
also provided, as well as ex post correction mechanisms.
The New Regulations shall apply to banks and banking groups
(Banks) subjected to the authority of the Bank of Italy including,
without limitation, foreign branches of Italian banks and Italian
branches of foreign banks. Many of the provisions set forth in the
New Regulations shall be applicable in accordance with the princi-
ple of proportionality: in this respect, among other issues, the New
Regulations shall apply in full to major banks only (i.e., those hav-
ing certain prerequisites, such as total assets equal to, or greater
than, Euro 40 billion, etc.), while some of the relevant provisions
shall not apply to minor banks and nancial intermediaries. The
New Regulations aim at causing banks to adopt adequate remunera-
tion and incentive measures which may help improve competitive-
ness and good governance, in accordance with long-term strategies
and sound and effective risk management, particularly with regard
to share-based incentives.
(2) The Supervisory Circular of March 2, 2012 (Comunicazione
del 2 marzo 2012 Bilanci 2011: distribuzione di utili e corre-
sponsione di remunerazioni, 2012 Bullettin, March 2012,
n.3, Shareholder dividends and compensations) stresses the
need for full implementation of the Bank of Italy provisions of
March 30, 2011, so as to ensure inter alia, the sustainability of
the variable component of remuneration in relation to the
nancial situation and the achievement or maintenance of an
adequate capital base in an unfavorable cyclical phase.
(3) March 13, 2013 Supervisory Circular on 2012 accounts:
valuation of credit assets, remuneration policy, distribution of
dividends.
(4) The Bank of Italy therefore expects the banking system as a
whole to reduce variable remuneration signicantly, in line
with the criteria laid down in the March 2011 provisions and
the indications of the Supervisory Circular of March 2, 2012.

For the banks that have incentive plans based on a one-year
performance accrual period that made a loss in 2012 or had a
negative risk-adjusted operating margin, the correct applica-
tion of the March 2011 provisions:
(a) prevents awarding or paying bonuses based on the 2012
results to board members, the general manager, or other
key personnel whose variable remuneration depends
exclusively or prevalently on objectives referring to the
bank as a whole;
(b) must entail, for the rest of the staff, at least a signicant
reduction in bonuses even in the event of attainment of
individual performance objectives and those of the relevant
business unit.
(5) Legislative Decree no. 58 of February 24, 1998 Consolidated
Law on Finance pursuant to Articles 8 and 21 of Law no. 52
of February 6, 1996 (see art. 123- ter). Text updated with
amendments introduced by Italian Legislative Decree no. 69 of
21.6.2013, converted with amendments from Law no. 98 of
9.8.2013 and by Law no. 97 of 6.8.2013 (see Box 1).
(6) ISVAP Regulation No. 39, June 9, 2011 (ISVAP Regulation),
in force since June 23, 2011, sets out rules on remuneration
policies of insurance companies with the objective of ensuring
the adoption of remuneration systems in line with the interna-
tional principles on remuneration policies in the nancial
sector, including Commission Recommendations 2009/384/EC
and 2009/385/EC, April 30, 2009.
GOVERNMENT-OWNED UNLISTED COMPANIES

In accordance with the DPR 05/10/2010 n. 195 the Italian
Regulator set a maximum remuneration and compensation limit for
government-owned unlisted company employees.
State employees compensation cannot exceed the maximum
compensation perceived by the president of the High Court of
Appeal (Corte di Cassazione). Corporate governance is becoming a
key issue. In Italy, corporate governance rule implementation has
been making great strides, however it will take some time to evalu-
ate their application in real life in the coming years.
The emerging regulatory framework is extremely heterogeneous
for several reasons. First, for many years there was hesitancy in reg-
ulating this matter as the market was considered the appropriate
tool to ensure the proper functioning of the remuneration system.
Some rms peculiarities tend to reduce the consequences of poten-
tial limitations on remuneration level and this is even truer in an
international and competitive directors labor market.
142 MARCO ARTIACO
When certain types of expertise are not industry-specic,

national or regulatory limits on the level of remuneration may create
distortions in the labor market.
These limitations may reduce control effectiveness on remunera-
tion schemes, and encourage both rms and directors to adopt inno-
vative remuneration schemes with the intention of circumventing
these quantitative constraints (OECD, 2011). Secondly, by its own
nature, remuneration is a complex matter. For this reason, rules are
mostly set by regulators or through self-regulation authorities rather
than by legislative bodies.
For this reason, some countries chose to determine an accurate
discipline on this subject, some others decided to leave room for a
self-disciplinary approach to remuneration matters. Therefore, dif-
ferent countries have different approaches in regulating the matter.
UNLISTED COMPANIES
In Italy, the majority of small and medium enterprises are not listed
or quoted on tradable equity markets. The overwhelming majority
of SMEs or start-up companies remain under the ownership and
control of the founder or founding family. Such unlisted companies
lie at the heart of the Italian economy.
For unlisted companies, in accordance with Article 2389 Civil
Code The shareholders ordinary meeting xes the remuneration of
the members of the board of directors. This prevision aims to over-
come the agency problem in unlisted companies.
In general, regulators and legislators ability to inuence remu-
neration schemes in a substantial way is rather limited.
Nevertheless, lawmakers have enacted specic measures to control
directors remuneration level. Regulators have become more and
more focused on the determination of specic measures that are sup-
posed to implement the capacity of the structure of corporate gov-
ernance to produce proper remuneration and incentive systems.
Remuneration Design Schemes

In Italy, remuneration schemes are a function of shareholder owner-
ship and corporate governance, as well as the above-mentioned
regulatory framework.
The structure and operation of the board of directors is a
determinant of the remuneration system; more recent studies have
attempted to identify the relationship between pay and the charac-
teristics of the board. This is done by using empirical models that
relate the size of the compensation system (amounts and structure)
with variables, such as the characteristics and functioning of the
board of directors (e.g. number of meetings, number of outside

directors, number of inside directors).
Decisive elements are the size of the board of directors and the
effort spent (Boyd, 1996). Others have investigated, through empiri-
cal analysis, the correlation that exists between pay, professional
characteristics of the members of the board of directors, and busi-
ness variables (Bryan, Hwang, Klein, & Lilien, 2000).
The remuneration scheme is based on different components:
some are linked to directors responsibilities, others aim to promote
good managerial practices. In Italy, the most common remuneration
scheme is based on the following elements: a base salary, a non-
equity-linked variable part (annual bonus), an equity-linked variable
part (sometimes stock option plans are offered to management as
part of their compensation at the withdrawal from ofce), and an
extraordinary part. This compensation scheme is consistent with the
Worldwide Total Remuneration Report (Tower Perrins, 1997).
As shown in the text, a directors remuneration scheme is linked to
their roles and responsibilities.
The board of directors is composed of different members with
different roles, duties, and responsibilities. Just to be clear, we can
divide board members into outside directors (professionals or dep-
uty) and inside directors (managers). Outside directors are expected
to monitor and challenge the performance of inside directors,
whereas inside directors participate in the day-to-day management
of the rm. The directors role among the board brings peculiar
duties and responsibilities, which must be taken into account in the
remuneration scheme design process (Lorsch & MacIver, 1989;
Mizruchi, 1983; Zahra & Pearce, 1989).
The board of directors is made up of many directors and acts
collectively with managerial, control and strategic functions.
According to the agency theory (Fama & Jensen, 1983) manage-
ment may wish to grow the company in ways that maximize their
personal power and wealth. In a stewardship perspective, manage-
ment's and shareholders interests match. For this reason, a controlling
and monitoring activity is not considered to be extremely useful.
Controlling and management functions can be synthetized in the board
composition. Among Italian companies, there can be both strong
CEOs and strong boards depending on the board characteristics:
strong CEOs inuence the boards decisions, whereas strong boards
control and monitor management behavior.
Some authors have identied a relationship between the level of
remuneration of the entire board of directors and that of the CEO.
The underlying assumption in this case, is that as the compensation
of the CEO increases, so will the propensity of the other members to
ask for higher returns. The same study also notes that there is an
indirect correlation between the level of commitment required by the
144 MARCO ARTIACO
CEO, and the board for control. In fact, in the presence of more
complex businesses, there is a larger increase in the compensation of the
CEO, and for the board of directors (Brick, Palmon, & Wald, 2002).
In order to understand remuneration structure as well as
compensation levels in Italy, some examples are provided in the
following paragraphs. The average compensation of Italian listed
companies directors between 2007 and 2010 is shown in Table 1.
The xed compensation package design is an essential part of
the remuneration design process. In fact, most of the other remu-
neration elements depend on the xed remuneration part.
Target bonuses and option grants, for example, are usually esti-
mated as a percentage of the xed remuneration part. Pension bene-
ts and termination benets are tied to the remuneration level.
Having said that, every increase in xed compensation amount
brings positive effects on other compensation elements
One of the main issues arising in recent years is the dichotomy
between inside and outside directors, which determines a compensa-
tion difference. The gures in Table 1 show that remunerations
schemes are based on a xed part, which remunerates the chair-
man's legal representative role (in contrast to the CEO's managerial
role).
This evidence suggests that base salary is predominantly
responsibility-related. Chairpersons deserve legal representation
whereas CEOs deserve managerial responsibility. Usually, inside
directors (i.e. chairman, managing director, CEO) have a full-time
commitment in the rm and they are involved in its day-to-day
management. Outside directors are not fully involved in the rm but
they are expected to monitor executive directors work. Outside
directors make their contribution in board meetings. Outside direc-
tors may also be independent directors.
However, inside directors remuneration is signicantly different
from that of outside directors. This separation is far too high in
terms of the importance of the directors role, and it shows that, in
Italy, remuneration schemes tend to favor inside directors with a
Table 1: The Average Compensation of Italian Listed Companies

Directors between 2007 and 2010.
Fixed Remuneration Component (h/1000) 2007 2008 2009 2010
Chairman 505 524 503 538

Vice-chairman 224 250 245 228
CEO 423 407 417 435
Outside directors 51.4 56.4 61.9 61.9
Source: SpencerStuart (2010), Italia Board Index.

managerial role, instead of rewarding outside directors with a super-

visory role.
Another interesting fact about remuneration schemes in Italy is
the amount of the remuneration that is a xed part over the total
remuneration package (see Table 2).
A positive trend in base salarytotal compensation ratio can be
highlighted with the only exception of vice-presidents. Nonetheless,
CEO base salarytotal compensation ratio is well below 50%.
CEOs are supposed to be led by positive economic results. This is
the reason why variable remuneration is higher than xed salary.
Figures show that inside directors assigned with a managerial
role are provided with a variable-based compensation, whereas out-
side directors are provided with a xed-based compensation. Inside
and outside directors base salaries are closely related to their
competencies, responsibilities, and their commitment to their role as
board members. In consideration of outside directors role and
functions, their xed-based compensation should be linked to their
independence from the companys fortune.
Figures show that a pay for performance culture has caught
on. This evidence is consistent with the Anglo-Saxon model
described by Yensen and Murphy.
All these elements cannot be determined in abstract terms,
because they are linked to corporate characteristics and environ-
ment. However, in the remuneration design process, some elements
are in common among rms.
The great majority of Italian listed companies directors are
awarded with a variable compensation. According to the 2012
(Assonime, 2013) Survey, 178 Italian companies adopted incentive
remuneration systems. A total of 61% of these rms (equal to 146
rms) opted for short-term variable compensation (annual bonus).
Short-term remuneration schemes are based on an ex ante deter-
mination of achievable management goals (e.g. revenues, prots,
EBITDA, etc.), and on an ex post evaluation of achieved targets.
Short-term incentive plans are based on planning and controlling
Table 2: The Amount of the Remuneration Fixed Part over

Total Remuneration Package.
Base Salary/Total Compensation Ratio 2007 2008 2009 2010
Chairman 59% 55% 61% 64%

Vice-president 43% 46% 46% 41%
CEO 31% 34% 36% 39%
Outside directors 86% 89% 90% 91%
Source: SpencerStuart, 2010; Italia Board Index.

146 MARCO ARTIACO
tools, namely the annual budget (Airoldi & Zattoni, 2001). The
variable compensation part is closely related to the board perfor-
mance. In the presence of an incentive plan system, managing direc-
tors who achieve company targets, get a variable compensation
such as the annual bonus. The variable compensation part is a
performance-based award: no bonus will be paid unless a certain
performance target is reached. A target bonus is paid when a standard
target is achieved. Some companies are characterized by a peculiar
compensation scheme: directors who are eligible to be rewarded with
an annual compensation plan are effectively rewarded with the annual
bonus only if they achieve some specied personal targets.
Incentive systems linked to short-term objectives have been
recently subjected to harsh criticism, as they are believed to be the
reason for risky choices (OECD, 2009).
The most recent policy regulations have been calling upon
boards to award directors with a long-period oriented variable
compensation (long-term incentive plans). In 2012, 120 out of
240 Italian listed companies (50% overall) chose to adopt incentive
systems linked to 35-year goals. This percentage increases if we
only analyze Italian nancial rms. This fact is due to recent
regulation.
One interesting fact about remuneration schemes in Italy is the
widespread use of stock option plans. At the end of the 1990s in
Italy, stock option plans were not as common as in the USA, the
UK, or France (Murphy, 1998). At present in Italy, stock options
packages are still uncommon compensation tools mainly due to
poor nancial market performances and a disadvantageous tax
treatment. Stock option packages usually constitute a variable com-
pensation tool. Stock options are a performance incentive tool,
which aligns management and shareholders interests. Stock options
packages give directors the right to buy or subscribe for companys
shares. Stock options are technically American call options, which
give the holder the right to buy shares at a xed price during a
dened time period. At the end of 2010, only 58 Italian (listed and
unlisted) companies chose to adopt stock option incentive plans.
Among these, 42 listed companies adopted stock option incentive
plans for their 93 directors (SpencerStuart, 2010). In Italy, stock
option plans are losing their appeal mainly because of their tax
regime and the stock market trend.
Some studies (Rappaport, 2005; The Walker Report, 2009) support
the need to align the compensation of top management administra-
tors while putting into perspective any long-term trends, and by
always taking into account the interests of company, and that of the
shareholders. Others (Kirkpatrick, 2009) support linking compensa-
tion and risk.
With reference of this fact, some interesting elements emerge
from an analysis of the two major listed Italian companies, namely
Telecom Italia and Enel. An in-depth analysis of their 2012 remu-
neration reports highlights that they all have adopted a similar com-
pensation and incentive structure. The following examples are
extremely relevant; Telecom Italia and Enel are both big companies,
subject to listed company regulations, with advanced corporate gov-
ernance. The Telecom Italia 2012 remuneration system is described
in Box 1.
Box 1: Telecom Italia 2012 Remuneration Scheme.
Telecom Italia 2012 Remuneration Scheme

Outside directors remuneration
EUR 110,000 per year for every outside director;

EUR 45,000 per year for every internal control member and/or
corporate governance committee member;
EUR 20,000 per year for every remuneration committee member;
EUR 20,000 per year for every director who is appointed to the
supervisory board;
EUR 90,000 for the vice-president, who is responsible for the
internal control system functioning.
Board of directors Chairman Remuneration

Fixed Compensation
EUR 110,000 per year for the director role;

EUR 1,400,000 per year for the chairman role;
EUR 35,000 per year as executive committee member.
Variable Compensation
Variable compensation linked to annual performance goals. The

target value is equal to the xed compensation plus a variable
percentage, from 50% to 150%, of the xed compensation linked
to assigned targets achievement;
(continued)
148 MARCO ARTIACO
One-off participation in the 2011 long-term incentive plan, equal

to a EUR 2,100,000 cash bonus (150% of the xed compensa-
tion) plus 2,253,702 ordinary Telecom shares (150% of the xed
compensation expressed in shares);
Benets as similarly recognized for the companys management;
Net annual payment to the supplementary pension fund equal to
10% of the xed salary and equal to 10% of the annual premium
expected, for results to the target level.
CEO Remuneration
Fixed annual remuneration equal to EUR 1,000,000 as a gross

annual salary for the employment relationship;
Waiver of the xed compensation for the position of director and
member of the executive committee;
Variable remuneration for the chief executive ofcer related to
annual performance objectives, with target value equal to the
xed amount and range of variation from 50% to 150%, depend-
ing on the level of achievement of objectives;
One-off participation in the 2011 long-term incentive plan, repre-
sented by a cash bonus of EUR 1,500,000 (150% of the xed
annual remuneration) and 1,609,787 ordinary shares (150% of
the xed annual remuneration expressed in shares;
Benets as similarly recognized for the companys management.
Source: Remuneration report, Telecom 2013.
As described above, Telecoms remuneration system is based on

a xed compensation component as well as a variable compensation
component (incentive system). Compensation and incentive amounts
vary according to the role and duties of the single director.
Telecoms board of directors is composed of 17 members of whom
12 are outside directors.
Outside directors are rewarded with xed compensation only.
Directors xed compensation varies between a minimum of EUR
110,000 and a maximum of EUR 200,000 per year as a function of
participation in one or more committees.
The chairman is rewarded with both a xed and a variable com-
pensation. Chairmans xed compensation amounts to EUR
1,918,000 cash (consisting of EUR 110,000 for his/her director role,
EUR 1,400,000 for his/her chairman function, EUR 408,000 in
perks and other compensation). A variable fee of EUR 1,050,000
made up of both annual awards resulting from incentive systems

and long-term incentive schemes must also be added.
The chief executive ofcer is rewarded with both a xed and a
variable compensation. CEO xed compensation is equal to EUR
1,005,000 in cash. A variable compensation of EUR 317,000, made
up of both annual awards resulting from incentive systems and
long-term incentive schemes, must be added.
The relationship between Telecom inside directors variable
remuneration and total remuneration is signicantly lower than the
average of Italian listed companies. In particular, in 2012 the ratio
between Italian listed companies CEOs variable compensation and
total compensation was equal to 43%, whereas, the Telecom CEO
variable compensation over total compensation ratio was equal
to 24%.
The same applies to Telecom vice-president, with a variable
compensation/xed compensation ratio equal to 17%, well below
the national average.
Inside directors remuneration is ultimately, in line with that of
similar size companies, EUR 8,416,000. The level of inside directors
remuneration has been decreasing in recent years; however, it
includes long-term incentive plans, thanks to outside directors com-
mitment to safeguarding stakeholders interests.
This phenomenon is consistent with literature (Boyd, 1996),
which attributes to the board characteristics the ability to control
the board remuneration. However, it was not free of charge, in fact,
shareholders cost of management is equal to EUR 6,411,000 while
cost of control is equal to EUR 2,050,000.
Enels remuneration system is designed as described in Box 2. It
is based on a xed compensation component and a variable com-
pensation component (incentive system).
The total compensation amount and potential incentives vary
according to the directors roles and duties.
Enels board of directors is composed of nine members of whom
seven are outside directors (Remuneration Report Enel, 2013).
Outside directors are rewarded with xed compensation only.
Directors xed annual compensation varies between a mini-
mum of EUR 85,000 and a maximum of EUR 150,000 as a function
of their participation in one or more committees. The Enel chairman
receives both a xed and variable compensation. The chairman's
xed compensation is equal to EUR 750,000 in cash. The chair-
mans variable compensation is equal to EUR 600,000, made up of
annual awards resulting from incentive systems and long-term incen-
tive schemes. The chairman is nally rewarded with a EUR 37,000
payment as a compensation for his/her participation in the corporate
governance committee.
150 MARCO ARTIACO
Box 2: 2013 Enel Remuneration System.
2013 Enel Remuneration System

Outside Directors Remuneration:
EUR 85,000 annual gross base salary;

An additional compensation for committee members:
EUR 30,000 annual gross compensation for the committee
chairman;
EUR 20,000 annual gross compensation for committee
members;
EUR 1000 attendance fee (per session) for committee members
and committee chairman;
The maximum amount received by each committee member
may not exceed the total amount of EU 70,000 per year.
Chairman Compensation:
EUR 750,000 annual gross base salary. In addition, the chairman
is entitled to the compensation for his/her participation in any of
the committees;
The variable remuneration amounts to a maximum of 80% of the
xed annual compensation. The variable compensation is condi-
tional upon the achievement of annual performance objectives.
With specic reference to the year 2013, the company chose to
reduce it by 30%;
Other fees:
Insurance policy (to cover risks such as death or permanent
disability);
Protection measures in case of judicial or administrative
proceedings;
Insurance policy equal to one-twelfth of the total emoluments,
xed and variable part, for each year of the effective term of
ofce;
Extraordinary awards linked to strategically important
operations.
CEO DG Compensation:
EUR 1,423,357 annual gross salary divided into EUR 720,000
annual gross base salary for CEO role and EUR 703,357 gross
base salary for DG function;
Variable compensation:
Short-term compensation part amounts to a maximum of
150% of the xed annual remuneration. It is linked to the

achievement of annual performance objectives. With specic
reference to the year 2013, the short-term compensation was
reduced by 30% for the CEO managerial role;
Mediumlong-term variable compensation, linked to participa-
tion in incentive plans, subject to specic goals achievement.

Other compensation:
A severance package pay equal to 2 years of the xed compo-
nent (for every single function);

A non-compete payment; any violation of the non-compete
agreement involves damages compensation. the refund is set at
an amount equal to twice the equivalent value of the non-
competition agreement;
An insurance policy (to cover risks such as death or permanent
disability);
Protection measures in case of judicial or administrative
proceedings;
An insurance policy that provides one-twelfth of the total emo-
luments, xed and variable part, for each year of the effective
term of ofce;
A contributory pension;
An extra payment at the end of the mandate in case of particu-
lar relevant strategic achievements.
Source: 2013 Enel Remuneration Report.
The Enel CEO, who is at the same time appointed with DG

function, is rewarded with a xed and variable compensation. Enel
CEO compensation amounts to EUR 1,423,000 in cash. The CEO
variable compensation is equal to EUR 2,594,000 made up of both
annual awards resulting from incentive systems and long-term incen-
tive schemes.
The ratio between Enel CEO variable compensation and total
compensation turns out to be higher than the national average of
listed companies. In particular, in 2012 the ratio between Italian
listed companies CEOs variable compensation and total compensa-
tion was equal to 43%, whereas the Enel CEO variable compensa-
tion accounted for 65% of total compensation.
152 MARCO ARTIACO
This indicator is in line with the national average if you look at

the years 20072010. Enel directors remuneration is in line with
those of similar-size companies. The choice of valuable incentive sys-
tems is based on the will of diversifying management remuneration,
even in the presence of positive results and stable earnings. Thus
constituted, the Enel board cost is equal to EUR 6,406,000. The
shareholders cost of management is hence equal to EUR 5,405,000,
while control cost is equal to EUR 1,002,000.
Conclusions
Remuneration policies of Italian regulated rms seem to be oriented
to nding solutions in order to acquire and retain top managers.
Remuneration level and structure are set with the intent to assign
remunerations in line with the Italian market salary, rather than
designing a behavioral-oriented incentive system. However, the
Italian corporate governance system still seems weak.
Some of the tools that have been proposed by Italian regulators,
in order to improve effectiveness of remuneration systems are:
(1) An extension of remuneration disclosure measures: to avoid

opportunistic behavior it is necessary for the company to have
a more transparent approach when determining remuneration
systems. Since 2010, Italian listed companies and banks have
been obliged to provide an annual remuneration report con-
cerning directors compensations. In this sense, the approach
of say on pay, which is what the latest regulations point
towards, seems to be on the right track to solving the issue at
hand.
(2) A new paradigm in the incentive system for banks and banking
holdings: remuneration structure will be divided into a xed
and a variable part, provided that variable compensation is
linked to long-term objectives (35 years).
(3) Independent directors control over remunerations: the board
control function, which is expressed through independent
directors, is essential to ensure the effective operation of the
remuneration system. Independent directors have the responsi-
bility to perform some basic functions including the alignment
of the remuneration of bank and listed companies inside direc-
tors to long-term shareholders interests, the design of incentive
systems, the control function and the production of informa-
tion, which is essential for the protection of shareholders and
stakeholders (OECD, 2004).
(4) A better understanding of the underlying relationship
between risk and remuneration: certain components of the
compensation system are inuenced by risk management sys-

tems that guarantee an analytical approach through ad hoc
decision-making models. This solution aligns the objectives of
the board of directors, to those of the shareholders. In fact, we
believe that the structure of the remuneration system comes
down to a contractual issue for banks, as noted by Core,
Guay, and Larcker (2002) and Jensen and Meckling (1976) for
which it is only necessary to identify, beforehand, the optimal
compensation model that aligns the objectives of the board to
those of the shareholders.
Corporate governance is one of the tools that can be used to

stem directors power and to address the effectiveness of systems of
remuneration. The solutions selected by authorities in order to regu-
late nancial rms such as transparency, remuneration system struc-
ture, incentive mechanism control, and risk management should be
extended to all companies in which remuneration is a critical issue
due to the magnitude of the amounts, the existence of possible con-
ict of interest situations with other stakeholders involved, and the
generation of potential systemic risks linked to the intrinsic nature
of the business (for example, state-owned rms or rms which oper-
ate in a concession regime). Compensation issues have been
addressed by nancial regulations as a source of potential systemic
risks.
The current macroeconomic situation has been highlighting that
compensation issue cannot be limited solely to nancial rms. A cor-
rect remuneration system is at heart of the rms ability to engage
different stakeholders in the production and redistributive process
and more generally, to develop the rms social cohesion.
Remuneration issues affect every single rm, but they are more
relevant in those cases in which a plurality of interests is involved. If
one accepts stakeholder interest protection as objective evidence of
the need for remuneration controls, companies, which would be sub-
ject to compensation controls, would be extremely numerous. For
example, those rms that operate under public concessions (such as
transportation companies, freeway-managing rms, public interest
providing rms, arms-producing companies, etc.) or operating as
suppliers of Italian public administration would fall into this
category. We must move from a regulatory approach towards remu-
neration, linked to nancial-rm models and paradigms, to an
objective approach on remuneration issues.
Corporate governance measures on remunerations should be
related to their effective remuneration amount.
Firms should be free to assign higher remuneration if they are
able to assure adequate control mechanisms and if the remuneration
exceeds high-threshold remuneration (relevant remuneration).
154 MARCO ARTIACO
If those limits are overshooting, remuneration schemes can

become a key factor in company functioning. Firms governance
basically depends on the quality vision and motivation of leading
gures.
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CHAPTER
Directors
10 Remuneration
in Spain
Montserrat Manzaneque,
Elena Merino and Regino Banegas
In Spain, as in other international contexts, speculation that accom-
panied the stock market bubble and economic growth favored
the proliferation of excessive compensation to senior ofcers and
directors of companies. These remunerations have remained despite
the obvious decline in business economic performance. This situa-
tion has resulted in the proliferation of a legal focus on control and
transparency as measures to ensure remuneration commensurate
with performance and responsibility, especially aimed at listed com-
panies and nancial institutions.
The following sections summarize some of the most important
laws or recommendations relating to directors remuneration in
Spain, with particular emphasis on those that are currently in place
(from 2013) for listed companies and nancial institutions.
REGULATION FOR LISTED COMPANIES

The law and recommendations applicable to listed companies, sum-
marized in Figure 1, shall now be addressed.
Ley de Sociedades de Capital or Companies Act (Royal Decree, 2010)

Spanish legislation establishes the principle of gratuitousness in rela-
tion to directors, unless the bylaws provide otherwise, as set out in
157
158 MONTSERRAT MANZANEQUE ET AL.
Mandatory Voluntary
Ley de Sociedades de
Capital Unified Good Governance
Or Sustainable Economy Act Code of Listed Companies
Companies Act (Law 2/2011) (CNMV, 2013)
(Royal Decree, 2010)
(Article 217)
Specification of
remuneration systems
in the company bylaws (Article 61 3rd) (Recommendation 8)
1. Disclosure of directors
(Articles 218 and 219) compensation through Reserve the right of the
Special requirements for the Annual Report on Board of Directors to
remuneration systems in Remuneration of approve the remuneration
form of profit sharing or Directors policy and the directors
remuneration through remuneration
2. Requires putting a vote
shares
of the General
(Recommendations 33 36)
Shareholders Meeting in
Remuneration policy
(Article 260) the annual report as a
orientation criteria
Directors remuneration separate point on the
disclosure in notes of agenda.
the annual accounts
Figure 1: Laws or Recommendations Relating to the Directors Remuneration in Spain.

Source: Own Research.
Article 217 of Ley de Sociedades de Capital or Companies Act1

(from now on LSC). This article species that the bylaws should
include a reference to the remuneration systems used to compen-
sate the directors. Therefore, the company cannot compensate direc-
tors with systems that do not appear in the bylaws. This has
encouraged the development of company bylaws in this regard.
Also, the LSC imposed a number of limitations, conditions, and con-
straints related to compensation in the form of prot sharing
(Article 218), which will be detailed later.
On the question of the ratication or approval of the compensa-
tion system by the competent corporate body as a control mechan-
ism, the Spanish law is not concrete. At greater depth, it is
important to make reference to the voluntary recommendations of
codes of good governance, something that will be discussed later.
Only in relation to the remuneration consisting of the delivery of
shares, options or linked to the value of these shares, does the LSC
(Article 219) specify the need of approval of the General
Shareholders Meeting. The agreement will express, as applicable,
1
Royal Legislative Decree 1/2010, of July 2, approving the revised text of
the Corporations Act.
Directors Remuneration in Spain 159
the number of shares to be granted, the exercise price of the stock

options, the value of the shares taken as reference, and the duration
of this remuneration system.
With regard to remuneration disclosure, the LSC (Article 260)
includes the contents of the previous Royal Legislative Decree 1564/
19892 (Article 200), establishing that the companies have to include
a breakdown of salaries, allowances and payments of any kind
granted to directors and obligations for pensions or life insurance,
advances, loans, and guarantees granted in their favor, as part of the
notes to the annual accounts. However, it is noteworthy that this
law refers to global information grouped by type of remuneration
and, therefore the information on remuneration received by each
member of the Board of Directors is left out of this requirement, an
area which we refer to later, the importance of which has been high-
lighted in all national and international forums on this topic.
Codes of Good Governance

As in other countries, Spain has followed the European and interna-
tional line on the issue of directors remuneration, which is to estab-
lish recommendations through codes of good governance. The
content of these codes can be followed or not by companies.
The rst code of corporate governance in Spain, the Olivencia
Report (1998) recommended that the policy for the remuneration of
directors, whose proposal, evaluation, and review should be attribu-
ted to the Remuneration Committee, which conforms with the cri-
teria of moderation, is related to the performance of the company
and that the company provides detailed and individualized informa-
tion regarding this (Recommendation 15).
Later, in relation to the Board remuneration, the Aldama
Report (2003) included the following recommendations (Section 6.
Remuneration of the Board and senior management, Chapter IV.
The company organs): (a) the remuneration in shares, stock options,
or options referenced to the share price should be limited to execu-
tives or internal directors; (b) the individual remuneration of direc-
tors with itemized breakdown should be listed in the notes of the
annual accounts; and (c) the clauses about golden parachutes of
the directors should have the formal approval of the Board of
Directors.
Afterwards, the Unied Good Governance Code of Listed
Companies (CNMV, 2006) (from now on CUBG) incorporated the
majority of content of the European recommendations regarding
directors remuneration (2004/913/EC, 2005/162/EC, 2009/385/
2
Royal Decree 1564/1989, of December 22, approving the revised text of
the Spanish Companies Act.
EC3) and of the previous codes developed in Spain (Aldama Report,

2003; Olivencia Report, 1998).
Particularly, in regard to directors remuneration, we can highlight
the recommendations 35, 40, and 41 of CUBG (CNMV, 2006).
Recommendation 35 starts from the conviction that complete trans-
parency regarding directors remuneration, including total payments
to executive directors, is a way to mitigate the risk of immoderate
compensation. This transparency should extend to all remuneration
components and concepts, including director severance packages.
Given the complexity of deferred payment schemes (insurance or
pensions), these will be best understood if they are translated for
comparative purposes into an estimated amount or annual equivalent
cost. The Code recommends that the board approve a detailed remu-
neration policy, as envisaged in Recommendation 40, which should be
written up and submitted at the General Shareholders Meeting.
Finally, Recommendation 41 proposes that the individual directors
remuneration should be listed in the notes of the annual accounts.
Another important recommendation in this respect is number 8,
which states that the Board of Directors right to approve the remu-
neration policy and the directors remuneration should be reserved.
The CUBG (CNMV, 2006) also incorporates a number of recom-
mendations concerning the criteria to take into account when setting
the remuneration policy (Recommendations 3639) to which reference
is made in Section Remuneration Design (Schemes) of this chapter.
In June 2013, an amendment of Unied Code was published
(CNMV, 2013), suppressing the recommendations incorporated into
the new rules published and which are discussed in this document.
These regulatory changes have meant Recommendations 35, 40, and
41 do not appear in the next text that has been incorporated into
CUBG (CNMV, 2013), since they have ceased to be recommendations
to become requirements. However, Recommendation 8, and in
absence of reference in the Spanish legislation as to the body which
should make the approval of the remuneration of directors and senior
ofcers, remains as such in the new text of the CUBG (CNMV, 2013).
Also, the recommendations about the remuneration policy orientation
criteria are maintained, although due to the rearrangement of the
contents they become Recommendations 3336 (previously 3639).
3
Commission Recommendation of December 14, 2004, fostering an appro-
priate regime for the remuneration of directors of listed companies (2004/
913/EC), Commission Recommendation of February 15, 2005, on the role
of non-executive or supervisory directors of listed companies and on the
committees of the (supervisory) board (2005/162/EC), and Commission
Recommendation of April 30, 2009, complementing Recommendation
2004/913/EC and 2005/162/EC as regards the regime for the remuneration
of directors of listed companies (2009/385/EC).
Sustainable Economy Act (Law 2/2011)

Previous experience on the poor compliance of the recommendations of
the codes of good governance, especially Recommendations 40 and 414
regarding directors remuneration of CUBG (CNMV, 2006), and in
applying the principles of good corporate governance arising from inter-
national agreements and organizations, the Sustainable Economy Act
(Law 2/2011) gave legal cover to the transparency. Article 27 requires
increasing transparency in relation to remuneration policy and directors
remuneration of those that are listed companies. In addition, the Article
61 3rd requires, starting from 2011, on the one hand, that the board
should submit a report on the directors remuneration policy to the
advisory vote of the General Shareholders Meeting, as a separate point
on the agenda. With the submission of this proposed remuneration
report to the advisory approval of the General Shareholders Meeting,
the system called say-on-pay has been incorporated into Spanish law,
through which voting occurs, binding or advisory, of the individual
remuneration of directors. Spain joins other European countries like
United Kingdom and Sweden, which already include this measure.
However, there are other countries like Netherlands and Norway that
have gone one step further towards a binding vote. After all, whats the
point of the vote if it is merely advisory? Davis (2007) explains that
the advisory vote is the yellow card. A large shareholder vote against a
pay report is the yellow card warning to the company board.
Therefore, it is expected that the failure to have the vote of the share-
holders is a warning regarding the actions taken on remuneration by
the Board of Directors. In other words, the advisory vote allows the
shareholders Meeting to take a stance which, without affecting the
validity of the companys remuneration commitments, may equate to a
vote of condence or no condence in the directors stewardship.
On the other hand, all listed Spanish companies, regardless of
the sector, should disclose their directors compensation individually
through the Annual Report on Remuneration of Directors. The
content of this report has recently been dened by Circular 4/2013.5
4
According to report by CNMV, available at www.cnmv.es, only 28.2% of
the listed companies comply with every point of Recommendation 40 in
year 2007 (the Board should submit a report on directors remuneration
policy to the advisory vote of the General Meeting as a separate item on the
agenda, etc.), 21.3%, 21.2%, and 27.3% in years 2008, 2009, and 2010,
respectively. For its part, 30.5% of the listed companies comply with the
disclosure of individual remuneration in year 2007, 30.5%, 28.2%, and
31.8% in years 2008, 2009, and 2010, respectively.
5
Circular 4/2013, of June 12, of the National Securities Market, which sets
the annual report models remuneration of directors of listed companies and
members the board of directors and the supervisory board of the savings
banks that issue securities admitted to trading on ofcial stock markets.
The content of this report is detailed in Section Remuneration

Reporting of this chapter.
Securities Market Act (Article 61 Encore)

The Aldama Report (2003), which has been referred to pre-
viously, and especially the Commission for its development,
decided to complement the voluntary recommendations with a
legislative intervention, forcing companies to report on the
degree of compliance with the recommendations. This was
reected in the Article 116 of the Ley del Mercado de Valores or
Securities Market Act, introduced by Law 26/20036 (at
present, Article 61 encore of the Securities Market Act as
amended by the Sustainable Economy Law). This article estab-
lishes the obligation for listed companies to make public an
annual corporate governance report (Corporate Governance
Annual Report). In this report, the listed companies shall detail
the recommendations of CUBG being followed and the reasons
why the rest are not being followed (the well-known principle of
comply or explain). Consequently, this report contains informa-
tion on the degree of compliance with the recommendations
related to the directors remuneration, to which we eluded earlier
(Recommendation 8 and Recommendations 3336, CUBG
2013).
Also, the Corporate Governance Annual Report contained
information, among others, about the remuneration of Board mem-
bers and related operations of the company and its shareholders and
its directors and executives (Circular 4/2007, CNMV). However,
the regulatory changes that occurred as a result of the enactment of
the Sustainable Economy Law have removed the references to the
information on directors remuneration from the Corporate
Governance Report,7 due to this information being included in the
6
Law 26/2003, of July 17, on Transparency and information instruments of
listed companies.
7
Following the approval of the amendment of the Unied Code of
Good Governance (CNMV, 2013), the Order ECC/461/2013 of March
20 includes the content of the new model and Circular 5/2013 denes the
ofcial model.
Order ECC/461/2013 of March 20, which will determine the content
and structure of the annual corporate governance report, the annual report
on remuneration, and other means of information of listed companies,
boxes savings, and other entities that issue securities admitted to trading on
ofcial stock markets.
Circular 5/2013, of June 12, of the National Securities Market, which
provides models of annual corporate governance reports of listed companies
of the savings banks and other institutions that issue securities admitted to
trading on ofcial stock markets.
Annual Report on Remuneration of Directors. The content of this

report is developed later.
Other Regulations of Listed Companies (Semiannual Financial

Information and Significant Event)
The Royal Decree 1362/20078 regulates the presentation by listed
companies of the semiannual nancial information. Circular 1/
20089 establishes models to submit such information. Among the
information to be collected, we highlight certain data on the remu-
neration of directors and senior ofcers (see Section Remuneration
Reporting).
Article 47 of Royal Decree 1362/2007 also establishes the obli-
gation to notify the CNMV as a signicant event, the compensation
systems of directors of companies listed on an ofcial secondary
market in Spain or another European Union market, involving the
delivery of shares in the company in exercising their duties, rights,
or share options or any system whose settlement is linked to the evo-
lution of the price of such shares. This communication may be made
directly by the director or senior ofcer in question or by society.
Communications should be made both at the time of the establish-
ment of the system (in the same way that contact should be made if
there is any change) and the time of settlement of the same. For the
communication of such information, as relevant information, the
CNMV proposes a model in Annex VIII of the Circular 2/2007,10
mandatory.
REGULATION FOR FINANCIAL INSTITUTIONS

Financial institutions have received special treatment by the impor-
tance in the economy of any country. This is why we have thought
it proper to refer to the recommendations and regulations applicable
8
Royal Decree 1362/2007, of October 19, by which develops the Law 24/
1988, of July 28, on the Securities Market (Law 1988), in relation to the
transparency requirements in relation to information about issuers whose
securities are admitted to trading on a secondary market or on another regu-
lated market in the European Union.
9
Circular 1/2008, of January 30, the National Commission on the Securities
Market, on periodic reporting issuers with securities admitted to trading on
regulated markets on yearly nancial reports, interim management state-
ments, and the quarterly nancial reports.
10
Circular 2/2007, of December 19, of the National Securities Market, by
adopting models of notication of signicant shareholdings of directors and
managers, operations of the issuer of shares and other models.
Voluntary Mandatory
International and European

European Union Spanish legislation
organisms
Law 2/2011 of
Principles for Sound Recommendation of 30
Sustainable Economy
Compensation Practices April 2009
(FSF, 2009) (2009/384/EU)
Royal Decree 711/2011

High-level principles of
Remuneration Policies
(CEBS, 2009) Green Paper on
Corporate Governance Circular 4/2011, 30
in financial istitutions November, Bank of Spain
and remuneration
policies (2010)
Application Standards of
the Sound Royal Decree-Law
Compensation Practices 2/2012, 3 February,
(FSB, 2009) consolidation of financial
sector
Figure 2: Laws or Recommendations Relating to Directors Remuneration in Spain in

Financial Institutions. Source: Own Research.
to such institutions in Spain (see Figure 2), but, without going into
the analysis, as this would exceed the scope of this work.
European and International Recommendations

The absence of good remuneration practices in some nancial insti-
tutions has been one of the factors that contributed to the nancial
crisis that began in the summer of 2007. Besides this, the importance
of nancial institutions in the economy of a country has recently led
some international forums, such as the G-20 and the Financial
Stability Forum (FSF) (now replaced by the Financial Stability
Board, 2009a and 2009b), senior European bodies, such as the
European Commission (2010), and international regulatory bodies,
such as the Committee Basel, and the Committee of European
Banking Supervisors (CEBS), to pay great attention to compensation
practices of nancial institutions.
Spanish legislation on directors remuneration of nancial insti-
tutions is closely linked to these European and international pro-
nouncements on the matter. So they have affected the Spanish
context in a double sense.
On one hand, in Spain, the Bank of Spain recommends that the

nancial institutions adopt and implement different documents pub-
lished by the above organisms, among others:
Principles for Sound Compensation Practices published by the

FSF11 (April 2009);
High-level Principles of Remuneration Policies published by the
CEBS12 (April 2009);
Application Standards of the Sound Compensation Practices
published by FSF13 (September 2009).
On the other hand, as a member country, it must take into

account the recommendations and documents proposed by the
European Union. On the issue of remuneration, the European Union
published the Commission Recommendation of April 30, 2009, on
remuneration policies in the nancial services (2009/384/CE), which
was later followed by the Green Paper on Corporate governance in
nancial institutions and remuneration policies (2010).
Sustainable Economy Act (Law 2/2011) and Royal Decree 771/2011

The adoption in Spain of the Law 2/2011, of March 4, of
Sustainable Economy and Royal Decree 771/201114 involved the
adaptation of Directive 2010/76/EU.15 The birth of this policy has
its origin in consensus by supervisors and regulatory bodies, includ-
ing the G-20 and the CEBS, that the inappropriate remuneration
structures of some nancial institutions have been a contributory
factor of the failure of individual nancial institutions and systemic
problems in Member States and globally.
Law 2/2011, amending Law 13/1985, authorizes the Bank of
Spain to require credit institutions adopting governance standards
including remuneration policies and practices consistent with sound
risk management and effectiveness.
11
Available at http://www.nancialstabilityboard.org/publications/r_0904b.
pdf
12
Available at http://www.eba.europa.eu/documents/10180/16094/High-
level+principles+for+ remuneration +policies.pdf
13
Available at http://www.nancialstabilityboard.org/publications/r_0909
25c.pdf
14
Royal Decree 771/2011, of June 3, by amending Royal Decree 216/2008,
of February 15, on the capital of nancial institutions and Royal Decree
2606/1996 of December 20, on deposit guarantee funds of credit
institutions.
15
Directive 2010/76/EU of the European Parliament and of the Council of
November 24, 2010, amending Directives 2006/48/EC and 2006/49/EC as
regards capital requirements for the trading book and for re-securitisations,
and the supervisory review of remuneration policies.
For its part, the Royal Decree 771/2011 adds a new chapter to
the Royal Decree 216/2008,16 in relation to remuneration policies of
banks.
Other Regulation for Financial Institutions

Circular 4/201117 amending Circular 3/2008,18 to incorporate the
criteria established by the Committee on Banking Supervision (Basel
III), especially in relation to the transparency that should prevail in
the remuneration policy delivered to entities managers and employ-
ees whose decisions affect the risk policy of the entity.
In addition, the Royal Decree-Law 2/201219 contains the rules
applicable to the remuneration of directors and executives of credit
institutions having needed or will need nancial support from the
Fund for Orderly Bank Restructuring.

THE REMUNERATION POLICY FOR DIRECTORS IN SPAIN. A QUESTION
LINKED TO THE BOARD STRUCTURE
As already mentioned, the document in which the remuneration sys-
tems of the company are contained is the bylaws. However, and fol-
lowing the recommendations of CUBG, the development of this
remuneration policy corresponds to the Nomination and Remunera-
tion Committee (sometimes given another name). Specically, this
text attributed to the Nomination and Remuneration Committee the
following functions (Recommendation 52, CUBG 2013):
a) Propose to the Board:

i. The remuneration policy for directors and senior ofcers;
ii. The individual remuneration of executive directors and
other terms of their contracts;
iii. The basic conditions of the contracts of senior ofcers;
b) Oversee compliance with the remuneration policy set by the
company.
16
Royal Decree 216/2008, of February 15, on the capital of nancial
institutions.
17
Circular 4/2011, of November 30, the Bank of Spain, by amending
Circular 3/2008, of May 22, on the calculation and control of minimum
capital.
18
Circular 3/2008, of May 22, on the calculation and control of minimum
capital.
19
Royal Decree-Law 2/2012, of February 3, consolidation of nancial
sector.
Thereby, the Board of Directors will have the documents neces-

sary to perform one of the functions assigned to it under
Recommendation 8 of the same text (CUBG 2013), which has
already been referred to, in order to approve this compensation pol-
icy. Once approved, the Board of Directors or the Nomination and
Remuneration Committee prepares a report on the remuneration
policy, which will be voted upon, only in an advisory sense, at the
General Shareholders Meeting as a separate item on the agenda,
according to Article 61 3rd of the Sustainable Economy Act (Law 2/
2011). The content of this report is discussed in Section Remuneration
Reporting of this chapter.
Also, the supervisory role of the Nomination and Remuneration
Committee on compliance with the remuneration policy
(Recommendation 52.b) is also noteworthy. To guarantee the
compliance of this function, the CUBG recommends that this
Commission be composed exclusively of external directors20 and
have a minimum of three members, notwithstanding that if members
of the Committee so approve, the executive directors or senior
ofcers can attend the different sessions. In addition, the President
must be independent (Recommendation 39, CUBG 2013).
After describing the decision-making process concerning the
remuneration policy based on the recommendations of the CUBG
2013 and the Economic Sustainability Act and before delving into
the compensation systems that revolve around the directors, it
should be noted that Spain has a corporate governance system of
companies characterized by a single Board of Directors (Unitary
Board System), in which different types of directors cohabit with
different functions and responsibilities (see Figure 3).
According to the CUBG (CNMV, 2006), the Board of Directors
for listed companies is composed of internal (inside) or executive
and external (outside) or non-executive directors. In the second case,
there are two categories: (a) independent, those who are in a posi-
tion to perform their duties without being inuenced by any connec-
tion within the company, its shareholders or its management; and
(b) proprietary, those who own equity state above or equal to the
legally determined threshold for a signicant holding, or otherwise
appointed due to their status as shareholders or those who represent
shareholders.
20
Although it was included in the proposed amendment to the Unied Code
of Corporate Governance, ultimately not included in the nal version, the
recommendation for incorporating on the Remuneration Committee a
remuneration expert, as picked up in the Commission Recommendation of
April 30, 2009 (paragraph 7).
Executive CEO
directors
Executive directors
Non-Executive Independent directors

directors Proprietary directors
Figure 3: Typical Board Structure in Spain. Source: Merino, Manzaneque, and Banegas
(2012, p. 395).
The remuneration structure for directors is linked to this struc-

ture. In general terms, there are two kinds of remunerations accord-
ing to the functions exercised by the directors, the time devoted to
exercise their functions and expected results of their work:
The remuneration for performance of core duties stemming from

Board membership usually linked to dedication, expertise, and
responsibility.
The remuneration to directors for performance within the company
of functions other than those attached to the position of director.
The remuneration to executive directors for performance of their
executive function usually linked to competitiveness and align-
ment of shareholders-managers interests.
The remuneration to other kind of directors, to perform other
functions distinct to the duties of oversight and decision-making
exercised jointly on the Board of Directors or on the companys
committees, like advice or representation (such as by a president,
e.g., who is not an executive who performs representation or
advice functions for which they are paid).
Also, the functions of the external directors deserve special

attention with respect to their compensation, as this could compro-
mise their independence. Hence, according to the CUBG 2013 the
companies should note several recommendations in this regard:
Recommendation 33. Remuneration comprising the delivery

of shares in the company or other companies in the group,
share options or other share-based instruments, payments
linked to the companys performance or membership of pen-
sion schemes should be conned to executive directors.
The delivery of shares is excluded from this limitation when
directors are obliged to retain them until the end of their
tenure.
Recommendation 34. External directors remuneration

should sufciently compensate them for the dedication, abil-
ities and responsibilities that the post entails, but should not
be so high as to compromise their independence.
Finally, should be noted that there are no limits in the Spanish
legal system regarding the amount to be received by directors as
compensation for the performance of their duties, except in cases
where compensation is based on participation in social benets (see
Section Remuneration Systems Elements in Spanish Companies).
Nevertheless, it is worth mentioning a particular case is limited
to the nancial sector. Specically, Article 5 of Royal Decree-Law
2/2012 establishes certain limitations on remuneration to entities
that receive support from the Fund for Orderly Bank Restructuring.
Despite this lack of legislation, the concern to avoid excessive
remuneration is evident in the reections that CUBG 2013 page 22
and 23 makes in this respect, advising them to avoid setting as an
objective achieving the average pay of other comparable companies.
Adopting these decisions could lead to an unwarranted upward
trend in pay or ratchet effect by the mere desire to approach the
average of companies whose remunerations are below this.
REMUNERATION SYSTEMS ELEMENTS IN SPANISH COMPANIES

In recent years, the remuneration packages for directors and senior
ofcers used by Spanish listed companies have spent less on sophisti-
cated systems based on xed remuneration and allowances in
keeping with more complex formulas that try to link compensation
with the companys strategic objectives, align the interests of man-
agers with those of shareholders and retain qualied professionals,
through the constitution of compensation systems that are compar-
able and competitive with other companies within the same sector.
In this sense, there are many remuneration systems or formulas
ranging from xed remuneration in cash to more complex systems
such as the deferred compensation linked to the medium- and long-
term objectives and materialized as shares to receive in the future.
So, the remuneration structure for directors, according to
Spanish practice, may include one or more of the concepts summar-
ized in Table 1.
These compensation systems and the rules applicable to them in
the Spanish context will be described in detail next.
Fixed Remuneration
a. Salary
It includes only the amounts paid to directors for their parti-
cipation on the Board of Directors or for services performed in
Table 1: Systems of Remuneration to Directors.

Remuneration System Description
Fixed Salary (Cash or in Fixed fee for their work on management or

remuneration Shares) committees of the Board of Directors.
Complements Fixed special allowances related to the responsibility,
travel expenses or attendance fees (xed amount
independent on the number of meetings), and so on.
Benets and Other standard benets, such as free use of company
perquisites car, free telephone or other additional perquisites.
Also, some benets like salary advances, loans,
insurance premiums, guarantees, and so on.
Annual variable Compensation in the Amounts of money calculated as a percentage of prot
remuneration form of prot sharing of the company.
Attendance fees Allowances related to travel expenses (the amount
depending on the number of meetings).
Multi-annual Stock options Remuneration that provides the beneciaries the right
variable (but not the obligation) to buy company shares for a
remuneration xed price (strike price) during a specied period
(Compensation (exercise period) after the vesting period.
systems tied to
Performance shares Commitment to deliver a number of shares within a
share price or in
period determined under the condition of meeting
shares)
certain nancial targets character or linked to the
shareholder returns.
Stock appreciation Rights that give the possibility to receive an amount in
rights cash or in shares. The amount is calculated as the
difference between the market price of the shares on a
certain date and the initial reference price multiplied
by the number of rights granted.
Deferred stock bonus Commitment to deliver a number of shares of the
company equal to the annual variable remuneration of
senior ofcers and directors.
Restricted shares Delivery of shares that the beneciary cannot sell in
the market during a period of time. Sometimes, the
company also sets other conditions such as compliance
with certain goals or no dividend payments.
Phantom shares Right to receive similar units to shares usually
provides entitlement to dividends, the value of which
is equivalent to one share. To the end of the term of
the plan, the directors are to be entitled to payment of
the shares revaluation.
Pension plans The perception of this type of remuneration is conditional upon retirement or
termination of senior executive in company.
Rights of Amounts as compensation in certain cases of termination of their relationship
compensation with the company.
for cases of
termination
Source: Own research.

their role as senior ofcers or directors. This pay remains con-

stant and is independent of the activity level of directors and
their potential impact of management on the results of the com-
pany.
The remuneration granted to the directors in terms of shares
is also considered in the same light. Sometimes, the companies
can force directors to invest the compensation received, in
whole or in part, into shares and hold it for a period of time, in
other words, a remuneration policy of mandatory reinvestment
in shares.
b. Complements
It includes concepts like Special Responsibility Allowance, extra
compensation for geographical mobility, and attendance fees for
meetings of the Board of Directors and its delegated committees
when the remuneration is independent of the number of meet-
ings which are attended by directors.
Benefits and Perquisites

Remuneration is granted, usually to senior ofcers or directors,
through the performance of their executive duties in consideration
of the services they provide to the company and which include
among others, the use of vehicles, health insurance, life insurance,
telephone charges, and so on.
In relation to these systems of remuneration, neither the regula-
tions nor the CUBG (CNMV, 2013) manifest itself in this regard.
Variable Annual Remuneration (Bonus)

It includes the amounts of money received in the form of prot shar-
ing or any other formula that links these perceptions to the achieve-
ment of specic measurable objectives (companys net sales or other
nancial management indicators).
Regarding this remuneration system, the CUBG (Recommenda-
tion 36, CNMV, 2013) recommends including safeguards to
ensure they reect the professional performance of the beneciaries
and not simply the general progress of the markets or the companys
sector, atypical or exceptional transactions or circumstances of this
kind.
Also, the CUBG (Recommendation 33, CNMV, 2013) recom-
mends that external directors are excluded from this system
(variable component linked to the companys net prot or other
nancial management indicators, e.g., operating prot or EBITDA,
or the value of its market value at a given point in time). The aim is
to avoid the conict of interest that could arise when directors
have to evaluate accounting practices or to take earnings-related
decisions when their salary depends on it. However, the CUBG
(CNMV, 2013) recognizes the contribution of these systems in
aligning the interests of directors with those of shareholders, hence

it considers appropriate its use when compensating the executive
directors.
a. Compensation in the form of prot sharing21

Because of the risk attributable to this system, by focusing on
short-term prots (manipulation of ctitious prots and dividends
according to the schedule of retributions, overvaluation of the
annual accounts with the appearance of ctitious prots, and so
on), it is subject to a concrete legal regime. Specically, Spanish law
requires that such compensation be collected in keeping with the
bylaws of corporation (Article 218 LSC), mentioning the percentage
or the amount destined for that purpose. Moreover, the law imposes
limits, conditions and constraints on this compensation system,
which in some cases differs, depending on the type of business asso-
ciations (see Table 2).
It should also be pointed out that the CUBG (Recommendation
35, CNMV, 2013) recommends that for the determination of
this remuneration any qualications stated in the external
auditors report which might prejudice the prots should also be
taken into account so that the compensation is not based on cti-
tious prots.
a. Attendance fees
It is a kind of remuneration that tries to cover the expenses
incurred by directors for attending board meetings and its delegated
committees when they are dependent on the number of meetings
attended by them. The aim of this type of compensation is to encou-
rage the active participation of directors.
Multi-Annual Variable Remuneration (Compensation Systems Tied to

Share Price or in Shares)
This is a remuneration to be received by the Board, either in cash or
in shares of the company. When the amount is in cash, this will be
determined with reference to the market value or share appreciation
of the company over a period of time.
There are a lot of remuneration elements in which this system
can be realized, as is described in Table 1.
21
Although this system may consist of prot sharing or any formula linked
to other nancial indicators, we only are focused on prot sharing because
other systems are rarely used in Spanish practice.
Table 2: Limits, Conditions, and Constraints Related to Compensation in the Form of Prot Sharing.
Maximum Limit Conditions to Consider Prior to Delivery Constraints for its Recognition
(Article 218, (Article 218, LSC) (Articles 273 and 274, LSC)
LSC)
Limited 10% of the The value of equity is not less than the share capital
Liability disposable (before or after benets distribution).
Company prot The available reserves must be at least equal to the
Joint Stock The mandatory reserve and the reserve established by the amount of research and development expenses appearing
Companies bylaws have been covered. on the balance sheet.
If there is goodwill, restricted reserves should be set aside
Directors Remuneration in Spain

A minimum dividend of 4% to the shareholders or the to the tune of the same amount. A percentage of the
maximum percentage established by the bylaws has been prots representing at least 5% of the initial amount
paid to the shareholders. should be destined towards covering this cost.
10% of net prot for each year must be transferred to the
legal reserve until the total amount of this reserve reaches
at least 20% of the share capital.
Source: Own research.
173
Regarding the specic rules applicable to them, and as men-

tioned previously, the LSC (Article 219) manifests that remuneration
consisting of the delivery of shares, stock options, or linked to the
value of these shares, should be expressly specied in bylaws and be
approved by the General Shareholders Meeting. The agreement will
express, as applicable, the number of shares to be granted, the
exercise price of the stock options, the value of the shares taken as
reference and the duration of this remuneration system.
For its part, the CUBG (CNMV, 2013) recommends
(Recommendation 33) that this type of system be conned to execu-
tive directors, for the reasons that have been discussed previously. In
addition, the CUBG (CNMV, 2013) expressly refers to share-based
variable incentives, proposing payments based on the improvement
in the share price to the cost of capital for shareholders or that of
peer organizations instead of on the absolute change in the price.
The objective of this assertion is to avoid disproportionate earnings
for market reasons.
Pension Plans
As discussed, in this remuneration system concepts are included that
are related to retirement or termination of the directors when they
have reached a certain age. Under Spanish law, the commitments of
the company for these items are usually materialized in two alterna-
tives: (a) dened contribution systems, in which the company agrees
to pay a specied amount periodically for the director; or (b) dened
benet systems when the company agrees to guarantee a certain
income to the director.
These systems are governed by Spanish law by Royal Decree
304/2004, of February 20.22 This regulation aims to develop the
revised text of the Law Regulating Plans and Pension Funds,
approved by Royal Legislative Decree 1/2002, of November 29.23
Rights of Compensation for Cases of Termination

Sometimes, the contracts of executive directors include certain
indemnication clauses for termination of their jobs (called golden
parachutes), which is a common practice in Spain since the employ-
ment or commercial relationship they have with the company is not
covered by the Statute of Workers.
22
Royal Decree 304/2004, of February 20, which approves the plans and
pension funds Regulations.
23
Royal Legislative Decree 1/2002, of November 29, approving the revised
text of the Law Regulating Plans and Pension Funds.
Table 3: Average Remuneration per Director (20042011).

2004 2005 2006 2007 2008 2009 2010 2011
Type of Remuneration (Data in thousands of Euros)

Fixed remuneration 82.4 84.4 71.4 102.2 104.7 102.9 104.7 111.9
Variable remuneration 41.6 43.8 53.0 69.0 65.1 68.5 63.2 75.1
Attendance fees 21.3 25.4 19.0 26.0 27.5 28.3 27.8 28.3
Others 50.4 65.6 68.5 82.7 71.1 89.7 64.5 64.9
Total 195.7 219.2 211.9 279.9 268.4 289.4 260.2 280.2
Type of Directors (Data in thousands of Euros)
Executive director 578 654 872 918 999 1,115 1,022 1,128
Proprietary director 82 83 86 101 102 96 93 99
Independent director 65 80 85 105 104 110 115 117
Other outsiders 119 212 208 135 162 140 116 143
Number of business 182 176 173 173 164 156 153 149
Average of directors per 9.7 9.6 9.9 10.1 10.4 10.4 10.4 10.5
Board
Source: Compiled from data of Corporate Governance Report of the issuers of securities
admitted to trading on the ofcial secondary market (CNMV).24
PRACTICE REGARDING REMUNERATION SYSTEMS IN SPAIN

(20042011)
Regarding the level of compensation, the data collected from the
Corporate Governance Report of the issuers of securities admitted
to trading on ofcial secondary markets reveal an average remunera-
tion per director of h280.2k for 2011 which represents an increase
of 43.2% from 2004 and 7.7% compared to 2010 (see Table 3).
The component that has grown more has been the variable remu-
neration in response to the demands of national and international
organizations.
Regarding the type of director the most signicant increase has
occurred for executives who have seen their remuneration increased
by almost 100% from 2004.
Regarding the remuneration structure, the Spanish compensa-
tion system to directors is characterized by xed salary, although,
the variable remuneration linked to the company performance has
grown in the last years, to stand at 26.8% of the remuneration
structure (see Figure 4).
24
Available at http://www.cnmv.es/portal/Publicaciones/PublicacionesGN.
aspx?id=21
Type of Remuneration Year
2004 2005 2006 2007 2008 2009 2010 2011
Fixed remuneration (%) 41.9 38.5 33.7 36.5 39.0 35.5 40.2 39.9
Variable remuneration (%) 21.1 20.0 25.0 24.6 24.3 23.7 24.3 26.8
Attendance fees (%) 10.8 11.6 9.0 9.3 10.3 9.8 10.6 10.1
Others (%) 26.2 29.9 32.3 29.5 26.5 31.0 24.9 23.2
Fixed remuneration Variable remuneration

Attendance fees Others
Figure 4: Aggregate Remuneration for Board of Directors Percentage Distribution by

Type of Remuneration (20042011). Source: Compiled from data of Corporate
Governance Report of the issuers of securities admitted to trading on the official
secondary market (CNMV).
One issue to which different codes have paid special attention over
the years is the transparency of the remuneration of directors which,
despite already being regulated (section 200 LSA, current art.
260 LSC), has always been highly opaque, due to individual infor-
mation not being provided by companies, without which there has
never been a homogeneous and comparable model to adhere to for
the submission of information.
Until 2011, the format in which companies collated information
regarding the remuneration policy was voluntary and there was no
ofcial model, reasons why the Spanish companies would offer
information on the remuneration of directors and senior ofcers
without following homogeneous criteria. However, in general terms,
the content has been consistent with recommendations 35 and 41 of
CUBG (CNMV, 2006) which stipulated concrete information
regarding:
Recommendation 35. The companys remuneration policy, as
approved by its Board of Directors, should specify at least the
following points:
a) The amount of the xed components, itemized where necessary,

of board and board committee attendance fees, with an estimate
of the xed annual payment they give rise to;
b) Variable components, in particular:
i. The type of directors they apply to, with an explanation of
the relative weight of variable to xed remuneration items.
ii. Performance evaluation criteria used to calculate entitlement
to the award of share options or any performance-related
remuneration;
iii. The main parameters and grounds for any system of annual
bonuses or other, noncash benets; and
iv. An estimate of the sum total of variable payments arising
from the remuneration policy proposed, as a function of
degree of compliance with pre-set targets or benchmarks.
c) The main characteristics of pension systems (for example, sup-
plementary pensions, life insurance and similar arrangements),
with an estimate of their amount or annual equivalent cost.
d) The conditions to apply to the contracts of executive directors
exercising senior functions. Among them:
i. Duration;
ii. Notice periods; and
iii. Any other clauses covering hiring bonuses, as well as indem-
nities or golden parachutes in the event of early termina-
tion of the contractual relation between company and
executive director.
Recommendation 41. The notes to the annual accounts should

list individual directors remuneration in the year, including:
a) A breakdown of the compensation obtained by each company

director, to include where appropriate:
i. Participation and attendance fees and other xed director
payments;
ii. Additional compensation for acting as chairman or mem-
ber of a board committee;
iii. Any payments made under prot-sharing or bonus
schemes, and the reason for their accrual;
iv. Contributions on the directors behalf to dened contribu-
tion pension plans, or any increase in the directors
vested rights in the case of contributions to dened benet
schemes;
v. Any severance packages agreed or paid;
vi. Any compensation they receive as directors of the other
companies in the group;
vii. The remuneration executive directors receive in respect of
their senior management posts;
viii. Any kind of compensation other than those listed above,

of whatever nature and provenance within the group, espe-
cially when it may be accounted a related-party transaction
or when its omission would detract from a true and fair
view of the total remuneration received by the director.
b) An individual breakdown of deliveries to directors of shares,
share options or other share-based instruments, itemized by:
a. Number of shares or options awarded in the year, and the
terms set for their execution;
b. Number of options exercised in the year, specifying the num-
ber of shares involved and the exercise price;
c. Number of options outstanding at the annual close, specify-
ing their price, date and other exercise conditions;
d. Any change in the year in the exercise terms of previously
awarded options.
c) Information on the relation in the year between the remunera-
tion obtained by executive directors and the companys prot,
or some other measure of enterprise results.
In addition, the different Spanish codes of good governance

(Aldama Report, 2003; Olivencia Report, 1998), which have already
been mentioned, have insisted on the disclosure of the individual remu-
neration granted to members of the Board of Directors. However, and
inter alia, it has been a habit that has extended little in practice.
For their part, the Corporate Governance Annual Report, and
as previously mentioned, following the request of the aforemen-
tioned Securities Market Act (Article 61 encore) and the development
of the Circular 4/2007 (CNMV), contained aggregate information on
the directors remuneration by type of remuneration concept and type
of director.
As such, the lack of information on individual remuneration
and the need to seek comparable and homogeneous models of infor-
mation are the main reasons that have guided the last Spanish regu-
latory reform regarding this issue.
Currently, in relation to the disclosure of directors remuneration,
the last Spanish legislative reform, the Sustainable Economy Act (Law 2/
2011), has led to the modication of the contents of the Annual
Corporate Governance Report and the emergence of a new information
model called the Annual Report on Remuneration of Directors.
That is why the legal requirement for listed companies to report
on remuneration has ensured that the majority of information on
this topic, previously collected in the Annual Corporate Governance
Report, is now collected in the aforementioned Annual Report on
Remuneration of Directors.
In fact, in the new model of the Annual Corporate Governance
Report (Circular 5/2013) only has to include information on the
overall remuneration of the Board (section C.1.15) and total remu-

neration for members of senior ofcers who are not executive direc-
tors (section C.1.16).
Meanwhile, the Annual Report on Remuneration of Directors
includes information on past, present, and future remuneration poli-
cies granted to directors, expressing the individual remuneration
given to each of the members of the Board of Directors (see
Table 4).
Table 4: Annual Report on Remuneration of Directors.

Annual Report on Remuneration of Directors
(A) Remuneration policy of the company for the nancial year, with full explanation of the
following:
A.1. The remuneration policy;
A.2. The process for determining the remuneration policy;
A.3. The xed component of remuneration;
A.4. The variable components of the remuneration systems;
A.5. Systems of long-term savings of the compensation;
A.6. Indemnities agreed or paid to directors;
A.7. The conditions of the contracts of executive directors;
A.8. The supplementary payments;
A.9. Advances, loans, and guarantees;
A.10. Remuneration in kind;
A.11. The compensation earned by the director under payments made by the listed company to
a third party in which the director serves;
A.12. Other remuneration;
A.13. The actions taken to reduce risk.
(B) Remuneration policy planned for future years, indicating the following:
B.1. General Forecast remuneration policy;
B.2. Decision-making process for setting the remuneration policy;
B.3. Created incentives to reduce risk;
(C) Overall summary of how the remuneration policy applied during the year ended
(D) Details of the individual remuneration of each of the directors, stating:
D.1. Individual remuneration of each of the directors (including remuneration for the exercise
of executive functions) accrued during the year, indicating the following:
The remuneration earned by the company, showing separately cash remuneration, reward
systems based on actions, systems of long-term savings and other benets.
The remuneration earned by company directors for their membership on the Boards in other
companies of the group, showing separately cash remuneration, systems of share-based
payment systems, long-term savings and other benets.
Summary of the total remuneration.
Table 4: (Continued )
Annual Report on Remuneration of Directors
D.2. Report on the relationship between the remuneration received by the directors and the
prots or performance of the entity, explaining, where appropriate, how variations in the
company performance have inuenced the change in the remuneration of directors.
D.3. Report the results of the advisory vote of the general meeting in the annual report on
salaries last year, indicating the number of negative votes if issued.
(E) Other information of interest which cannot be included in any of the preceding
paragraphs.
Source: Compiled from data of Corporate Governance Report of the issuers of securities
admitted to trading on the ofcial secondary market (CNMV).
As part of the semiannual nancial information, listed compa-

nies must collect the following information about the remuneration
of directors and senior ofcers (Circular 1/2008):
Amount accrued in both the issuing corporation by the group

companies.
Remuneration information broken down into the following:
xed remuneration, variable remuneration, allowances, bylaw,
transactions in shares and/or other nancial instruments, other
remuneration, and other benets (advances, loans, contributions
made during the period and funding obligations and pension
plans, life insurance premiums paid during the period and guar-
antees provided to them).
The latest measures taken in Spain on the issue of remuneration of
senior ofcers and directors (preparing the annual report and sub-
mitting it to advisory vote of the General Shareholders Meeting) are
looking to get more control over compensation policies and increase
information transparency thereof. The principle aim is that of
curbing the excesses in compensation produced in recent years,
irrespective of the global economic crisis in which we have been
immersed. As these measures begin to be implemented this year, it
remains to be seen in the years to come as to whether these measures
manage to reach the deterrent effect desired and remuneration is
moderated.
The Spanish government is currently considering taking other
measures as well, such as: (a) limits on compensation to variable
remunerations and allowances; and (b) the possibility that the vote
of the General Shareholders Meeting regarding the Annual Report

on Remuneration of Directors to be binding.
Regarding the rst aspect, a new Commercial Code is being
developed, which has devoted a chapter to the corporate governance
of listed companies. One of the points of this future standard, which
is already drafted and pending approval, is that it limits variable
remuneration to be distributed among the members of the Board of
Directors to a maximum of 1% of the prot before tax. However,
as a sign of just how controversial this measure is, within the
Commission for the preparation of this legislation, the rst attempts
have already emerged at discussion between those who prefer a pro-
cedure with all of the law and those who bow down to maintaining
the self-based guidelines for listed companies.
Moreover, in June 2013, the Spanish government set a goal to
put the national standards at the highest level of performance
against the criteria and principles of Good Governance, which con-
stituted a Committee of Experts on Corporate Governance. To
achieve this objective, the Commission should study the current
situation in Spain and propose measures to improve areas, especially
those explicitly laid out, in evaluating the role of the General
Shareholders Meeting in controlling remuneration policy bodies
management and senior ofcers of the company, and the possibility
of developing a code of good governance for unlisted companies.
After the report by the Committee of Experts, the National
Securities Market is responsible for making the necessary changes in
the Unied Code of Good Governance.
Regarding the weight of the vote of the General Shareholders
Meeting, it is currently under discussion as to the possibility of mak-
ing it consultative or binding.
The authors welcome the proposal to limit variable remunera-
tion of Board members, however, it could also be interesting to limit
xed remuneration and allowances, if we take into account that this
is a very important part of the remuneration granted to the direc-
tors. In the same vein, it could also be interesting if the vote on the
remuneration policies failed to achieve the desired effect of moderat-
ing the remuneration, to plan for the possibility that such a vote was
binding in the face to the approval of remuneration policies.
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CHAPTER
Directors
11 Remuneration in
Ethiopia
Hussein Ahmed Tura
Introduction
The Ethiopian Commercial Code1 (hereinafter the Commercial
Code) is a basic legislation governing various types of business
organizations including partnerships, joint ventures, private limited
companies, and share companies. Given that this legislation has not
been updated since its adoption in 1960, it lacks provisions on
many aspects of company governance particularly on directors
remuneration. In addition to inadequacy of provisions pertinent to
share companies, there is no single stipulation regarding directors
remuneration of private limited companies. With respect to share
companies, the law does not delineate any difference between execu-
tive and non-executive directors remuneration. Furthermore, it does
not seem to entitle directors to receive remuneration as of right. The
Commercial Code states that directors may receive remuneration
only where the general meeting of shareholders decides to that effect
or where companies incorporate terms on directors remuneration
into their articles of association. Besides, the law does not require
companies to establish a remuneration committee. Moreover, there
is lack of legal provision or clear practice on the link between direc-
tors remuneration and performance of companies. Regarding the
quantum of directors remuneration, the National Bank of Ethiopia
(NBE) recently adopted a directive limiting the annual directors
remuneration in the commercial banks not to exceed 50,000 Birr
1
See Commercial Code of Ethiopia (1960).
185
186 HUSSEIN AHMED TURA
and monthly allowance 2,000 Birr, respectively. Despite the signi-

cance of regulating directors remuneration in banking industry
owing to its overall importance to the countrys economy, this insig-
nicant lump sum may adversely affect the independence of direc-
tors, retention of talented experts, and very disproportionate to the
counter of legal responsibilities put upon the directors.
This chapter explores the Ethiopian company law with respect
to directors remuneration. With a view to showing the prole of the
Ethiopian companies, it begins with a brief discussion on the features
of companies and the growing tendency toward separation of owner-
ship and control in share companies. The main discussion focuses
on directors remuneration in Ethiopian share companies with special
reference to the remuneration regulation, remuneration design
(scheme), remuneration reporting, and remuneration challenges.
Profile of Ethiopian Companies

The majority of Ethiopian companies are family-based or closely
owned and small in size of their operation.2 Most of them are pri-
vate limited companies, which are considered to be the best form
for a company with only few owners.3 For instance, among the
125 companies formed from 1991 to 1993, only 6 were share com-
panies while 119 were private limited companies.4 By the same
token, among 2,098 companies formed from 2008 to 2009, only 38
were share companies while 2,060 were private limited companies.5
Few years ago, only wealthy people used to set-up well capitalized
share companies with ve or more members who are often kith or
kin of the founders.6 The case of entrepreneurs and professional
managers launching companies with huge capital base and with
nominal contribution from their own pockets was rare. Establishing
companies by raising capital through public equities has been in the
boom in the country, especially since mid-2008.7
2
Most of the smallest Ethiopian businesses are not organized as companies
but as sole proprietorships, which are also required to register with the state.
Those businesses have little or no reason to be companies; for instance, lim-
ited liability has little meaning for small-scale businesses especially when
business is done on personal basis and court lawsuits are virtually unknown
or impracticable.
3
See USAID (2007, p. 19).
4
See Girma (1994, p. 217).
5
See Tura, (2011a, p. 46).
6
See Addis Fortune Magazine (2011).
7
http://www.hg.org/article.asp?id=19590 (Last visited on July 9, 2013).
Directors Remuneration in Ethiopia 187
Although there are few share companies ordinarily incorporated

under the existing Commercial Code and are unconnected to State
Owned Enterprises, endowments and Midrock Groups, the majority
of Ethiopias largest companies are owned or controlled by state
bodies or political parties.8 Structurally, the endowment companies
appear to have some similarity with nominee and proxy companies
that were used to be found in some European institutions.9 Such
companies account for larger part of the economy than privately
owned companies, which can add a political tone in doing busi-
ness.10 State-owned companies are not organized under the com-
pany law and thus not subject to its rules and protective provisions.
The regulation on boards of public enterprises is to be found in
Proclamations No. 25/1992 and No. 277/2002. The boards of pub-
lic enterprises, excluding those in nancial sector, are supervised by
the Privatization and Public Enterprises Supervising Agency
(PPESA). On the other hand, public nancial enterprises are super-
vised by the Public Financial Enterprise Agency. PPESA is responsi-
ble for the appointment and replacement of board members of all
public enterprises under its jurisdiction including the chairman. The
Public Enterprises Proclamation No. 25/1992 requires state-owned
enterprises to keep books of accounts following Generally Accepted
Accounting Principles. The annual audits of the enterprises are car-
ried out by the Ofce of Auditor General.11
The Emerging Separation of Ownership

and Control in the Ethiopian Share
Companies
There has been unprecedented growth in the number of companies
formed and under the process of formation through initial public
offering of shares (IPOs) presently in Ethiopia.12 While this has
helped the companies to mobilize huge capital from the public, it
has also brought about the dispersion of corporate ownership
8
See Negash (2008, p. 10).
9
Ibid.
10
USAID (2007, p. 20).
11
PSD (2009, p. 16).
12
For instance, six banks were newly formed in the country, while other 16
commercial banks are operating in the market. See http://capitalethiopia.
com/index.php?option=com_content&view=article&id=14181:three-hund
red-million-birr-for-new-bank&catid=12:local-news&Itemid=4 (Last vis-
ited on September 23, 2013).
Table 1: Ownership Patterns in Some of the Non-Financial and Financial

Companies.
Name of Companies Combined Holdings Average Combined No. of
of Highest 10 Holders Holding Holdings of Shareholders
in % in % Directors in %
Awash Int. Bank SC NA 0.037 NA 2,834

Birhan Int. Bank SC NA 0.01 NA 6,000
Bunna Bank SC NA 0.008 NA 11,200
Cheha Business SC 5.64 0.564 3.954 177
Crstal Tannery SC 6.667 0.083 2.583 360
Ehil Beranda Ehil 9.0 0.909 6.363 110
Negadewoch SC
Papirus School SC 3.89 0.359 7.5 110
Sky Bus SC 1.138 0.020 0.399 2,793
YesheraTera Birhan 6.57 0.657 5.921 152
Limat SC
Zemen Bank SC 9.37 0.034 1.659 2,878
Source: The Trade Registry at the FDRE Ministry of Trade, 2013.
among several thousands of shareholders in each of these compa-

nies.13 Although separation of ownership and control usually comes
into effect with the existence of thousands of shareholders in a given
company, this may not be true in case where the distribution of
shares is relatively even (Table 1).
As can be gathered from Table 1, there is a movement, particu-
larly in the nancial share companies and recently in other sectors,
from a closely held company towards more and broad-based share
ownership. Even though what is truly triggering the dispersion of
ownership is not clear, two factors are believed to constitute the
causes for this phenomenon. The rst one is related to the rise of
ination which might have made saving less attractive for the pub-
lic,14 driving investment towards the widely available publicly
offered shares. However, a comprehensive study of shareholder
13
Petros (2010, p. 14).
14
In Habesha Cement SC, for instance more than 40% of the shareholders
have 5,000 ETB (5 shares) each which is the minimum allowed holding,
whereas 90% of the shareholders in Buna Bank (i.e., 10,350 out of 11,500)
own less than 100,000 shares each. See Reporter (Amharic Version) of
October 11 Edition. Likewise, in Brehan Bank S.C., the size of shareholders
owning less than 100,000 is 95% percent (i.e., 5,708 out of 6,000 share-
holders) see, Addis Fortune Magazine, edition of October 4, 2010.
proles needs to be conducted along with the analyses of the volume

of savings in banks in the context of formation of share companies
through IPOs in Ethiopia.15 The second reason seems to be the
design of company promoters who put a minimum and maximum
amount of shareholding.16 This in turn must have been propelled by
the emergence of professional and eager managers who are condent
enough to collect capital from the wider public and make prot.17
Despite lack of clear policy regarding non-nancial companies,
the government policy in relation to the nancial share companies
engaged in banking business seems to be supporting dispersed share
ownership. In this regard, Article 11(1) of the Banking Business
Proclamation No. 592/2008 prohibits any person other than the
FDRE Government from holding more than 5% of the shares in a
bank. Moreover, while Article 2(11) denes a shareholder who
owns 2% or more of the shares as an inuential shareholder, the
Proclamation refers to tness criteria to be met by such a person
under Article 4(1). The Proclamation also states that a share transfer
that will make a person an inuential shareholder shall be approved
by the NBE under Article 10(1). To implement these provisions, the
NBE has issued directives entitled Time Limit for Reduction and/or
Relinquishing Shareholdings Directive No. SBB/47/2010 that spe-
cies the time limit for reduction of excess shares. It provides that
within 36 months from the effective date of this directive (i.e., 16th
day of August 2010), a person who holds shares in a bank, either
on his own or jointly with his spouse or with a person who is below
the age of 18 years and related to him by consanguinity to the rst
degree, in excess of 5% of total subscribed capital of the bank shall
reduce such holding to 5% or less and/or is inuential shareholder
in a bank, must relinquish his shareholdings in another bank.18 A
person who fails to comply with the provisions of this directive shall
be penalized in accordance with Article 58(7) of Proclamation No.
592/2008. Such a person shall be punished with a ne up to 10,000
Birr and with an imprisonment up to three years.19 Thus, the cumu-
lative reading of these provisions shows that the governments policy
in relation to nancial share companies is toward diffused owner-
ship. Nevertheless, there is no clear policy regarding non-nancial
15
According to Access Capital research, in the year 2009, more than a bil-
lion Birr share sale was launched by six companies. Access Capital SC
2009. See http://www.africaneconomicoutlook.org/leadmin/uploads/aeo/
2014/PDF/CN_Long_EN/Ethiopie_EN.pdf. It is not clear whether or not
bank deposits dropped by an equivalent amount.
16
17
Ibid.
18
See Directives No. SBB/47/2010, Article 3(1) and (2).
19
See Banking Business Proclamation (2008).
share companies as the Commercial Code does not contain a provi-

sion dealing with this issue.
Even if the policy towards diffused ownership in the nancial
institutions might be related to the fear of minority shareholder
exploitations, this should not be taken as a conclusion that compa-
nies with small investors are not important to Ethiopia. If the coun-
try needs to create a middle income segment of its population, and if
it wants to have big companies that can pool capital from the
broader public and compete on global level in post-WTO accession,
encouraging the public to invest in share companies is an indispensa-
ble policy.20 Concentrated companies are vital for the countrys
economic development as they add assets to its overall GDP and
create job opportunities to the citizens. Thus, it can be argued that
concentrated ownership should not be prohibited for the mere fear
of minority shareholders exploitation by block holders. The govern-
ment should encourage such types of share companies since forma-
tion of companies in such manner enables them to pull huge amount
of capital from the general public by way of public subscription as
may be deemed necessary.21
In general, the emergence of newer companies with dispersed
shareholders who have no control over the company is changing the
company environment in Ethiopia. In such cases, control over the
company is left in the hands of a few managers who in turn may be
controlled by block holders. This demonstrates that the law should
be reformed in a way that ensures shareholders protection and
boosts the condence of investors on share companies. In other
words, appropriate laws and institutions that can tackle problems of
corporate governance emerging under the new situation of separa-
tion between ownership and control in the country are highly
necessary.
Directors Remuneration in Ethiopian

Share Companies
REMUNERATION REGULATION
The Commercial Code recognizes directors remuneration under
Article 353. It provides that directors may receive a xed annual
remuneration, the amount of which shall be determined by a general
meeting and charged against general expenses.22 It also stipulates
20
See Tura (2011a, p. 80).
21
Ibid.
22
See Commercial Code of Ethiopia (1960). Article 353 (1).
that the articles of association may provide that the directors may
receive a specied share in the net prots of a nancial year.23
Thus, directors remuneration can be decided through two proce-
dures. First, the general shareholders meeting may decide that a
xed annual remuneration should be paid to the members of a
board of directors. Second, companies may specify in their articles
of associations that certain percent (e.g., 510%) of their net prots
in a nancial year shall be paid to directors. Moreover, the
Commercial Code states that the xed remuneration and share in
the prots to be allocated to the board of directors shall be allocated
in one sum; and that the board shall arrange the distribution among
its members in such proportion as it deems t.24 However, the
amount of a share in the net prots may not exceed 10%. This share
is calculated after deduction of: (a) amounts allocated to reserve
funds provided by law or the articles of association; (b) the statutory
dividend, where provided in the articles of association or where not
provided, a sum representing 5% of the paid up value of shares
which have not been redeemed; (c) amounts allocated to reserve
funds established by resolution of a general meeting; and (d) amounts
carried forward.25 In xing share in prots, amounts distributed
or capitalized and charged in a previous balance sheet shall be
considered.26
It should be noted that the directors share in the net prots
shall not be paid where no dividend has been distributed to the
shareholders.27 This provision is a precondition for enforcement of
specied share in the net prots of a nancial year under sub-article
2 of article 353. This means, directors remuneration may not be
paid where companies make prots but where a decision is reached
by directors that no dividend will be distributed to each shareholder.
One may wonder why directors could be denied remuneration after
succeeding in making prots. The main reason behind this stipula-
tion might be aimed at precluding directors from reserving some
portion of the prot for their own remuneration while at the same
time unwilling to distribute dividend to the shareholders. Besides,
directors may decide to re-invest the annual prot instead of distri-
buting it to the shareholders as their remuneration percentage will
increase in the next year. Thus, directors may choose to re-invest the
annual prots of a company even for several years as this normally
increases their share based on the level of the growth. Thus, the
23
Ibid. Article 353(2).
24
25
26
27
directors will be obliged to distribute dividend to shareholders in

order to receive their remuneration out of annual net prot as per
article 353(2) of the Commercial Code.
Moreover, the Ministry of Commerce and Industry, taking into
account the special benets which have been provided to directors
having the status of founders and having regard to the position of
the company and to the salaries and benets of its employees, may,
on the position of shareholders representing not less than 10% of
the capital, order the reduction of the remuneration of the directors
where it considers it to be excessive.28
REMUNERATION DESIGN (SCHEME)

The Commercial Code recognizes three types of remuneration
schemes. These are xed annual remuneration,29 share in annual net
prots,30 and mixed remuneration scheme.31
Fixed Annual Remuneration, which must be decided by the
general shareholders assembly, does not depend on the making of
prots by a company. As it is charged against general expenses,
directors can be paid without waiting for annual prots of a com-
pany. Such type of remuneration may be determined by a general
shareholders meeting (GSM) at the beginning of a nancial year.
Here one may wonder as to why the law entitles directors to receive
remuneration even in the absence of prot. One possible reason is
that it is difcult to conclude that there was no work done by direc-
tors in a budget year though the company fails to make prot.
Companies might fail to make prots due to various reasons. For
instance, companies might not make prots during the phase of their
establishment though directors made their best efforts to that effect.
Thus, if remuneration is not paid in such period because of absence
of prot, no one may be willing to serve in board of directors.
Similarly, companies might not make annual prots even after long
operation in the market where they undertake further constructions
and new investments. Adopting share in prot-based remuneration
alone can affect a company by encouraging short termism at the
expense of the long-term benets. If the directors remuneration is
exclusively based on the share in annual prot, directors may take
28
29
Ibid. Article 353(1): Directors may receive a xed annual remuneration,
the amount of which shall be determined by a general meeting and charged
against general expenses.
30
Ibid. Article 353(2): The articles of association may provide that the
directors may receive a specied share in the net prots of a nancial year.
31
Ibid. Article 353(3): The xed remuneration and share in the prots to be
allocated to the board of directors shall be allocated in one sum.
every risk to make prot, which in turn undermines the long-term

goals of the company and the interest of shareholders. Thus, being
an appropriate incentive mechanism, xed yearly remuneration is
vital to strike a balance between conicting interests of a company
and its stakeholders.
Share in Annual Net Prots is the second scheme of directors
remuneration recognized under Article 353(2) of the Commercial
Code, which substantially differs from that of the xed annual
remuneration. The articles of association of a company may stipu-
late that directors may receive specied share in the net prots of a
nancial year, the amount of which may vary from year to year on
the basis of the overall amount of net prot made by the company.
For instance, 5% of ten million and 10% of two million result in
differing amount. This share is calculated after deduction of
amounts allocated to reserve funds provided by law or the articles
of association; the statutory dividend, where provided in the articles
of association or where not provided, is a sum representing 5% of
the paid up value of shares which have not been redeemed; amounts
allocated to reserve funds established by resolution of a general
meeting; and amounts carried forward as per Article 353(4) of the
Commercial Code.
Mixed Remuneration Design is the third option stipulated under
Article 353(3) of the Commercial Code, where a company may enti-
tle its directors to receive mixture of xed yearly remuneration and
share in prots in a single nancial year. For example, the GSM
may decide that directors receive ve million Birr (xed annual
remuneration); and the articles of association of the same company
may provide that directors are entitled to 3% of the net prots of a
nancial year. The amount of remuneration may vary depending on
the size of the company and its annual net prots. Adopting a mixed
directors remuneration design can be benecial to both directors
and the company. In one hand, the xed annual remuneration
design helps directors to be more prudent and hard working toward
the implementation of the long-term strategies and objectives of the
company. On the other hand, if the remuneration is solely a xed
yearly allowance, directors may be demotivated to make prots in a
short period of time since they may entirely focus on long-term
goals. Moreover, they may lose diligence to work toward prot
making as they are guaranteed to be remunerated irrespective of the
annual net income of the company. Thus, xed yearly remuneration
alone cannot be appropriate incentive. In a similar vein, designing
directors remuneration on the basis of share in annual net prots
alone may also have its own downsides. For instance, it may moti-
vate directors to take excessive risks to make annual prot in order
to be remunerated, which in turn can undermine the overall long-
term strategies of a company. The mixed remuneration design,
therefore, can be used as an appropriate incentive mechanism that

can motivate directors to work towards the long-term wellbeing of a
company without being discouraged from striving to make annual
prots.
It should be noted here that the Commercial Code does not pro-
hibit the share companies from paying monthly allowance. In addi-
tion, it does not cover other compensation schemes such as bonuses,
stock options, pension, and benets (car, healthcare, etc.).
By adopting Directives No. SBB/49/2011, the NBE, the supervi-
sory body of the nancial institutions in the country, has set the
maximum annual directors remuneration of a commercial bank not
to exceed 50,000 Birr for each director since January 15, 2011.
Moreover, the Directives impose a limit on the monthly allowance
given to banks board members for transport, telephone, and other
related costs. Accordingly, monthly allowance pay to a bank direc-
tor shall not exceed 2,000 (Two Thousand) Birr. The Directives
further stress that no bank can pay any compensation for the
board directors, other than these two payments.
REMUNERATION REPORTING
The Commercial Code requires statements to be provided concern-
ing directors remuneration. It stipulates that the balance sheet sub-
mitted to the annual general meeting shall show the total amount of
remuneration, allowances, annuities, retirement benets and benets
in kind given to the directors.32 Pursuant to this provision, all
share companies are duty bound to disclose details on directors
remuneration. As a mandatory legal provision on remuneration
reporting, it may play a signicant role in ensuring transparency in
boardroom. It is particularly relevant to control excessive self-
rewarding activities by executive or non-executive directors. In addi-
tion, the Commercial Code species that loans or guarantees to
directors shall also be shown.33 Disclosure of details on directors
loans or guarantees is required to control conict of interests
between the company and its directors. It is also important to avoid
indirect self-rewarding of directors who assume duciary duties on
behalf of shareholders. However, except nancial institutions which
are currently under strict regulation of the NBE, share companies
are not answerable for failing to observe this mandatory provision
of law as most companies do not report their remuneration regularly
as per legal requirement.
32
33
REMUNERATION CHALLENGES
Although the Commercial Code lays down guidelines regarding
directors remuneration, there are certain challenges surrounding its
enforcement. For instance, the Commercial Code does not oblige
share companies to pay directors remuneration unless it is decided
by the Shareholders General Meeting or it is otherwise incorporated
into the articles of association of a company. It is also not clear
as to whether the law entitles other employees to participate on
annual share in prots although there is a clue to this end. Besides
the lack of denition of the term director in the Commercial Code,
the law does not distinguish between a remuneration of executive and
non-executive directors remuneration. There are also controversies
surrounding the quantum of directors remuneration in commercial
banks. The following few sections devote to a critical analysis of the
challenges surrounding directors remuneration in Ethiopia.
Directors Remuneration: Right or Privilege?

The rst controversy surrounding directors remuneration in Ethiopia
emanates from the term may in Article 353(1) of the Commercial
Code. This may give rise to a question as to whether directors of share
companies are entitled to remuneration as of right or whether it con-
stitutes a mere privilege that is paid or denied by the sole decision of
companies shareholders. It may be argued that since the term may
is a permissive auxiliary and the law requires the amount of remunera-
tion to be xed by the general meeting of shareholders, directors have
no right to claim its payment as of right. This tends to limit directors
right to enforce payment of remuneration where there is no clear
contractual relationship between a company and its directors. In fact,
directors remuneration may be incorporated into a companys articles
of association that would be a contractual basis for its enforcement.
Otherwise, it would be difcult for directors to enforce their right to
remuneration in courts of law where it is not expressly stipulated in
the articles of association or decided by shareholders general meeting.
This has also been a practical challenge. For instance, directors of
Wogagen Bank, one of prot-making private banks in Ethiopia,
worked for four years without receiving any xed yearly remuneration
or share in annual net prots since it was neither decided by general
shareholders meeting nor incorporated into the companys articles of
association. One of the former members of the board of directors of
this bank disclosed that we were failed to sue the company for
payment of directors remuneration in the belief that there is no legal
or contractual basis for our claim. He also added that this bank
started to pay them after it was decided by the general meeting of
shareholders. Moreover, he does not think that directors remunera-
tion is right unless there is a clear contract on the matter.
On the other hand, it can be argued that directors should be

entitled to remuneration irrespective of a decision of shareholders or
its inclusion into a companys articles of associations. This is
because the same legislation (the Commercial Code) contains provi-
sions imposing heavy liabilities on members of board of directors
individually and collectively. For instance, Article 364 of the
Commercial Code prescribes the following liability of directors to
the company.
1. Directors shall be responsible for exercising the duties

imposed on them by law, the memorandum or articles
of association and resolutions of meetings, with the
care due from an agent.
2. Directors shall be jointly and severally liable to the
company for damage caused by failure to carry out
their duties.
3. Directors who are jointly and severally liable shall have
a general duty to act with due care in relation to the
general management.
4. Directors shall be jointly and severally liable when they
fail to take all steps within their power to prevent or to
mitigate acts prejudicial to the company which are
within their knowledge.
5. Directors shall be responsible for showing that they
have exercised due care and diligence.
6. A director shall not be liable where he is not at fau1t
and has caused a minute dissenting from the action
which has been taken by the board to be entered forth-
with in the directors minute book and sent to the
auditors.
In the same token, Article 366 of the Commercial Code stipu-

lates for directors liability to creditors as follows:
1. Directors shall be liable to the companys creditors

where they fail to preserve intact the companys assets.
2. Proceedings may be instituted by the creditors against
the directors where the companys assets are insufcient
to meet its liabilities.
3. A resolution of the general meeting not to institute pro-
ceedings against the directors shall not affect the cred-
itors rights.
4. Creditors may not apply to set aside a resolution to
compromise except on the grounds available to them
under civil law.
Furthermore, Banking Business Proclamation No. 592/2008 under

Article 58 (6) provides that members of board of bank directors shall be
punished with a ne from Birr 50,000 to Birr 100,000 and with a rigor-
ous imprisonment from 10 to 15 years when any of them: a) obstructs
the proper performance by an auditor of his duties in accordance with
the provisions of this Proclamation or inspection of a bank by an
inspector duly authorized by the National Bank; or b) with intent to
deceive, makes any false or misleading statement or entry or omits any
statement or entry that should be made in any book, account, report or
statement of a bank; c) knows or ought to know the insolvency of the
bank and receives or authorizes or permits the acceptance of a deposit.
Therefore, it is paradoxical for the law to allow companies to
deny payment of directors remuneration particularly where they
have already made annual net prots while imposing the above
heavy liabilities on directors. Therefore, there should be a right
to remuneration corresponding to duties imposed on directors
emanating from a mandatory provision of law.
In addition, the role of effective directors remuneration as a tool
of good corporate governance in share companies should not be
underestimated. It can play a signicant role in aligning the interest of
shareholders with those of directors who are expected to undertake
wider powers given to them by the law, the memorandum or articles
of associations and resolutions passed at meetings of shareholders.34
Besides, an appropriate remuneration design is an incentive that may
enhance the diligence and commitment of directors to carry out their
overall duties in the interests of shareholders honestly. The main pro-
blem of corporate governance is the agency cost where the power of
control and ownership separates and solely falls in the hands of few
managers or controlling block holders. The institution of board of
directors is created to safeguard the interests of dispersed shareholders
against opportunism of those who control the company. Although the
Commercial Code stipulates for directors remuneration under Article
353 as an incentive mechanism, it should be adequate and legally
enforceable. The Commercial Code also allows directors to become
shareholders in a company35 and obliges them to deposit as security
with the company such number of their registered shares in the com-
pany as is xed in the memorandum of association which shall not be
handed back until the owners have ceased to be directors and have
fully discharged their liabilities, if any to the company.36 Accordingly,
the Commercial Code tries to mitigate agency costs in a share
company by providing an incentive and controlling mechanisms.
34
Ibid. Article 363.
35
36
Ibid. Article 349(1) and (2).
Moreover, it should be noted that directors normally superintend

the management on behalf of the shareholders of a company with
dispersed share ownership. They also formulate general and specic
policies and strategies of a company as well as decide on credit trans-
actions, involving millions of money in case of nancial companies
provided that they will be responsible if things go wrong.
Furthermore, the function of directorship by its nature involves costs
that need to be compensated for the time and effort sacriced for the
benet of a company. Therefore, there is no reason why directors
would assume the responsibilities in prot-making companies without
remuneration, and there is no justication for the law to deny a right
to remuneration while it imposes burdensome liabilities on board
members. Thus, Article 353 of the Commercial Code should be made
a mandatory provision that obliges share companies to pay directors
remuneration where the articles of association remain silent.
Remuneration of Executive and Non-Executive Directors: No Distinction?

Director may be dened as a person having control over the
direction, conduct, management or superintendence of the affairs of
the company.37 Although the Commercial Code does not dene
the term director, it is dened under Article 2(6) of the Banking
Business Proclamation No. 592/2008 as any member of the board
of directors of a bank, by whatever title he may be referred to. The
important factor to determine whether a person is a director is to
refer to the nature of the ofce and its duties and it does not matter
by what title she/he is referred to. In other words, if she/he is the
member of the board and performs the functions of a directorship,
she/he would be considered as a director in the eyes of the law.
Article 347(1) of the Commercial Code stipulates that [O]nly
members of a company may manage the company. A company
may have managing or whole time directors who are in charge of
the day-to-day conduct of the affairs of a company; and that they
are together with other team members collectively known as man-
agement of the company.38 A company may also have part time
non-executive directors who have nothing to do with the day-to-day
management of the company. They may attend board meetings and
meetings of committees of the board in which they are members.39
The Commercial Code also stipulates that a company shall
have not less than three and more than twelve directors who shall
form a board of directors.40 However, Article 353 of the
37
See Fernando (2006, p. 189).
38
Ibid.
39
See Fama and Jensen (1983).
40
See Commercial Code of Ethiopia (1960), Article 347(2).
Commercial Code does not make a distinction between remunera-

tion that should be paid for the executive directors and non-
executive directors. This may create confusion on whether it is
justiable to remunerate both executive and non-executive directors
likely.
Should Body Corporate Directors Be Remunerated?

The Commercial Code stipulates that [B]odies corporate may be
directors, but the chairman of the board of directors shall be a per-
son.41 Nonetheless, it is not clear as to whether a body corporate,
which does not have a physical existence and is always represented
by a physical person, should be entitled to directors remuneration
because of mere fact of its membership in a certain board.
Particularly, since remuneration is paid to directors for their tangible
contribution to a company they govern, a body corporate (juridical
person) is not in a position to undertake directors duties/functions;
and that it is always represented by a physical person, which gives
rise to agency relationship.
A basic question worth consideration here is whether it is rea-
sonable to remunerate a legal person (body corporate), which is
represented by a physical person while a physical person (represen-
tative) claims payment of remuneration to his own use. In other
words, are representatives of a body corporate or a legal person
who participate in another prot-making company to carry out
board of directors functions legally obliged to transfer directors
remuneration that they received for their participation in a board of
directors of another company?
Assume that Nib International Bank (NIB) is a member

of board of directors of Awash International Bank (AIB).
As NIB (legal person) is not in position to undertake func-
tions of directorship like participating in committee
meeting, preparing business plan and controlling the
management, it was represented by Mr. X (a physical
person). Assume also that AIB paid annual remuneration
amounting 500,000 (Five Hundred Thousand) Birr to
each of its eight members of its board of directors. Who do
you think is legally entitled to receive this remuneration, NIB
or Mr. X?
In this regard, there has been a case between Tumsa
Endowment for Oromia Development (Plaintiff) versus Mr. Abdishu
Hussein (defendant), which was brought before the Federal High
41
Ibid. Article 347 (4).
Court of Ethiopia. In this case, the defendant was the former general
manager of the plaintiff for almost ten years. He was also speci-
cally empowered to represent the plaintiff in all companies where it
owns shares and to participate on meetings, to vote and safeguard
the interests of the plaintiff. Accordingly, the defendant participated
in the board of directors of Wogagen Bank SC (one of the privately
owned banks in Ethiopia) for eight consecutive years by representing
the Plaintiff. During this period, he received about 2.5 million Birr
in the form of directors remuneration from the Wogagen Bank SC
and used it for his own gain. This remuneration was decided in
accordance with Article 353(1) of the Commercial Code by the 11th
Annual GSM of Wogagen Bank SC. As can be read from the
Minutes of this meeting, the main reason for deciding for payment
of the directors remuneration was to compensate directors who
sacriced their time, knowledge, and efforts to maintain the interests
of shareholders and the Bank. It is further mentioned that annual
share in net prots (5%) was meant to be an incentive to instill dili-
gence and commitment in board members for their future endeavors.
Moreover, the decision passed by the GSM took into consideration
the legal responsibilities and burdensome duties assumed by direc-
tors as a justication to pay directors remuneration.
The new management of the plaintiff brought a legal proceeding
against the defendant in 2012 alleging that the defendant was not
legally entitled to receive remuneration for his personal gain; and
that since he was the former general manager of the plaintiff, he
acted as a mere representative while participating in the board of the
Bank on behalf of the plaintiff, which was the actual and legal direc-
tor; and that he illegally misappropriated the remuneration paid to
the actual board member (the body corporate) and pleaded to the
court to order the transfer of the total amount of money received in
the form of directors remuneration with its legal interest (9%) to
the Plaintiff.
On the other hand, the defendant argued that although he partici-
pated in the board of the Bank which paid him remuneration while
he was the representative of the present plaintiff, he is legally entitled
to receive directors remuneration; and that he committed no fault in
appropriating the sum of money he received in the form of directors
remuneration for his personal gain which he received because of his
personal efforts and contributions he personally made to the Bank
with other members of the board, but not on behalf of the plaintiff.
He further claimed that the purpose of remuneration is compensating
individual board members than articial person that has only an
imaginary existence, and that the plaintiff could not make any tangi-
ble contribution to the operation and growth of the bank although it
was a board member. He stated that he protected the interest of
the plaintiff, which received a chunk amount of dividend because
of his participation in the board of the Bank on its behalf. However

he contended that it would be illogical to pay remuneration to the
plaintiff since remuneration is an incentive given to the board mem-
bers for their personal commitments and diligence. He also adduced
the decision passed by the general meeting of shareholders of the
Bank that appreciates directors previous performance in controlling
the management, formulating and implementing viable business
goals, objectives and strategies as a result of which the Bank became
more protable. The decision also clearly indicates that directors
sacriced their time, knowledge, and honestly undertook their du-
ciary duties which resulted in the overall growth of the Bank and
enabled each shareholder to receive substantial amount of dividend
and that it is fair to reward each director for their wonderful contri-
bution so that they will continue to work diligently and honestly in
the future.
The defendant also argued that the former board of the plaintiff
tacitly approved the remuneration he received and utilized for his
personal use as he was not asked to transfer it to the asset of the
plaintiff. He also alleged that it is a customary practice in the
Ethiopian share companies where individual representatives of body
corporate receive directors remuneration for their own gain despite
the fact they represent their employer companies and participate in a
board of another share company.
The Federal High Court decided in favor of the plaintiff by cit-
ing Articles 2209 and 2210 of the Civil Code of Ethiopia. However,
this decision was reversed by the Federal Supreme Court appellate
division which found that directors remuneration was paid to the
defendant for his personal contribution to the Wogagen Bank SC;
that the scope of the power of agency entrusted upon the defendant
by the plaintiff does not prohibit receiving directors remuneration
(Article 2181 of Civil Code); that the defendant participated in the
board of directors of the bank after personally fullling the require-
ments set by the NBE; that he personally assumed the legal responsi-
bilities in accordance with the new Banking Business Proclamation
and NBE directives; that as directors remuneration is an incentive
or reward or compensation for persons who can work and produce
tangible outcome, it would be unjust to deny payment of remunera-
tion to the defendant; and that directors remuneration is an allow-
ance meant for compensating costs incurred by directors while
performing their functions.42
42
This case is still pending at the Federal Supreme Court Cassation Division,
which will render nal and binding decision. Source: Federal Supreme Court
Cassation Division (2014).
The implication of a power of agency entrusted upon a physical

person to participate in a board of directors of a share company
could be relevant where disagreement arises between the body cor-
porate director (principal) and the physical person (agent) as to who
is legally entitled to receive remuneration. The existence of contract
of agency should not be confused with entitlement to remuneration
because of the following reasons. First, directors are not as of right
entitled to remuneration because of their being elected as members
in certain board of a share company including commercial banks as
per Article 353(1) of the Commercial Code of Ethiopia. The pay-
ment of directors remuneration is based on the exclusive decision of
GSM on the basis of directors actual works, contributions, and
overall company performance. In other words, Article 353(1) of the
Commercial Code is not a mandatory provision regarding the pay-
ment of remuneration unless it is decided by a general meeting of
shareholders. On the other hand, the main purpose of directors
remuneration is to compensate individuals who actually work and
contribute their time, expertise, and effort toward the development
of a business organization. It may also serve to attract talented and
experienced professionals to increase the overall business perfor-
mance of a company. Besides, remuneration is an incentive or
reward for the performance of directors.
Accordingly, there is no reason why body corporate director
would be entitled to remuneration unless the content and purpose of
specic agency as per Article 2181 of the Civil Code clearly show
that the agent is empowered to receive remuneration on behalf of
the principal. Otherwise, there would be no basis, contractual or
legal, to effect payment to a body corporate director, given that a
sole fact of membership does not give rise to a right to remunera-
tion. Therefore, the existence of power of agency in which a physical
person is appointed to participate in certain board, without specic
agency to receive remuneration, should not be construed as preclud-
ing a physical person (agent) from receiving remuneration for his
own benets as long as the payment is effected based on the perfor-
mance of the company paying it. It is obvious that a body corporate,
because of its very nature, cannot undertake actual work that may
produce tangible result for which remuneration could be paid. Thus,
after all, why should a legal person be rewarded at the expense of a
physical person who sacrices his time, effort, and knowledge?
Moreover, the scope and purpose of agency should be taken into
account. For a body corporate to be entitled to directors remunera-
tion, there must be an express and specic agency on this particular
point.
Second, the directors of commercial banks should not be taken
as mere representatives of a body corporate. Banking Business
Proclamation and Directives of the NBE set preconditions regarding
professional qualications, ethical conducts, and heavy civil and

criminal liabilities (see Proclamation No. 592/2008, Article 58; NBE
Directives SBB/54/2012). Election of a person to participate in a cer-
tain board of directors does not give rise to automatic assumption of
position of a director unless the National Bank approves him per-
sonally. Therefore, a person who served as a director in certain
board of private bank should be legally entitled to remuneration,
not only because he works but also he assumes the responsibility of
directorship with risks of civil and criminal liabilities. Hence, there
is no justication for the law to deny a right to remuneration while
imposing burdensome liabilities on a person who works in a board
of directors of certain private bank.
Amount of Bank Directors Remuneration Becomes Controversial

There is also controversy regarding the amount of directors remu-
neration, especially, in relation to the nancial companies in
Ethiopia. According to Article 353(4) of the Commercial Code, the
amount of directors remuneration ranges from 5% to 10% of the
annual net prot of a company subject to deductions provided under
sub-articles of the same provision [Article 353(4)(ad)]. The NBE
has found such payments in banks as being huge amount of money
as they remunerate their board members with generous pay
packages.43 For example, in 2010 alone, private banks declared a
net prot of 1.4 billion Birr after paying 575.4 million Birr in prot
tax and the directors of 11 private banks received a total of 37.3
million Birr in allowances and prot sharing in the 2009/2010 scal
year.44 Among them, Awash International Bank held the leading
position by spending 9.3 million Birr on its directors, followed by
Nib International Bank which awarded its members of board of
directors 7.5 million Birr.45 According to the survey conducted by
the NBE, the highest paid director pocketed one million Birr per
annum, whereas the lowest paid was 102,000.00 Birr.46
The NBE further observed that competition among shareholders
to secure a seat on the board was prevalent due to this generous
remuneration scheme for directors in the private banks.47 In order
to regulate this problem, the NBE issued Directives No. SBB/49/
2011 on January 6, 2011, in accordance with Article 14(4)(e) of the
Banking Business Proclamation No. 592/2008 which authorizes it to
issue directives on the maximum remuneration of a director of a
43
44
Ibid.
45
Ibid.
46
See Capital Magazine (2011).
47
See Tura (2011b, p. 70).
bank, to address disputes and create industry peace and good corpo-
rate governance among nancial institutions.48 The directives limit
the remuneration of individual private bank directors to 50,000.00
Birr in one operating year, and a monthly allowance of 2,000.00 Birr.
Banks are also prohibited from paying directors any benets, in cash
or in kind, in addition to the set annual amount. The failure to imple-
ment the directives could earn a non-complying bank a penalty of
10,000 Birr and make it liable for criminal and civil suits.49
The Directives have indeed entailed debate among different per-
sons including members of boards of directors of private banks and
ofcials of the NBE. The Directives have been criticized for a num-
ber of reasons. First, it is contended that the xed pay scheme pro-
posed by the Directives does not take into account the size of
the banks, the experience and responsibility of each director, or the
complexity of the operations they are engaged in.50 Second, the
Directive is believed to have removed the right of shareholders to
reward those they trust to sit in the boardroom and make decisions
on their behalf.51 According to this view, although banks in particu-
lar and nancial institutions in general are highly important for the
overall economy of the country thereby deserving regulation to
avoid scandals, it should equally be taken into account that private
banks are prot-oriented institutions and individuals involved in
their governance also deserve incentives which are proportionate to
their contribution.52
Third, it is argued that the new pay package is too draconian
and would push talented individuals out of the governance of the
banking sector.53 A banker in the top management of a private
bank who requested anonymity admits the importance of regulat-
ing banks in the current situation but underlines that while the
directives is a move towards the right direction, the new remunera-
tion scheme, set at a maximum of fty thousand Birr for the board
of directors has been set too low. This was also shared by eight
members of board of directors of private banks who wished their
name to be withheld. They argued that the amount of remunera-
tion set does not take into consideration the workload, which
involves meetings and committee work, as well as the risk involved
in being a director. They also argued that the content of the direc-
tives in relation to the amount of directors remuneration would
48
Directives No. SBB/49/2011, Preamble.
49
Proclamation No. 592/2008, Article 58.
50
Hussein, Directives No. SBB/49/2011, Preamble.
51
Ibid.
52
Ibid.
53
discourage many people as it is mainly those with many years of

experience in the banking sector that are sought after. Some of them
stated that they would not want to take the workload for the next
term of election and risk of a 15-year imprisonment if things go wrong.
In the fourth place, the low remuneration might also open the door for
corruption in the banking industry as the board of directors is the top
governing body that decides on key nancial and credit issues.
On the other hand, the Government argues that the Directives
will have positive contribution towards the creation of industry
peace and good corporate governance in the commercial banks in
the country.54 It is asserted that sound corporate governance is
vital for the health of individual banks and the banking sector as a
whole while excessive remuneration recently being paid by banks
to directors have become a threat to the health of the banking sys-
tem.55 It is also suggested that [t]he amount paid to directors
before issuance of the directives was excessive and was creating a
corporate governance crisis and conicts among shareholders to
obtain seats on the boards of directors.56 It has also been main-
tained that the NBE, as the regulator of nancial institutions, is
responsible for setting guidelines on the remuneration of board of
directors in light of good corporate governance practices in the best
interest of all stakeholders.57 Furthermore, it is hoped that the
Directives can promote long-term prots and interests of companies
by discouraging high risk taking for the short-term gains.
Given the economic signicance of banks, the directors remu-
neration must be in line with the interest of all stakeholders. That is
why the Proclamation No. 591/2008 authorizes the NBE to foster
a healthy nancial system and to undertake such other related activ-
ities as are conducive to rapid economic development of
Ethiopia.58 Furthermore, the Banking Business Proclamation
empowers the NBE to issue directives on the maximum remunera-
tion of directors.59
54
Directives No. SBB/49/2011, Preamble.
55
See NBE.
56
The NBE asserted that it has received many requests from shareholders
and those who did not get seats on a banks board to intervene, before the
issuance of the Directives. Interview with Mr. Solomon Desta, Director of
Bank Supervision for NBE, April 26, 2011.
57
Ibid.
58
Proclamation No. 591/2008, Article 4: To achieve these purposes, the
NBE is further empowered to license and supervise banks, insurance compa-
nies, and other nancial institutions; and to create favorable conditions for
the expansion of banking, insurance, and other nancial services for the
achievement of these objectives in accordance with relevant laws.
59
Ibid. Article 14(4)(e).
Moreover, directors remuneration in Ethiopia should be in line

with international best practices. Instead of setting monetary
gures on the directors pay, the regulator should have required
banks to set up a remuneration committee independent of the board
to prepare a remuneration policy.60 This is supported by the experi-
ence of countries with good practices in the corporate governance of
nancial institutions. For instance, the G20 summit held at
Pittsburgh on September 2425, 2009, underlined the pressing
need for remuneration and governance principles in nancial institu-
tions which should be based on a globally consistent framework
aimed at aligning compensation with long-term value creation, not
excessive risk taking.61 Moreover, it has been stressed that a board
remuneration committee should be an integral part of an institutions
governance structure and should be competent, independent and be
able to demonstrate that compensation decisions are aligned with the
institutions nancial stability and future performance.62
Therefore, the NBE should have considered the internationally
accepted practices while setting the amount of remuneration.
Lack of Legal Requirement for Remuneration Committee

Another legal gap in relation to regulation of directors remunera-
tion is the silence of the law on remuneration committee. The
Commercial Code and other relevant laws do not provide for estab-
lishment of a remuneration committee in share companies in
Ethiopia. The practice is also unsatisfactory as companies rarely
establish remuneration committee in their board. The importance of
this committee is underlined in a number of countries. For instance,
various corporate governance codes and principles contain provi-
sions calling for establishment of remuneration committee. In this
regard, the OECD Principles of Corporate Governance provides
that Boards may consider establishing remuneration committee
with a minimum number or be composed entirely of non-executive
members.63 London Stock Exchange (LSE) Combined Code also
stipulates that remuneration committees should be made up exclu-
sively of non-executive directors who make recommendations on the
companys framework of executive remuneration and who must
operate independently from managerial interference and from any
60
61
See Deringer (2009).
62
Ibid., p. 5.
63
Organization for Economic Cooperation and Development, OECD
Principle of Corporate Governance (1999, revised 2004), Principle VI.E.1 and
Annotation to OECD Principle VI.E.1. See http://www.oecd.org/corporate/
principles-corporate-governance.htm.
intrusive business relationship; they should be granted full authority

to seek counsel from both inside and outside sources.64 It stresses
that [t]hey should establish a formal and transparent procedure for
developing policy on executive remuneration and for xing the
remuneration packages of individual directors.
Similarly, Basel Committee on Banking Supervision stated that A
Compensation Committee should be set up for providing oversight of
remuneration of senior management and other key personnel and
ensuring that compensation is consistent with the banks culture, objec-
tives, strategy and control environment.65 In the same token, Securities
and Exchange Board of India (SEBI) lays down non-mandatory
recommendations on remuneration committees as follows.
The board should set up a remuneration committee to deter-

mine on their behalf and on behalf of the shareholders with
agreed terms of reference, the companys policy on specic
remuneration packages for executive directors, including
pension rights and any compensation payment. The remu-
neration committee should comprise of at least three direc-
tors, all of whom should be non-executive directors, the
chairman of the committee being an independent director.
The Chairman of the remuneration committee should be
present at the AGM to answer the shareholder queries.66
Although none of the relevant laws of Ethiopia requires the

establishment of remuneration committee in nancial as well as
non-nancial companies, valuable lessons could be drawn from
international best practices for the future legal improvement in this
regard.
Participation of Employees Other than

Directors on Annual Share in Profits
Commercial Code lacks a provision entitling employees or workers
other than directors to annual remuneration. However, the back-
ground document on Article 353 of the Ethiopian Commercial Code
states the following:
64
London Stock Exchange Combined Code on Corporate Governance
(2003).
65
Basel Committee on Banking Supervision, Principles for Enhancing Cor-
porate Governance, Bank for International Settlements Communications
CH-4002 Basel, Switzerland, October 2010, principle 3, section 53.
66
SEBI (2000).
Remuneration of directors must be limited if one wishes to

avoid inequitable payments. This article contains severe
provisions It nishes with an important provision for the
protection of minorities, in which appears, following the
example of German law, the desire to maintain a certain
proportion between the remuneration of directors and that
of the companys other personnel(employees, workers). It
follows that the tremendous problem of the participation of
the personnel in the prots of the enterprise can be attached
to this provision and the whole problem can be discussed at
the same time unless one thinks that under present circum-
stances the discussion would be premature.67
As can be understood from this commentary, Article 353 of the

Commercial Code was introduced following the example of German
law with a view to maintaining certain proportion between the
remuneration of directors and that of the companys other personnel
(employees, workers). Germany, with its system of codetermination
granting employees a formal role in corporate governance, is
often cited as the prime example of the stakeholder model.68
Nonetheless except the above explanatory note on Article 353 of the
Commercial Code, there is no other clue under the Commercial
Code as to whether workers or employees other than directors are
entitled to share in annual prots in the Ethiopian companies.
On the other hand, Article 353(4)(b) is not clear because of lack
of denition of statutory dividend69 and as to whose interest it
was reserved. When we read this provision in light of the above
commentary on Article 353, statutory dividend seems meant to
67
See Winship (1974, p. 16).
68
See Salacuse (2002, p. 54).
69
Article 353(4)(b) of the Commercial Code provides that the amount of
share in the net prots may not exceed 10% and that this share should be
calculated after deduction of the statutory dividend, where provided in
the articles of association, or where not provided, a sum representing 5% of
the paid up value of shares which have not been redeemed. However, it is
not clear why the law requires the deduction of this amount before payment
of directors remuneration. It is also difcult to identify a beneciary of the
statutory dividend or a sum representing 5% of the paid up value of
shares which have not been redeemed to be deducted from the annual net
prot. A clue in the Commercial Code that would be of help to relate the
term statutory dividend in Article 353(4)(b) to terms envisaged in Articles
337 and 457 as statutory interest or xed or interim interest. This is
discernible from the provisions of Article 337(2) that runs these shares do
not confer any right to that part of the dividend representing the statutory
interest. It may, therefore, be argued that the term statutory dividend in
Article 353(4)(b) is the same with statutory interest, xed interest, or
interim interest.
maintain the interest of employees since other sub-provisions of

Article 353 of the Commercial Code are clear enough and do not
give any implication regarding participation of other employees on
share in annual prots of a company. In contrast, some members of
board of directors and executive ofcers of share companies in
Ethiopia believe that employees do not have any legitimate right to
participate in prot-sharing scheme of companies particularly on the
annual net prots and may receive only certain amount of bonuses
on the sole will of board of directors.70 Due to its vagueness,
Article 353(4)(b) of the Commercial Code remains inapplicable. The
draft version of the revised Commercial Code also maintains this
provision without any modication to it.
The objectives of companies differ in civil law and common law
legal systems. In Germany and other European civil law countries,
the main objective of a company is to maximize the interest of stake-
holders including employees, suppliers, depositors, and the commu-
nity at large unlike the shareholder model of corporate governance
followed in the common law countries such as the US and the UK,
which primarily targets the protection of interests of the share-
holders of publicly held companies.71 The difference on the experi-
ences of countries basically stems from their cultural backgrounds,
philosophical underpinnings of doing business, and the concept of
prot sharing that could be extended to role of employees of a
company.72
In Germany, the interests of the employees can be represented in
an organization by variety of ways, including through trade unions,
codetermination (employee participation on board of directors),
prot sharing, equity sharing, and team production solution.73 The
concept of prot sharing with employees in order to protect their
interests in an organization became much more widely used in
Europe in the 1990s.74 The majority of prot-sharing schemes are
broad-based. That is, all or more employees were included in the
scheme of prot sharing rather than just executives only.75 Prot
sharing motivates the individual worker to put in his/her best as
his/her efforts are directly related to the prots of the organization,
in which one gets a share.76 The objective of such prot sharing is
to encourage employees involvement in the company and improve
70
See Hussein, Directives No. SBB/49/2011, Preamble.
71
See Salacuse (2002, p. 23).
72
Ibid.
73
Ibid.
74
Ibid.
75
Ibid.
76
Ibid.
their motivation and distribution of wealth among all the factors of

production.77
We have seen that the background document on Article 353 of
the Commercial Code tends to recognize other employees right to
participate in the prot sharing of a share company in Ethiopia,
although it is not clear as to whether Article 353(4)(b) is reserved to
achieve this purpose. Involving employees in annual prot sharing is
in line with the notion of corporate social responsibility. The above
commentary should be taken as a benchmark for share companies
in Ethiopia to rethink of rewarding not only directors but also other
employees as doing so will benet them more.
Conclusion
The Commercial Code of Ethiopia provides for the directors remu-
neration.78 There are three schemes of annual directors remunera-
tion recognized under the Commercial Code including annual xed
remuneration, share in annual net prots, and mixed remuneration.
Companies also pay monthly allowances and other cash and in kind
benets. Directors remuneration can be decided by GSM or speci-
ed in a companys articles of association.
However, the law lacks important provisions and clarity regard-
ing the directors remuneration which makes its application contro-
versial and complicated. For instance, the law does not expressly
oblige companies to pay directors remuneration unless it is pro-
vided in the articles of association or decided by shareholders meet-
ing. Nevertheless, there is no justication for the law to deny a right
to remuneration while it imposes burdensome liabilities on a person
who works in a board of directors. Besides, the Commercial Code
does not specify any difference between remuneration of executive
and non-executive directors. In this regard, lack of denition of the
term director in the law may complicate the issue as to whether a
body corporate is entitled to directors remuneration where an agent
participates in another companys board of directors without speci-
c purpose of receiving remuneration on its behalf. Particularly, a
person who serves as a director in certain board of private bank in
Ethiopia should be legally entitled to remuneration, not only because
she/he personally contributes for the growth of the company but
also because she/he assumes the responsibility of directorship with
risks of civil and criminal liabilities.
77
Ibid.
78
See Commercial Code of Ethiopia (1960), Article 353.
The NBE xed the maximum amount of directors remuneration

not to exceed 50,000 Birr per year in companies engaged in banking
business. This directive neglects factors such as the workload, which
involves meetings and committee work, and the risk involved in
being a director. On the other hand, excessive remuneration systems
can hurt a companys long-term strategy by encouraging undue
focus on short-term gains. For instance, executive incentive schemes
that encouraged excessive risk taking are part of a wider problem
that contributed to the global nancial and economic crisis in
2008.79 There is thus the need to strike the appropriate balance
between the pitfalls of exaggerated payment packages versus inade-
quate thresholds of remuneration to directors.80
The directors remuneration should be incentive-oriented based
on company and individual best director performance and mean-
while be designed so as to align directors interests with those of
shareholders subject to the precaution against excessive payments.81
The remuneration packages for executive directors should be deter-
mined by the remuneration committee which should follow clearly
laid down and transparent procedures.82 Criteria such as perfor-
mance and the companys position among its competitors in the
same or similar industry can indeed be considered in the determina-
tion of all incentive schemes.83
Furthermore, the remuneration packages of all directors should
be disclosed in the annual report. The disclosures regarding all ele-
ments of remuneration package of all the directors, that is, salary,
benets, bonuses, stock options, pension, etc., should be made to
the shareholders. Besides, shareholders should have the nal say in
approving remuneration of the full-time as well as the non-executive
directors. The remuneration packages of senior employees holding
key executive posts should be approved by the board and full details
thereof should be disclosed to the shareholders.
References
Addis Fortune Magazine. (2011, April 28). Addis Ababa.
Banking Business Proclamation. (2008). Article 58(7), Proclamation No. 592, Fed.
Neg.Gaz. 14th year, No. 57.
Capital Magazine. (2011, February 29). Addis Ababa.
79
See CIMA (2010, p. 2).
80
See Hussein, Directives No. SBB/49/2011, Preamble, p. 76.
81
Ibid.
82
Ibid.
83
Ibid.
CIMA (the Chartered Institute of Management Accountants). (May 2010). Executive

remuneration schemes and their alignment with business sustainability. Discussion
paper, p. 2.
Commercial Code of Ethiopia. (1960). Proclamation No. 166/1960, Book II, Articles
210 to 554, Neg.Gaz. Extraordinary Issue No. 3.
Deringer, F. B. (2009, October). LLP, remuneration and corporate governance in
nancial institutions. Retrieved from www.freshelds.com. Accessed on April 26,
2012.
Fama, E. F., & Jensen, M. C. (1983). Separation of ownership and control. Journal of
Law and Economics, 26, 301325.
Federal Supreme Court Cassation Division. (2014). Retrieved from http://www.fsc.
gov.et
Fernando, A. C. (2006). Corporate governance: Principles, policies, and practices
(p. 189). New Delhi: Pearson Education.
Girma, A. (1994). Problems and prospects for the emergence of a stock market in
Ethiopia. In G. Yoseph & A. H. B. Kello (Eds.), The Ethiopian Economy: Problems
and Prospects of Private Sector Development. Proceedings of the third annual confer-
ence on the Ethiopian economy, Addis Ababa (p. 217).
London Stock Exchange Combined Code on Corporate Governance. (2003, July).
Retrieved from http://www.frc.org.uk/documents/pagemanager/frc/Web%20Optimi
sed%20Combined%20Code%203rd%20proof.pdf. Accessed on May 11, 2015.
NBE. The Preamble of Limits on Board Remuneration and Number of Employees
Who Sit on Bank Board Directives No. SBB/49/2011.
Negash, M. (2008). Rethinking corporate governance in Ethiopia (p. 10).
Johannesburg: University of the Witwatersrand.
Petros, F. (2010, March). Emerging separation of ownership and control in Ethiopian
share companies: Legal and policy implications. Mizan Law Review, 4(1), 14.
Private Sector Development [PSD]. (2009, June). Hub, draft project document for
development of corporate governance in Ethiopia, p. 16.
Salacuse, W. J. (2002, December). Corporate governance in the UNECE region, The
Fletcher School of Law and Diplomacy, Turfts University, Medford, MA. Paper com-
missioned for the Economic Survey of Europe, 2003 No. 1 by the secretariat of the
United Nations Economic Commission for Europe, UN/ECE, Geneva, p. 54.
Securities and Exchange Board of India [SEBI]. (2000, March). Report of the Kumar
Mangalam Birla Committee on Corporate Governance, Final Report: India,
Section 6.2. Retrieved from http://www.sebi.gov.in/commreport/corpgov.html.
Accessed on May 11, 2015.
Tura, H. A. (2011a). Corporate governance in Ethiopia: What should the future look
like? LL.M Thesis, Addis Ababa University School of Law, p. 80.
Tura, H. A. (2011b, June). Overview of corporate governance in Ethiopia: The role,
composition and remuneration of directors in share companies. Mizan Law Review,
6(1), 70.
USAID. (2007, January). Ethiopian Commercial Law and Institutional Reform and
Trade Diagnostic, p. 19.
Winship, P. (1974). Background documents of the Ethiopian commercial code of
1960 (p. 16). Addis Ababa: Faculty of Law, Haile Sellassie I University.
CHAPTER
Reviewing
12 Institutions
Remuneration
Requirements: From
European Legislation to German
Implementation$
Oliver Kruse, Christoph Schmidhammer
and Erich Keller
Introduction
This chapter analyses the implementation of remuneration policies
in German banking institutions starting from European legislation
standards. The regulations are examined with respect to appropriate
prerequisites of incentive-compatible remuneration systems.
The risk-taking behavior of the nancial sector was an impor-
tant driver of the nancial crisis of 20072009.1 Consequently,
supervisors and banking authorities were required to develop effec-
tive rules for sustainable nancial stability. For managers, excessive
$
The chapter reects the personal opinions of the authors and not necessarily the views of
Deutsche Bundesbank.
1
A survey of the institute of International Finance in 2009 shows that 98%
of the institutions were convinced and that inappropriate remuneration
practise strongly contributed to the nancial crisis. The following weakness
was mentioned: asymmetric alignment of remuneration systems, transpar-
ency, strategy, and risk taking. See International Monetary Fund [IMF]
(April, 2008), chapter 2, and Financial Stability Board (FSB, 2013).
213
214 OLIVER KRUSE ET AL.
risk taking could be an incentive when prots and losses are

rewarded asymmetrically. This means that managers expect high
compensation payments related to short-term prots while losses do
not necessary lead to negative rewards. From a scientic perspective,
the moral hazard problem is induced by the behavior of managers
and investors. Both prot from unlimited upside returns, while
downside risk is limited due to government intervention. This is the
case when institutions are regarded to be systemic relevant or too
big to fail.2 The problem of moral hazard could be solved by
implementing systems that are able to control management activ-
ities. Implementing and operating systems would cause agency costs.
A number of papers have analyzed the impact of moral hazard,
for example, Jensen, M.C. and Meckling, W. H (1976). Authors
investigate the general nature of agency costs generated by the exis-
tence of debt and outside equity.3 In the case of the nancial crises
where losses are socialized and tax payers had to pay the bill, a
signicant reduction of social welfare is the consequence. In the case
of systemic relevant institutions, excessive protection payments
could destabilize economies and increase the risk of government illi-
quidity. To avoid this scenario, clear rules of banking supervisors
help to insure the safety of the nancial system. Although this causes
agency costs, the implementation of rules can be expected to be
signicantly cheaper than costs induced by the retrieval of an insol-
vent major institution. Consequently, banking supervisors started to
develop and implement prudential rules on an international
level. For example, the Basel Committee on Banking Supervision
(BCBS) denes Compensation Principles and Standards
Assessment Methodology in 2010 (BIS, 2010), which can be
regarded as recommendation for banking systems worldwide. The
European Parliament and Council has adopted remuneration poli-
cies (EU Directive, 2013), namely Directive 2013/36/EU on access
to the activity of credit institutions and the prudential supervision
of credit institutions and investment rms, amending directive
2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC
(CRD IV). European standards are subsequently implemented into
German legislation via legal acts, denominated as Regulation on the
Supervisory Requirements for Remuneration Systems in Institutions
(Verordnung ber die aufsichtsrechtlichen Anforderungen an
Vergtungssysteme von Instituten InstitutsVergV).
After illustrating the prerequisites of an incentive-compatible
remuneration system, this chapter provides an overview about the
regulative framework of the EU. In the next section, we describe the
2
Bebchuk and Spamann (2010).
3
Jensen and Meckling (1976).
Reviewing Institutions Remuneration Requirements 215
characteristics of the German remuneration regulation in compari-

son to the EU framework. Finally, the chapter discusses the incen-
tive-compatibility of the European and German remuneration
systems and concludes with future challenges.
Prerequisites of an Incentive-Compatible
Remuneration System
Since many years remuneration systems are well accepted in human
resource management. Popular examples in literature analyzing
remuneration systems for banks are, for example, Erdmann (1991),
Rinker (1997), or Kruse (2001). The three authors state that impor-
tant functions of an effective implementation and operation of remu-
neration systems are that:
They should increase the motivation which leads to a better

performance. Variable elements of remuneration signicantly
support this function, especially when the performance of an
individual and the business performance are adequately
rewarded. In cases where an individuals performance strongly
inuences the business performance of the whole unit or bank,
exceptional high bonuses are paid, see, for example, in invest-
ment banking activities or in distribution functions.
They should promote operational and strategic business objec-
tives. For this function the time-horizon is important. If short-
time bonuses are paid solely, operational objectives will be
promoted. Short-time bonuses can contradict strategic objec-
tives of institutions, if high risk taking is incentivized.
They should increase employee attractiveness. Institutions are will-
ing to pay high bonuses in order to attract high performers.4
Because functions can be contradicting, it is challenging to

design remuneration systems which adequately fulll the main fea-
tures, for example, an increase in motivation and strategic objec-
tives.5 Erdmann (1991), Rinker (1997), or Kruse (2001) show that
diverging functions can only be achieved, if the following prerequi-
sites are fullled.
Transparency: Motivation theories and their evaluation illus-
trate that variable remuneration increases motivation, if employees
4
Herring et al. (2014).
5
Rosenstiehl (1975), Staehle (1999).
clearly understand performance-related bonus systems. Vice versa is

true for systems that are not transparent.6
Flexibility: Remuneration systems should allow for exibility in
order to adjust for changing internal and external conditions.
Compensation Impact: Motivation theories indicate that the
amount of variable payments has to be perceived as signicant.
Otherwise variable components do not contribute to increase
motivation.
Efciency: Remuneration systems are regarded to be efcient, if
the cost-value ratio is low. In other words, the costs for remunera-
tion and handling should be in due proportion to its benets.
Justice: This prerequisite includes three elements. First, remu-
neration has to cover knowledge and skills. Second, the level of per-
formance should be adequately rewarded and nally, remuneration
should be in line with market conditions. Similar market conditions
for all participants are designated as level playing eld.
Individual and Team Practicability: Remuneration systems
should consider the performance of an individual and if appropriate,
the performance of a team. This prerequisite contributes to the per-
ception of justice.
Figure 1 shows that functions and prerequisites are directly and
indirectly connected. Kruse (2001) highlights that the prerequisites
Transparency, Flexibility, Compensation Impact, Efciency, Justice,
and Individual and Team Practicability signicantly contribute to
the acceptance of a remuneration system. Only when bonus systems
are accepted, a successful implementation and sustainable operation
can be achieved.
Regulative Remuneration Standards

of the EU
Article 75 of the Directive 2013/36/EU provides an overview of
remuneration policies in the EU. The role of national authorities, for
example, national banks like the German Federal Financial
Supervisory Authority (BaFin), as well as the role of the European
Banking Authority (EBA), and the European Securities and Markets
Authority (ESMA) is described. While national authorities are
required to collect information which are disclosed by banking insti-
tutions (and provide EBA with information), EBA has to issue guide-
lines which support banks to implement the guidelines set out in
Articles 9295 of the Directive. The focus of information collection
6
Porter and Lawler (1968).
Functions
Increasing Promoting operational

Enhancing employer
performance and strategic business
attractiveness
motivation objectives
Acceptance
Individual and
Transparency
team practicability
Compensation
Flexibility Efficiency Justice
impact
Prerequisites
Figure 1: Functions and Prerequisites of Remuneration Systems.7 Source: Kruse (2001).
and reporting is on natural persons who earn more than 1 million

Euros per year.8
Article 92 of the Directive highlights that remuneration rules
which have to be applied on the group, parent company, and (off-
shore) subsidiary level. Remuneration policies should include a
broad range of staff reaching from senior management, risk takers,
staff engaged in control functions, and any staff who has material
impact on the risk prole of an institution. The risk prole of an
institution can be characterized according to size, international
structure as well as nature, scope, and complexity of activities.9 This
characterization is of special interest for the German banking system
which is heterogeneous in size and complexity of its institutions.
Based on data provided by Deutsche Bundesbank (2013),10 the het-
erogeneity can be shown by relating the number of institutions and
7
Kruse (2001).
8
Directive 2013/36/EU, Article 75.
9
10
Bankenstatistik, March 2013, of Deutsche Bundesbank (2013).
the corresponding balance sheet total. The German banking system

includes 1,867 independent banks where, for example, 1,104 coop-
erative institutions (59% of the number of German institutions)
comprise approximately 11% of the balance sheet total, while 4
large banks comprise more than 31%.11 The German remuneration
regulation accounts for that fact, which is described in Section The
Implementation of Remuneration Regulations in Germany.
The Directive 2013/36/EU enumerates remuneration characteris-
tics which have to be implemented on a national level. Important
requirements are that12:
remuneration policy is consistent with effective risk management

and does not encourage excessive risk taking;
remuneration policy is in line with the long-term business
strategy;
management is responsible for implementing a review process of
the remuneration policy; staff involved in control functions are
independent from business units they oversee;
a remuneration committee has to be implemented in institutions,
which directly oversees senior ofcers; the implementation of a
committee is primarily addressed at signicant institutions with
respect to size, scope, and complexity; organizational details are
described in Article 95 of the Directive 2013/36/EU.
Article 92 makes a clear distinction between xed and variable

remuneration criteria. While xed wages reward professional and
organizational experience, variable remuneration should reect a
sustainable and risk-adjusted performance. Details of variable remu-
neration elements are described in Article 95 of the Directive 2013/
36/EU. One central element is a long-term oriented compensation of
performance-based components. The time span of the variable remu-
neration should be spread over the business-cycle of an institutions
business risk. Furthermore, variable compensation should not
exceed xed components. An exception is the remuneration of
shareholders or owners of institutions who could earn up to 200%
of the xed income.13 At least 50% of the variable remuneration
shall consist of shares, equivalent ownership interests, or instru-
ments that could be converted to Common Equity Tier 1.14
11
Statistical data is based on December 2012.
12
13
Directive 2013/36/EU, Article 95; the opportunity 200% variable remu-
neration obliges the decision of member states.
14
In order to establish sustainable long-term oriented risk manage-

ment strategies, a minimum of 40% of variable allowances have to
be deferred over a period of 35 years. In the case of high volume
payments, at least 60% have to be deferred.15 The EBA has illu-
strated a multiyear example of xed and variable upfront and
deferred payments (EBA, 2012). For institutions that benet from
government intervention, Article 93 of the Directive 2013/36/EU
imposes additional rules restricting variable remuneration policies.
The Implementation of Remuneration

Regulations in Germany
In Germany, European remuneration standards are implemented via
Regulation on the Supervisory Requirements for Remuneration
Systems in Institutions (Verordnung ber die aufsichtsrechtlichen
Anforderungen an Vergtungssysteme von Instituten InstitutsVergV).
As required by European law, German regulation fully covers the
content dened in Directive 2013/36/EU. One noticeable difference
appears in the structure. The German regulation is divided in gen-
eral requirements and special requirements of major institutions.16
The division accounts for the heterogeneity of the German banking
system, including a low number of major banks and a high portion
of small- and medium-sized banks like savings banks, cooperative
banks, or credit and special institutions. In 17 of the German
regulation major institutions are classied with respect to the size
of the balance sheet amount, exceeding 15 billion Euros.17 Besides
the size of an institution, the risk structure can also determine
major banks. For example, if an institution exceeds 15 billion
Euros and the risk structure is regarded to be low, an institution
can be classied not to be major. Vice versa is true for banks which
are below the level of 15 billion Euros, however, comprising a
high risk structure.
Each institution has to consider general remuneration rules like
the relation between xed and variable payments, the alignment of
variable payments, and an institutions strategy or organizational
policy principles. Major institutions are required to fulll more
detailed regulatory standards. For all banks, variable remuneration
has to be aligned with the success of an institution. Major banks are
15
16
Translated paragraphs of the German remuneration standards rely on
Wagner and Schulte (2014).
17
Three years average.
additionally required to consider an individuals qualitative as

well as quantitative prot contributions. Further examples of
requirements are the analysis of individual risk contribution proles,
the deference of variable payments, and the implementation of
remuneration ofcials. Altogether, absolute implementation costs
which are necessary to establish adequate remuneration systems are
expected to be signicantly higher for major banks.18 However,
basic remuneration rules have to be fullled independently of the
bank size. Although the German regulation accounts for the hetero-
geneity of its banking system, relative costs (related to the balance
sheet total) could be signicantly higher for smaller banks.
Incentive-Compatibility of the European

and German Regulation of Remuneration
Systems
In Table 1, we analyze whether the prerequisites of an incentive-
compatible remuneration system are fullled for the European
regulation as well as the German implementation by applying
the features described in section Prerequisites of an Incentive-
Compatible Remuneration System.
Altogether, a high portion of prerequisites that are necessary for
a successful and motivating working environment are fullled. Some
arguments are open or limited, for example, justice between EU
members and non-EU members or the compensation impact with
respect to variable elements. Regarding the acceptance of managers
or staff, new regulations might be unpopular although a high por-
tion of prerequisites are fullled due to limited variable remunera-
tion opportunities or implementation and operation costs. However,
a high level of acceptance can be expected in society.
Conclusion and Perspectives

Implementing and operating remuneration standards causes agency
costs leading to a reduction of social welfare. Compared to potential
costs induced by government interventions, for example, in the case
of an insolvency of a major institution, agency costs can be expected
to be signicantly lower. This argument is possibly the strongest
18
Regulation on the Supervisory Requirements for Remuneration Systems in
Institutions (2013).
Table 1: Analysis of the Prerequisites of an Incentive-Compatible

Remuneration System of the EU Regulation and German Implementation.
Requirements European Remuneration German Implementation
Regulation
Transparency Fullled: remuneration policy has Fullled: remuneration policy has

to be published; signicant banks to be published; major banks (e.g.,
have to deliver more detailed > 15 billion Euros) have to deliver
information more detailed information
Flexibility Limited: clear framework with Limited: clear framework by using
national options national options, e.g., denition of
major banks/exceptions for
collective employees
Compensation Limited: the variable elements shall Limited: the variable elements shall
Impact not exceed 100% of xed not exceed 100%/200% (national
components (but national options) option if the institution is owned
by shareholders or members)
Efciency Open: high costs for implementing Open: high costs for implementing
and operating the system; labor and operating the system; labor
costs could be reduced due to costs could be reduced due to
restricted variable payments restricted variable payments
Justice Fullled (inside EU): Fullled (inside EU and inside
Germany):
xed remuneration should reect
professional experience and xed remuneration should reect
organizational responsibility; professional experience and
performance-related, variable organizational responsibility;
remuneration (level playing eld limited performance-related,
inside EU); restrictions of variable remuneration (level
variable payments are identical; playing eld inside EU);
market orientation (level playing restrictions of variable payments
eld inside EU) are identical;
market orientation (level playing
Open: EU jurisdictions versus non-
eld inside EU)
EU jurisdictions
Open: Germany versus non-EU
jurisdictions
Individual and Fullled: variable remuneration Fullled: variable remuneration
Team Practicability should be the result of individual should be the result of individual
and the business unit assessment and the business unit assessment
Acceptance Fullled: society Fullled: society
Open: employees/management Open: employees/management
supporting the acceptance of remuneration regulations in the

society.
However, the perspective of managers or staff could strongly
differ from the perspective of the society. Only in the case of a
perfect international level playing eld, the prerequisite justice
would be fullled contributing to the acceptance of remuneration
regulation. Because of international diverging standards which con-

tradicts level playing eld, the acceptance of managers or staff can
be expected to be low. Other arguments possibly reducing accep-
tance of managers or staff are relative implementation and operation
costs (divided by bank size) which can be expected to strongly
diverge with respect to bank size.
Acceptance can be regarded to be highly important for a
successful implementation of remuneration standards. Current
survey experiences of the BaFin illustrate, that some institutions
try to undermine regulatory requirements, for example, not fully
dening risk takers or implementing asymmetric variable remunera-
tion components (avoiding maluses).19 Michael Barnier (EU
Commissioner) for example states that some institutions are invest-
ing big efforts avoiding regulatory remuneration standards.20
Altogether remuneration standards are an important step in the
direction of a sustainable nancial stability. However, achieving
high levels of acceptance which signicantly would contribute to the
stability of the law will be a huge challenge in the near future.
References
Bebchuk, L. A., & Spamann, H. (2010). Regulating bankers pay. Georgetown Law
Journal, 98, 247287.
Brsenzeitung. (2014). Brsenzeitung, March 5, 2014.
Botterweck, B., Jaeger, M., Steinbrecher, I., & Vergtungssysteme (2014).
Prfungskampagne: Qualittsmngel bei allen Instituten. BaFin Journal, February,
89.
Deutsche Bundesbank. (2013). Deutsche Bundesbank, Bankenstatistik, Mrz 2013.
Erdmann, U. (1991). Die Entlohnung von Fhrungskrften in Kreditinstituten.
Frankfurt am Main, 1991.
FSB. (2013). Financial Stability Board: Principles for an Effective Risk Appetite
Framework. Consultative Document, 2013.
Herring, F., Low, H.-P., William, A., & Slulte, W. (2014). Remuneration System, The
implementation of national and European Rules in Banks and Investment Fund
Companies. Frankfurt.
IMF. (2008). International Monetary Fund: Global Financial Stability Report,
Containing Systemic Risks and Restoring Financial Soundness, April 2008.
Jensen, M. C., & Meckling, W. H. (1976). Theory of the Firm: Managerial behavior,
Agency costs and ownership structure. Journal of Financial Economics, 4, 305360.
Kruse, O. (2001). Variable Vergtungssysteme in Banken eine Akzeptanzstrategie
zur Gestaltung und Implementierung, 2001.
19
Botterweck, Jaeger, Steinbrecher, and Vergtungssysteme (2014).
20
Brsenzeitung, March, 5, 2014 (author unknown).
Porter, L. W., & Lawler III, E. E. (1968). Managerial attitudes and performance.
Homewood, IL: Irwin.
Rinker, A. (1997). Anreizsysteme in kreditinstituten, Gestaltungsprinzipien und
steuerungsimpulse aus controllingsicht. Frankfurt am Main: Knapp.
Rosenstiehl, L. V. (1975). Die motivationale Grundlagen des Verhaltens in
Organisationen, Leistung und Zufriedenheit. Berlin: Duncker & Humblot.
Staehle, W. H. (1999). Management, Eine verhaltenswissenschaftliche Perspektive.
Mnchen: Vahlen.
Wagner, O., & Schulte, M. (2014). Vergtungssysteme die Umsetzung der nationa-
len und europischen. Regelungen in Banken und Fondsgesellschaften. Verband der
Auslandsbanken.
CHAPTER
The European
13 Approach to
Regulation of
Directors
Remuneration
Roberta Provasi and Patrizia Riva
Introduction
During the last 10 years the European Commission has outlined a
framework for community action to improve company laws and
corporate governance practices in the European Union, to enhance,
as a consequence, the real economy, promoting efciency and
competitiveness of European companies worldwide as well as
strengthening the shareholders rights and third parties protection.
This review process, which started in 2003 with the Action Plan
for the Company Law Modernization and Corporate Governance
Enhancing has accelerated in recent years. It was the result of the
global economic and nancial crisis and of the careful consideration
on the factors which contributed to its occurrence which followed.
With regard to the problem of determining the remuneration of
companies directors, the European Community has agreed with the
approach pointing out that the problem originates mainly on con-
icts of principalagent. These arise both: (a) within public com-
panies with widespread shareholders, between executive directors
(agent) and shareholders as a whole (principal); and (b) within
companies controlled by a limited number of shareholders, between
controlling shareholders (agent) and other shareholders (principals).
225
226 ROBERTA PROVASI AND PATRIZIA RIVA
The Commission noticed that in recent years, on one hand there

has been an increasing relevance of the variable part of directors
remuneration (i.e., linked to performance and responsibilities),
but on the other hand there has been an orientation to short-term
remuneration policies with a detriment of the results obtained in
the long term. For these reasons, since 2004, the Commission has
repeatedly tried to address the matter with three recommendations
(Commission Recommendation 2004/913/EC, 2005/162/EC, and
2009/385/EC) which addressed the following topics:
(a) transparency regarding remuneration policies in general and

remuneration of individual executive and non-executive direc-
tors in particular;
(b) shareholder votes on remuneration reports;
(c) embedding an independent remuneration committee and the
provision of appropriate incentives to stimulate results and
value creation in the long term.
Nevertheless, in 2010 and already earlier in 2007, in

Commission reports SEC (2007) 1022 and (2010) 285, the
Commission had been able to see that certain Member States did
not adequately address the issues related to remuneration. For this
reason in 2010 with the Green Paper on corporate governance of
nancial institutions consultation, the Commission returned to the
theme by asking and obtaining clear indication about the need to
rene directors incentive structure, so as to encourage long-term
results, sustainable for companies.
Most observers, however, were opposed to the introduction of
regulatory measures concerning the remuneration structure in listed
companies, while others had favored the introduction of European
rules to give greater transparency to the remuneration policies and
to give shareholders a right to vote on these issues. As a result of
this long debate, the Green Paper of the European Union in 2011
focused on two of the issues mentioned, namely:
(a) making compulsory for companies the disclosures on remu-

neration policies adopted and on compensation attributed to
executive and non-executive directors;
(b) requiring the shareholders to vote on the remuneration policy.
In 2012 a further consultation on the future of European com-

pany law was undertaken.
The results of all these consultations led the Commission to pub-
lish, on December 12, 2012, the document Action Plan: European
company law and corporate governance a modern legal frame-
work for more engaged shareholders and sustainable companies, by
The European Approach to Regulation of Directors Remuneration 227
which the European Commission wanted to expose the future lines

of action to be pursued both in the area of corporate governance of
listed companies and in corporate law. The main lines of action set
out in the above action plan were:
(a) to strengthen transparency;

(b) to involve shareholders, in particular to encourage members to
an active participation in corporate governance through
enhanced monitoring by shareholders on remuneration policies
and on transactions with related parties.
The European Commission recognized in particular the dangers

of inadequate remuneration policies (too focused on short-term
goals and not justied by the results achieved) and incentive struc-
tures in favor of directors that could lead to unjustied transfers of
value in favor of the executive directors, with potential damage to
the company, shareholders, and other stakeholders. For this reason,
the European Commission expressed the view that policies on remu-
neration must be able to create long-term value, provide welfare for
corporations and should therefore be based on a real connection
between remuneration and achievements. In addition, a more ef-
cient supervision by shareholders on remuneration policies adopted
by the listed companies should be required as it could be part of the
solution to the problem.
Therefore, the need to strengthen the transparency of remunera-
tion policies and individual remuneration accorded to managers
(principle of say on pay), as well as to recognize to shareholders a
right to vote (to be established if binding on the directors or if purely
consultative) regarding the remuneration policy adopted by the com-
pany as described in the remuneration report, which sets out the
way in which this policy has been implemented in the previous year,
emerged. With this initiative, the Commission also intended to
remedy the problem of inconsistency between the disciplines of indi-
vidual Member States relating to the right to vote on remuneration
policy and/or the remuneration report, also in order to ensure the
comparability of the information disclosed to the market by the
companies in the different EU states.
On April 9, 2014, the European Commission published the
Proposal for a Directive amending Directive 2007/36/EC as regards
the encouragement of long-term shareholder and Directive 2013/34/
EU regarding certain report elements on corporate governance. The
primary goal of the proposed revision of the Directive was to contri-
bute to the long-term sustainability of the EU companies, creating
favorable conditions for shareholders and to improve the cross-
border voting rights by increasing the efciency of the equity invest-
ment chain in order to contribute to the growth, jobs creation and
competitiveness in the EU. In particular, regarding the remuneration

of directors, since in the current framework several weaknesses were
found, the proposal aims to strengthen the correlation between
directors remuneration and results, by strengthening shareholders
monitoring. The document did not regulate the remuneration level,
which is left to the decision of the companies and their shareholders.
Articles 9bis and 9ter required listed companies to disclose detailed
and easily accessible information regarding the remuneration policy
and individual remuneration of directors and Article 9ter authorizes
the Commission to prescribe a standard of presentation of some of
this information by an implementing act. As stated in the proposal,
all the benets of the directors in any form must be considered in
the remuneration policy and included in the report. These rules give
to shareholders the right to approve the remuneration policy and to
vote on the report on remuneration. Therefore, the report favors the
exercise of shareholders rights and ensures the liability of directors.
Literature Review
Directors remuneration has been considered one of the central
issues in the debate on the stability of nancial markets as it con-
cerns not only large nancial institutions but all the companies
which have recognized corporate governance relevance (Baur, 2008;
Bebchuck & Fried, 2004; Bender, 2004; Fernandez, 2003; Ferrarini,
Moloney, & Vespro, 2003).
The different approaches developed in literature share some
basic principles:
1. The principle of fair and reasonable remuneration. Compensa-

tion must be adequate to attract and retain top executives, but
at the same time it needs to be dened in order to safeguard the
interests of shareholders and stakeholders. Interests of managers
may not be consistent with those of the company. Managers
can pursue their own interests to the detriment of others, com-
mitting the company in highly risky projects. This may be to
raise their own power and possibly the value of their options in
the short term.
2. The principle of transparency as an essential tool to monitor
and neutralize the bad tendencies of compensation designers
who often try to make the amount of part of the remuneration
not clearly intelligible (the so-called camouage mechanism).
In listed companies the two principles are particularly relevant

for executives (directors and managers) for which the remuneration
system is variable and linked to the performance (especially with

stock option plans) (Santosuosso, 2010).
Best practices and regulatory codes in the different systems have
provided rules to ensure greater transparency and increasingly pre-
cise mechanisms (such as annual remuneration reports). In addition,
some rules have been introduced to better dene and align the inter-
ests of managers with those of shareholders and stakeholders enrich-
ing and qualifying the bargaining process (internal and external to
the company) to get free and balanced negotiations and a higher
rate of agreements aligned to market conditions (arms length bar-
gaining). Most effective incentive plans have the characteristic that a
signicant part of the remuneration is related to the overall corpo-
rate performance (in terms of protability for the shareholder-
bondholder) with a focus on the medium and long term. Short-term
goals involve the risk of management myopia which drive to maxi-
mize current results reducing or even postponing policies (especially
investment) that contribute to the going concern and success of the
company over time (Core, Guay, & Larcker, 2003).
The basic requirement is to provide shareholders and indepen-
dent directors, as well as non-executive directors, with greater
powers.
This is possible by: (i) introducing rules to enhance the
independence of the board increasing the number of independent
directors and appointing a nomination committee and a remunera-
tion committee, composed of non-executive and independent
directors with powers of recommendations, proposals, and advice;
(ii) requiring independent consultants to work out critical details of
remuneration agreements; and (iii) asking for a shareholders meet-
ing vote on executive relevant remuneration plans (Bhagat & Black,
1999).
In many jurisdictions all these aspects are directly regulated by
the law so that the economic rule is elevated to a legal provision.
French Law (L.225-42-1, co.2, of the Code de Commerce) prohibits
remuneration, for listed companies, not related to performance.
German law (87-1 AktG) requires that the supervisory board
sets the total remuneration of the management board at an appro-
priate level, based also on performance and that the criteria
for determining the fairness are linked to the tasks of each member
of the board and benchmark considerations valuing the choices
made by similar companies (Baums, 2001); it is not allowed to
exceed the established extent except for specic reasons. In Italy
negotiation takes place primarily between directors and share-
holders: as a general rule remuneration is dened when directors are
appointed or by a shareholders meeting (art. 2389, paragraph 1,
Civil Code).
Despite the existence of regulatory frameworks, distorting the

effects of executive top management behavior persist and operations
performed happen to affect the value and the stock prices of the
company or its subsidiaries or parent. The literature is unanimous in
considering this as being due to: (a) the mismatch between the
executive directors interests and those of the stakeholders; (b) the
provision of plans acknowledging compensation disproportionately
in favor of managers; and (c) the low efciency of both the agree-
ment mechanisms and the execution monitoring (Melis, Carta, &
Gaia, 2008).
In models based on performance (equity-based pay models) the
selection of the performance indicator is complex and executive
directors may cooperate to structure the remuneration components
to their advantage, suggesting they are in the condition to manipu-
late indicators (Chefns, 2003). Similarly, in models based on simple
options (share-option-based pay) managers inuencing the structur-
ing step can achieve greater benets without any link to the com-
pany performance (Chance, Kumar, & Todd, 2000).
Limits are also related to the governance dysfunction.
The board of directors even with the presence of independent
directors is sometimes almost inactive and in awe of the executive
directors. The reasons can be extremely varied, economic or not,
from solidarity dynamics (collegiality, teamwork, desire to avoid
conict, sometimes friendship and loyalty) to real conicts of inter-
est, related to the inuence that executives may have on the appoint-
ment of directors and on the renewal of their assignment (Brick,
Palmon, & Wald, 2006).
Many studies have aimed at identifying reforms to better
link compensation to performance and especially to try to strengthen
the negotiating power of the shareholders to the power of the directors
in order to balance the interests of different stakeholders involved.
In particular, the American doctrine suggested (Ferrarini, 2005):
to use share prices as the main performance index, neutralizing

market effects and sector inuence and not recognizing special
bonuses or privileges for non-measurable effects of special
operations (such as company acquisitions);
to reduce the so-called windfalls in equity-based plans, consid-
ering and neutralizing results obtained by chance and which can-
not be considered as due to managers good performance;
to keep all incentive mechanisms implemented by the company
to create value, but modifying the payment timing (separating
the assignment step from the payment step and distributing the
second over a longer period of time), and avoiding all sort of
soft landing mechanisms in case of management failures (the
so-called golden parachutes);
to ensure accountability and transparency, fairly reporting any

remuneration component (including deferred wages, retirement
fund and consulting, stock option plans) in order to avoid any
possible remuneration camouage.
European Approach to the Regulation

of Directors Remuneration
Although the phenomenon in Europe has not reached the propor-
tions observed in the United States, due to the different structure of
share ownership of the European companies, in recent decades there
has been an increasing use of different remuneration forms to moti-
vate directors (Becht, Bolton, & Roell, 2002).
The issue was therefore subsequently been taken into considera-
tion as part of the action plan drawn up by the European
Commission in order to dene the priorities of the harmonization
process of European company law (see The Communication from
the Commission Modernizing company Law and corporate gov-
ernance in the European Union. A plan to move forward, May 21,
2003, Com (284) 2003 nal) (COM, 2004).
In particular, in this plan, the Commission expressed the inten-
tion to start a process of homogenization of the various national
legal provisions concerning the remuneration of listed company
directors in regulated European markets. The Commission decided
to opt in the rst phase for the issuance of a recommendation, which
is an act devoid of mandatory value for Member States but indicat-
ing the legislative policy goals that the Commission intends to pro-
mote and possibly pursue with ad hoc legislative measures, where
possible by a spontaneous adaptation by member countries. The
measure provided by the action plan was concretely translated
into two separate recommendations:
(a) the rst Recommendation, approved on December 14, 2004

(Recommendation 2004/913/EC, published in the Ofcial
Journal of the European Union of December 29, 2004. 153),
which specically regulated the remuneration of listed com-
pany directors in regulated European markets;
(b) the second Recommendation, adopted on February 15, 2005
(Recommendation 2005/162/EC, published in the Ofcial
Journal of the European Union of February 25, 2005), which
regulated the role that independent directors should play in
the corporate governance of listed companies.
RECOMMENDATION 2004/913/EC
The Community Recommendation 913/2004 is based on some state-
ments already included in the previous 2003 document. It gives a
range of proposals to strengthen shareholders rights and modernize
the boards of directors. It provides for an initiative aimed at encoura-
ging an appropriate regulatory regime for directors remuneration in
the Member States. It makes it clear that new regulation is necessary
to avoid conicts of interest and hence to implement appropriate
governance controls, based on adequate information rights. Form,
structure, and level of directors remuneration are matters falling
within the competence of companies and their shareholders, but it is
also one of the key areas where executive directors may have a con-
ict of interest. It is important that listed companies display appro-
priate transparency in dealing with investors, so as to enable them to
express their views.
In brief, the EC Recommendation is exclusively referred to the
directors remuneration of listed companies in regulated European
markets. It invites the States to introduce by June 30, 2006:
(1) a combined set of disclosure obligations intended to increase

transparency for market and for shareholders especially with
regard to the directors remuneration, possibly extending such
measures to other components of the administration not part
of the board, such as the general manager;
(2) a specic commitment with regard to the remuneration
through equity incentives.
More specically, according to the rst set of provisions, listed

companies in regulated markets should draw up and publish (also
on the website) on an annual basis a remuneration statement to be
included in the annual report or separately, in which should expose
the directors remuneration policy that the company intends to
follow in the next year and in subsequent years. The structure and
consistency of the different remuneration components of individual
directors (xed fees, variable compensation in the form of bonuses,
or non-cash remuneration and even amounts paid by the company
to administrators for other activities different from the one covered
by the contract) should be disclosed. The information should be
given also related to assignments carried out within the group to
which the company belongs. The Recommendation then invites
Member States to adopt specic legislative provisions to establish
that, as already experienced in regulated US markets, share-based
remuneration may be adopted only after the shareholders annual
general meetings vote. The Commission suggests that the share-
holders approval should be imposed for each additional directors
long-term incentives.
The document is structured into four sections and the main

guidelines are the following:
Sections
I Section Scope and denition
II Section Remuneration policy
III Section Remuneration of individual directors
IV Section Share-based remuneration
Guidelines
Transparency and accountability generate investor condence
Harmonized regulation contributes to eliminate unequal treatment
Shareholders need a clear vision of the remuneration policy
Remuneration policy should be part of the agenda of the annual
general meeting giving shareholders an effective chance to express
their views and an opportunity to debate
Remuneration policy will be better controlled if voted on by the
shareholders; the vote could be advisory
Disclosure of individual directors remuneration is important to
appreciate in the light of the overall performance of the company
Variable remuneration schemes (in shares, share options, or any
other right to acquire shares) should be subject to the prior approval
of the general meeting
The following paragraphs summarize the main contents of each sec-

tion and prole the ways guidelines are expected to be implemented
by companies at the three different levels of disclosure: the general,
the individual, and the specic situation of share-based remuneration.
REMUNERATION POLICY
Disclosure is required. Companies have to draw up a special report
of the remuneration policy named a remuneration statement. It may
be included in the annual report or in the notes to the annual
accounts of the company and posted on the website. It must focus on
policies for the following years and policies implemented in the pre-
vious year with particular emphasis on changes that have occurred.
The report must contain some main information:
1. Relative importance of the variable and non-variable compo-

nents of the remuneration.
2. Performance criteria on which variable components of the

remuneration are based.
3. Linkage between remuneration and performance.
4. Main parameters and rationale for annual bonus scheme and
non-cash benets.
5. Main characteristics of supplementary pensions or early retire-
ment schemes.
6. Main terms of the contracts of executive directors, especially
with regard to duration, applicable notice periods, and provi-
sions for termination payments.
7. Information on the preparatory and decision-making process
used for determining the formulation of remuneration policies,
such as the composition of the Remuneration Committee, the
role of external consultants whose services have been used in
determination of the remuneration policy, and the role of the
shareholders annual general meeting.
The EC Recommendation points out the relevance of share-

holders vote on directors remuneration: the topic must be on the
agenda of the shareholders annual general meeting. The vote may
be mandatory or advisory and member state may provide minimum
quorum (at least 25% of those present or represented).
REMUNERATION OF INDIVIDUAL DIRECTORS

The individual remuneration and other benets should be the dis-
closed in the annual accounts or in the notes to the annual accounts
or in the remuneration report. The main information which should
be presented is:
total amount of salary paid or due in the year;

remuneration and advantages received from any undertaking
belonging to the same group;
remuneration paid in the form of prot sharing or bonus and
the reasons for such compensation;
additional remuneration for special services outside the scope of
usual functions of a director;
compensation paid to or receivable in connection with the activ-
ity termination during that nancial year;
total estimated value of non-cash benets;
the number of share options offered or shares granted by the
company during the relevant nancial year and their conditions
of application;
the number of share options exercised during the relevant nan-
cial year and the price or the value in the share incentive scheme
at the end of the nancial year;
the number of options unexercised and the main conditions for

the exercise of the rights;
any change in the terms and conditions of existing share options
occurring during the nancial year;
any change in the benets accrue mechanism and retirement
fund contributions.
SHARE-BASED REMUNERATION
All share-based remuneration mechanisms must be approved during
the shareholders annual general meeting. The approval relates to:
grant of the share-based schemes, including share options, to

directors;
determination of their maximum number and main conditions
of the granting;
terms within which options can be exercised;
conditions for any change in the exercise price options;
any other incentive mechanism for which directors are eligible.
The annual general meeting should set the deadline within

which the body responsible for directors remuneration may award
these types of compensation to individual directors. It is also
required in the assembly approval in the case of a discounted option
arrangement under which any rights are granted to subscribe to
shares at a price lower than the market value of the share on the
date when the price was determined or is lower than the average of
market values over a number of days preceding it.
Before the general assembly meeting shareholders must be ade-
quately forewarned about the contents of the stock option plan and
incentive. The costs of these operations must be disclosed. Similar
information must be available on the companys web.
RECOMMENDATION 2005/162/EC
A second Recommendation was approved on February 15, 2005
and, even though it concerns the role of non-executive or supervi-
sory directors in the corporate governance of listed companies, it is
also closely related to the remuneration topic. It gives relevant sug-
gestions about the organizational process that listed companies
should follow to determine directors remunerations.
The presence of independent representatives on the board,
capable of challenging the decisions of management, is widely con-
sidered as a means of protecting the interests of shareholders and
other stakeholders. In companies with a dispersed ownership, the
primary concern is how to make managers accountable to weak
shareholders. In companies with controlling shareholders, the focus

is more on how to make sure that the company will be run in a way
that sufciently takes into account the interests of minority share-
holders. Ensuring adequate protection for third parties is relevant in
both cases. Whatever the formal board structure of a company, the
management function should therefore be subject to an effective and
sufciently independent supervisory function. Independence should
be understood as the absence of any material conict of interest.
The supervisory role of non-executive or supervisory directors is
commonly perceived as crucial in three areas, where the potential
for conict of interest of management is particularly high, especially
when such matters are not a direct responsibility for shareholders:
nomination of directors, remuneration of directors, and audit.
It is therefore appropriate to foster the role of non-executive or
supervisory directors in these areas and to encourage the creation
within the (supervisory) board of committees responsible respec-
tively for nomination, remuneration, and audit. Member States are
invited to introduce legislation that would require the establishment
of the three committees within the board of directors (or the supervi-
sory board in the dual system). As a general rule, therefore, the
nomination, remuneration, and audit committees should make
recommendations aimed at preparing the decisions to be taken by
the board. The primary purpose of the committees should be to
increase the efciency of the board by making sure that decisions
are based on due consideration, and to help organize its work with
a view to ensuring that the decisions it takes are free of material con-
icts of interest. The creation of the committees is not intended, in
principle, to remove the matters considered from the purview of the
board itself, which remains fully responsible for the decisions taken
in its eld of competence.
With regard to the remuneration committee, the Commission
suggests (in the guidelines provided in Annex I) that it should be
composed exclusively of non-executive directors who are not
involved in the daily management of the company and that at least a
majority of its members should be independent. Independence char-
acteristics are highlighted in the same recommendation and guide-
lines contained in Annex II. The Committee makes proposals, for
the approval of the board, on the remuneration policy for executive
or managing directors. Such a policy should address all forms of
compensation, including in particular the xed remuneration, per-
formance-related remuneration schemes, pension arrangements, and
termination payments. Proposals related to performance-related
remuneration schemes should be accompanied with recommenda-
tions on the related objectives and evaluation criteria, with a view to
properly aligning the pay of executive or managing directors with
the long-term interests of the shareholders and the objectives set by
the board for the company. The committee should make proposals
to the board on the individual remuneration to be attributed to
executive or managing directors, ensuring that they are consistent
with the remuneration policy adopted by the company and the
evaluation of the performance of the directors concerned. In doing
so, the committee should be properly informed as to the total com-
pensation obtained by the directors from other companies afliated
to the group. It is also asked to make proposals to the board on
suitable forms of contract for executive or managing directors and
to assist it in overseeing the process whereby the company complies
with existing provisions regarding disclosure of remuneration-
related items (in particular the remuneration policy applied and the
individual remuneration attributed to directors). Special attention
has to be given to the structure of remuneration for senior manage-
ment monitoring both the level and the structure. And nally with
respect to stock options and other share-based incentives which may
be granted to directors, managers, or other employees, the commit-
tee should debate the general policies, review information provided
in the annual report and to the shareholders meeting and make pro-
posals concerning special choices about granting options.
The Recommendation species that the remuneration committee
should be able to avail itself of consultants, with a view to obtaining
the necessary information on market standards for remuneration
systems. The committee selects the consultants, appoints them, and
should receive appropriate funding from the company to this effect.
Additional EU Interventions
In March 2009 the Commission with the Communication for the
Spring European Council, Driving European recovery provided
strategic guidelines to regulate and promote the best practices in
implementing the two previous Recommendations (2004/913/EC
and 2005/162/EC) and announced what would have been the
further steps to be taken. Among these, special attention was given
to the remuneration of nancial sector directors which resulted in
London G20 commitments. The Commission presented its plan to
restore and maintain a stable and reliable nancial system. In parti-
cular, the Communication announced that a new Recommendation
on remuneration in the nancial services sector would be presented
in order to improve risk management in nancial rms and align
pay incentives with sustainable performance.
The 30th April 2009 the EU Commission Recommendation on
remuneration policies in the nancial services sector was delivered.
It integrates the previous recommendations and contains some clari-
cation agreed to give greater consistency to the principles set out
with regard to remuneration policies orienting the containment of

nancial risk and was therefore addressed to the categories that
carry out activities with major impacts on business risk. The docu-
ment clearly sets out that excessive risk-taking in the nancial ser-
vices industry, and in particular in banks and investment rms, has
contributed to the failure of nancial undertakings and to systemic
problems in Member States and globally. These problems have
spread to the rest of the economy and led to high costs for society.
Whilst not the main cause of the nancial crisis that unfolded in
2007 and 2008, there is a widespread consensus that inappropriate
remuneration practices in the nancial services industry also induced
excessive risk-taking and thus contributed to signicant losses of
major nancial undertakings. Remuneration practices in a large part
of the nancial services industry have been running counter to effec-
tive and sound risk management. These practices tended to reward
short-term prot and gave staff incentives to pursue unduly risky
activities which provided higher income in the short term while
exposing nancial undertakings to higher potential losses in the
longer term. Creating appropriate incentives within the remuneration
system itself should reduce the burden on risk management and
increase the likelihood that these systems become effective. Therefore,
there is a need to establish principles on sound remuneration policies.
Again, in the same period (April, 2009), the Committee of
European Banking Supervisors (CEBS) published a set of High-
level Principles for Remuneration Policies (Rem. HLP); the princi-
ples were intended to assist in remedying unsound remuneration
policies. Whilst institutions remuneration policies were not the
direct cause of this crisis, their drawbacks, nonetheless, contributed
to its gravity and scale. It was generally recognized that excessive
remuneration in the nancial sector fueled a risk appetite that was
disproportionate to the loss-absorption capacity of institutions and
of the nancial sector as a whole.
On July 13, 2009 the European Commission published a revi-
sion proposal of Directive 2006/48/EC and 2006/49/EC on capital
requirements for credit institutions and investment rms (the Capital
Requirements Directive, or CRD). The presentation of the propo-
sal had been announced in the April 30, 2009 Communication, to
complement the Commissions recommendations on remuneration
policies in the nancial services industry and on the directors remu-
neration of listed companies.
With the proposal adoption the Commission set the goal of:
(a) make it mandatory for banks and investment rms to adopt

remuneration policies that should be measured as a function of
proper risk management of the nancial institution and be
effectively aligned with the long-term interests of the entities;
(b) consider remuneration policies and their relationship with risk

management subject to the supervision of the Authorities and
provide the necessary tools to monitor and punish those who
adopt remuneration policies that encourage excessive risk-taking.
In particular, the Recommendation of April 30, 2009 completes

the previous legislation and strengthens the remuneration policies
with regard to the following aspects:
(a) Principles and scope of application

The proposal applies to banks and investment rms author-
ized under Directive 2004/39/EC 8, having their legal head
ofce or central administration in a Member State. As stipu-
lated in the Recommendation for Financial Institutions, the
principles on remuneration policy should be applied both by
the parent company at the group level, both on individual com-
panies within the group, including those established in offshore
nancial centers; moreover, Member States should ensure that
branches of nancial companies resident in a third country and
operating in one Member State are subject to similar principles
to those applicable to nancial companies residing in the EU.
(b) Structure and remuneration
The remuneration should be structured in order to ensure an
appropriate balance between xed and variable parts. The
xed part must represent a sufciently high proportion of
total remuneration, such as to pursue a exible policy on
incentives and, where appropriate, not to pay any bonuses.
Recommendation for Financial Institutions provides:
the variable component should not exceed a xed precon-
ceived maximum amount;

it should enable rms to withhold bonuses in case of circum-
stances of economic deterioration;

the adoption of negotiating forecasts that enable companies
to ask their employees to refund, in whole or in part, the

bonus paid on the basis of data subsequently proved mani-
festly errors.
In case of a signicant bonus amount, payment of the prominent

part of the same should be deferred for an appropriate period of
time and be subject to the achievement of further performance tar-
gets in the medium to long term. According to the Recommendation
for Financial Institutions, the bonus amount to be deferred should
be given in relation to the total bonus amount in turn, compared to
the total remuneration of the beneciary. The Recommendation
for Financial Institutions also species that the payment of the
deferred bonus part should: consider the risks associated with the
achievement of results in which the bonus is tied and could be liqui-

dated in the form of shares, options, or other nancial instruments.
(c) Parameters used for bonus calculation

The remuneration related to the achievement of performance
targets should be calculated on the basis of results combination
obtained from the single unit concerned, the bank, or invest-
ment rm as a whole.
In identifying the parameters to be used to assess individual
performance, the Recommendation for Financial Institutions
and the Principles suggest using, in addition to nancial cri-
teria, also non-nancial and/or qualitative, such as the level of
compliance with the rules and internal procedures, criteria; this
is the level of customer satisfaction. The current and future
risks, the cost of capital used and liquidity related to the results
achievement (and to the actual payment of bonuses) should
also be considered in bonus calculation.
These results should be evaluated over a period of years in
order to ensure that the assessment process is based on the long-
term results of the company. For this purpose, the Proposal, as
far as the Recommendation for Financial Institutions, suggests
an evaluation period of between 3 and 5 years.
(d) Golden parachute
The amounts allocated in case of early dissolution of an
employment contract, the so-called golden parachute, must
reward goals achieved by employees during the employment
period and not be seen as reward for failure.
(e) Decision-making and governance
The remuneration policy must be drawn up and approved
by the board of directors (supervisory), which is responsible
for the application of its principles. Recommendation for
Financial Institutions suggests that, in the determination of
the remuneration policy, the control authorities, the human
resources department, and external experts should be involved.
In this sense, companies should make sure that the boards of
directors members, the remuneration committee and staff par-
ticipating in the remuneration policy draft, have the necessary
skills and are independent from the business units to which
they are called upon to pronounce. The implementation of the
remuneration policy should be subject (at least annually) to a
central and independent internal review.
As specied in the Recommendation for Financial
Institutions, the staff involved in the monitoring process should
be independent from the controls operating units and should
be adequately paid (independently from the results achieved
from the company subject to control).
(f) Transparency requirements and disclosures prole

The general principles of the remuneration policy should be
formalized and accessible to all staff to which they apply. Staff
should be informed in advance about the criteria that will be
used to determine their remuneration. The evaluation process
should be well documented and made available. Staff must
also receive information regarding:
a. the decision-making process used for determining the remu-
neration policy, including, where appropriate, information
on the composition and remuneration committee mandate,
the external consultants and the role played by all parties
involved;
b. the relationship between remuneration and performance;
c. the methods used for the results evaluation and the risk
adjustment;
d. the criteria for performance evaluation on the basis of
which shares allocation, options or remuneration variable
components are determined;
e. the main parameters and the reasons related to the granting
of any other bonus.
(g) Impact on the supervisory authorities powers
Remuneration policies are under the monitoring of the
supervisory authorities under the CRD. In order to ensure con-
verging political control, CEBS should ensure on an ongoing
basis the guideline arrangements, including on remuneration.
To the supervisory authorities, also in the remuneration mat-
ters, should be granted the power to adopt: restrictive mea-
sures, both qualitative (e.g., may require banks and investment
rms to reduce the risk inherent to their activities, products
marketed by them, as well as in remuneration systems) and
quantitative (e.g., they could oblige some parties to hold more
of their own funds to cover these risks); and/or nancial and
non-nancial sanctions.
The European Parliament subsequently gave its opinion on

remuneration of listed companies and remuneration policies in the
nancial services with the resolution of July 7, 2010. It is related to
the Commission Recommendation premise of April 30, 2009 and
with other provisions and proposals of International organization.
The resolution, structured in 45 sections, highlights the importance
of the following issues:
(a) an effective remuneration governance that considers the oppor-

tunity of establishing a remuneration committee for nancial
institutions and listed companies, which should be independent,
denes the remuneration policies, responds to shareholders and
supervisors, and works closely with the company risk commit-

tee for the evaluation of the incentives provided by the remu-
neration system;
(b) an effective conformity between remuneration and prudent
risk because remuneration must be in proportion to the size,
organization, and complexity of the company as well as appro-
priate to all risk categories and the risks timeline;
(c) a correct balance between xed and variable remuneration, it
is proposed that the variable remuneration is paid only if it is
sustainable according to the nancial situation, which is
deferred over a period considered appropriate (reasonable) and
that it should also be paid by other non-cash instruments;
(d) an effective prudential supervision and involvement of the
other parties involved, it is necessary that companies disclose
clear, comprehensive and timely information about the remu-
neration policies adopted.
The European Commission has undertaken an important path

for the modernization of company law and enhancing corporate
governance thanks to the publication of the Green Paper on corpo-
rate governance in nancial institutions and remuneration policies
adopted in June 2010. In this rst Paper the Commission had
already announced plans to launch a wider reection on the corpo-
rate governance of all listed companies. After only a year, the
Commission on April 5, 2011 published a second Green Paper on
the EU framework for corporate governance through which a con-
sultation was launched aimed at identifying ways to improve and
modernize the system of corporate governance of European listed
companies. It was followed by a consultation process, which ended
on July 22, 2011. The results were summarized in a Feedback
Statement dated November 15, 2011. Within the Green Paper, the
European Commission has fundamentally identied three main sub-
jects on which to start the consultation: (a) the board; (b) the share-
holders; (c) the comply or explain basis. In particular, with reference
to the remuneration policy the most participants to the consultation
were in favor of the proposal to introduce an obligation to disclose
information about the remuneration paid by the company to its
managers, in order to balance the different national rules and, in
this way, make it comparable to information provided by the com-
panies of different Member States.
Many of the above considerations are subsequently integrated
in Directive 2010/76/EC of November 24, 2010 amending
Directives 2006/48/EC and 2006/49/EC. In particular, this Directive
accentuated that the inadequate remuneration structures of some
nancial institutions contributed to the bankruptcy of certain nan-
cial institutions and caused systemic problems in the United States
and globally. To oppose the potentially disadvantageous effects

of designed remuneration structures remuneration policies that are
consistent with the effective risk management should be introduced.
A further consultation on the future of European company law
was undertaken and brought on December 12, 2012 to the publica-
tion of the new Action Plan: European company law and corporate
governance a modern legal framework to make shareholders
more engaged and sustainable companies. The action plan identi-
es three main lines of action:
(a) Increasing transparency with regard to listed companies and

institutional investors.
For this purpose, the Commission proposes the adoption of
compulsory measures to:
strengthen the commitment of information on the policies
adopted, to ensure diversity within the board and on the

evaluation of non-nancial risks through the Accounting
Directives;
allow shareholder identication by the company at the
European level;
introduce disciplinary reporting obligations about voting
policies and activism of institutional investors, and the vot-

ing report.
(b) Enhancing the active role of shareholders.
For this purpose, the Commission proposes to amend share-
holders rights to:
strengthen the control of the shareholders on the directors
remuneration, providing the obligation of an assembly vote

on remuneration policy and on the report that explains how
the policy was implemented and the remuneration of indivi-
dual directors;
strengthen the oversight of transactions with related parties;
introduce rules on the transparency of the advisors activity
and conicts of interest.

(c) Supporting the growth and competitiveness of listed and
unlisted companies.
The Commission aims to take the necessary measures to pro-
mote the freedom of the company and to create a legal frame-
work for the creation of cross-border transactions.
On June 26, 2013, the Parliament and the Council issued the
Directive 2013/36/EU amending the previous Directive 2002/
49/2002 and withdrawing Directives 2006/48/EC and 2006/
49/EC. Directive 2013/36/EU (CRD IV) gives large space to
the remuneration policies of credit institutions and supervision
over them. The Directive goal is to encourage remuneration
policies that are consistent with effective risk management. In
conclusion it is advisable that institutions specify clearly the

remuneration policies that they are aligned with, the risk pro-
pensity, risk values, and long-term interests of the institution.
In determining the remuneration policy it should be considered
as the xed and the variable components represented by mone-
tary components when they are non-monetary. To avoid exces-
sive risk-taking a maximum ratio between xed and total
variable remuneration should be set. The provisions on remu-
neration should be reviewed periodically to ensure prudential
containment of nancial stability and so as not to threaten the
shareholders rights.
In 2014 the Commission adopted further measures to
improve the corporate governance of listed companies; in parti-
cular, on April 9, 2014 the proposal for the revision of the
Directive 2007/36/EC on the shareholders rights was pub-
lished. With reference to the remuneration policies, for the
rst time at a European level, it introduced the voting rights
of shareholders on remuneration. The proposals commit
companies to publish transparent information, which is com-
parable and comprehensive, on their remuneration policies
and implementing procedures. According to the European
approach, no constraint in relation to the maximum amount
of wages is expected, but each company is required to submit
its remuneration policy to the binding vote of shareholders,
which should, however, set a ceiling on the directors remu-
neration. The company is also expected to disclose the wages
and working conditions of its employees, giving attention to
the ratio of employees salariesdirectors remuneration and
discussing the long-term sustainability of the company remu-
neration policies in the context of the general company
strategy.
Evidence on the Actual Compliance

of the Italian Remuneration Reports
to the CG Code
In Italy, the procedure for the implementation of European
Directives on listed companies directors remuneration began on
December 22, 2010 with the approval by the Council of Ministers
of the Legislative Decree 259/2010. It implemented the recommen-
dations of the European Community 2004/913 and 2009/385 and
has been enforced since 2012. In particular, the decree introduced
art. 123ter TUIF which provides the publication on the company
website of the report on remuneration policies and on the compensa-

tion at least 21 days before the shareholders meeting.
In 2011 the Corporate Governance Committee was established
(hereinafter also the Committee), as result of an agreement between
the promoters of the Corporate Governance Code (Borsa Italiana,
Abi, Ania, Assogestioni, Assonime, and Conndustria). The aim of the
Committee was to ensure a continuous and structured process for
both the implementation and the monitoring of the best practices
adopted by Italian listed companies (Riva and Provasi, 2015). Among
the other issues, the Committee controls the implementation of art.6
of the Corporate Governance Code which deals with the remuneration
issue, providing some recommendations, such as, for example,
the denition of a variable component of the remuneration of execu-
tive directors (principle 6.P.2), the provision of a cap to the variable
component of remuneration packages (criterion 6.C.1, let. b), as
well as the recommendation concerning indemnities eventually set
out by the issuer in case of early termination or non-renewal of
directors (criterion 6.C.1, let. f). The Remuneration Report should
provide at least information required by Consob in the Scheme no.
7-bis, Annex 3A of the Issuer Regulation which provides a scheme
about the information to be provided in the Remuneration Report.
That scheme requires information to be provided, on an individual
basis, in case of companies of non -small size, as dened by
Consob Regulation no. 17221/2010, also for key management per-
sonnel in case their total compensation (as a result of monetary
remuneration and that one based on nancial instruments, including
also those received by subsidiaries and afliated) exceeds the highest
total compensation paid to members of the administrative or con-
trol corporate bodies or general managers. This happens rarely and
it is generally related to exit situations, when a subject hierarchi-
cally subordinate receives exceptionally a total remuneration
which is higher than that paid to the top management of the com-
pany. The Remuneration Report is an extensive report, which pro-
vides a lot of information, both ex ante, on the policy adopted by
the company, and ex-post, on the effectively paid remuneration.
In December 2014, Assonime published the results of its annual
survey about the compliance with the Italian corporate governance code
(Italian Corporate Governance Committee, 2014). The 2014 analysis
covers 230 Italian companies, listed on the Italian Stock Exchange on
December 31, 2013, whose Reports were available as of July 15, 2014:
the survey covers substantially the whole stock list (Assonime, 2015).
It includes two monographic parts. The rst one analyzes as
in the previous year the remuneration of directors and statutory
auditors, while the second focuses on the application of the comply-
or-explain principle. The part dealing with remuneration of directors
and statutory auditors is based on information drawn from the
Remuneration Reports, which are made up of two sections: a rst

section, subject to a non-binding vote of the Annual General
Meeting (AGM), describes the company remuneration policy as well
as the procedures used for the adoption and the implementation of
this policy. The second section provides information on the remu-
neration actually paid to directors, statutory auditors, and general
managers (as well as, on an aggregated basis, the remuneration of
the key management personnel), distinguishing between remunera-
tions paid by the company and those paid by subsidiaries or
afliated companies.
With specic reference to the Remuneration Reports, even
though there are still areas for improvement, information made
available is substantial and signicant. The rst section of the
Report provides information on the remuneration policy and the
governance procedures. The policy may have a different level of
detail and specication depending on the company and on the speci-
c topic. In particular, not all companies have expressed a precise
orientation with respect to each point provided in the regulatory
scheme. A number of companies either communicate not to have
made specic provisions relating to a specic point or state that the
board may decide on a case-by-case basis.
1. Using benchmarks
The Scheme 7-bis of the Annex 3A to the Issuers Regulation
(the so-called Consob Scheme) requires issuers to provide, in the
rst section of their Remuneration Reports, whether the remu-
neration policy has been dened also with reference to the poli-
cies of other issuers and, if so, how this benchmark has been
selected. A total of 177 companies disclosed this information
(i.e., 77% of the aggregate). Among those providing this kind of
information, 68 companies (i.e., 30% of the aggregate) also pro-
vide information with respect to the criteria used to identify the
benchmark companies (peers): companies considered as basis
for comparison when xing Remunerations. Peer identication
is instead quite uncommon: the name of the benchmark has
been disclosed by only 13 companies (six in 2013), that is, 6%
of the aggregate.
2. Consistency with the remuneration policy

The Consob Scheme requires issuers to provide, in the second
section of their Remuneration Reports, an adequate representa-
tion of each item of the remuneration table, underlining the
consistency with the policy of reference. The Remuneration
Reports were analyzed looking for explicit information about
the consistency of remunerations paid in 2013 and the policy
of reference, which is, usually, the remuneration policy
approved by the Annual General Meeting (AGM) of the same

year. The AGM vote is, as already mentioned, an advisory vote:
the exceptions are companies in the nancial sector, where the
AGM should approve the remuneration policy. Information
on this point has been provided by a small number of issuers:
74 companies, that is, 32% of the aggregate (markedly
increased from 21% in 2013).
3. Policy changes
The Consob Scheme requires issuers to provide, in the rst
section of their Remuneration Reports, the objectives pursued
with the adopted remuneration policy, its principles and even-
tual changes to the policy compared to the previous year. In 38
cases (i.e., 17% of the aggregate, decreasing from 22% in 2013)
Reports explicitly disclose that the remuneration policy has been
changed with respect to the previous year. The reduction is
stronger among larger companies (from 34% to 19% of the
aggregate among FTSE Mib) and, in particular, in the nancial
sector (from 44% to 17% of the aggregate).
4. Fixed and variable remuneration

The Code recommends that a signicant part of the remu-
neration of managing directors and key management personnel
is linked to the achievement of specic performance objectives,
including non-economical objectives, set out in advance and
consistent with the remuneration policys guidelines. The exis-
tence of a variable remuneration linked to business results is dis-
closed by 175 companies (i.e., 76% of cases: the gure is
slightly increased from 2013, when the percentage was 74%).
The frequency of such disclosure increases according to the
companys size (94% in FTSE Mib, 88% in Mid Cap, 71% in
Small Cap). The existence of a relevant number of companies
(mediumsmall) where no director receives a variable remu-
neration may be surprising.
5. Parameters
The Code makes various recommendations regarding the
structure of the variable component. Inter alia, it is provided
that: (a) the xed component and the variable component
should be properly balanced; (b) a ceiling should be set for the
variable component; (c) performance goals should be predeter-
mined, measurable and linked to the creation of value for share-
holders over the mediumlong run; (d) the payment of a
signicant portion of the variable remuneration should be
deferred for an appropriate period of time; and (e) compensa-
tions provided for early termination should not exceed a
specied amount or a specied number of years of remunera-

tion.
A description of the predetermined performance para-
meters, to which the variable remuneration is linked, is almost
always provided. This is true in 167 cases (95% of the compa-
nies having a variable component for directors; 92% in 2013).
Parameter choices may be different; the reference to accounting
indicators (EBITDA, EBIT, Prot, EVA, etc.) largely prevails: it
can be found in 93% of cases. Much less common (42% of
cases) is the reference to business targets. The presence of
remuneration components related to shares market value
(stock-based compensation plans, usually options or allocation
of shares, the latter often linked to the achievement of business
results; more rarely phantom plans based on algorithms related
to this value) is reported by 38% of companies; it is more fre-
quent among larger companies (65% of FTSE Mib companies
disclosing the presence of variable components). The adoption
of stock-based compensation plans for directors is markedly
decreased (46% in 2013, 50% in 2012). In 126 cases (72% of
the companies having a variable component) an indication of
the relative weight of xed and variable component is provided.
Such information is more frequent in the nancial sector (85%
of cases); less frequently, but still in a pretty high percentage
(70% of cases) in other industries. It is basically impossible to
report aggregate statistics on the relative weight of the two com-
ponents because this information is generally provided in a non-
homogeneous form, depending on the different structures of
incentive plans. In 89% of cases companies communicate as
having set a cap on the variable remuneration.
6. Short- and mediumlong-term oriented variable components

The presence of incentive components clearly separated
in the remuneration is very widespread: variable remunerations
are generally linked to short-term (management-by-objectives
plans or MBO) or mediumlong-term performance targets
(long-term incentive plans or LTIP). The CG Code recommends
that the variable remuneration should be dened in such a way
as to pursue the creation of value for shareholders in the
mediumlong term, without any specic indication concerning
the timing of the performance targets. A short-term-oriented
variable remuneration has been observed in 156 cases (i.e.,
89% of companies disclosing the presence of a variable remu-
neration; 82% in 2013). On the other hand, 131 companies dis-
closed the adoption of a long-term-based variable remuneration
(i.e., 75% of the total, substantially increasing from 67% in
2013). Such a variable component is more frequent in the
nancial sector (80% of cases) and, above all, among larger

companies: 94% of companies among FTSE Mib disclosed the
presence of a long-term-based variable remuneration (the
percentage drops to 80% among Mid Cap and to 65% for
Small Cap).
7. Indemnities in case of resignation or dismissal

The existence of a cap for indemnities to directors in case of
resignation or unfair dismissal is explicitly reported in the
Remuneration Report in 57 cases, that is, 25% of the aggre-
gate, as recommended by the Code. It does not mean necessarily
that each of these companies has already adopted an agreement
on this point: in many cases, in fact, they have a policy which is
going to be applied in the future, if and when specic agree-
ments with directors and key managers will be signed. The fre-
quency of such a cap is much more frequent among FTSE Mib
companies (47% of cases). Eventual caps are dened according
to different parameters and, consequently, data are not easy to
analyze on an aggregate basis. The most common situation is
the settlement of the cap at 2 years of remuneration. However,
we can also nd companies where the cap is lower (for instance,
0.3 or 1 year of remuneration) or higher (for instance, 2.5 or 3
years of remuneration), up to a maximum of 6 years of remu-
neration. Companies are generally (even if sometimes not expli-
citly) referring to the global remuneration, including its variable
component. On the other hand, some companies make explicit
reference only to the xed remuneration, eventually linked to
the RAL of the recipient. In some other cases, they disclose the
payment of a xed remuneration, of a more complex remunera-
tion package, that includes a xed component plus a compo-
nent linked to the variable remuneration already received, or a
termination treatment (trattamento di ne mandato, TFM)
linked to the length of the mandate or the time prior to the nat-
ural termination of the mandate. Some companies underlined
that the policy should be understood as the main rule and
would not apply in exceptional circumstances. Other compa-
nies declare that the BoD can decide to provide these indem-
nities; others state that the payment of an indemnity is
generally not intended (except from law prescriptions for
directors that are also managers of the company). In such cases,
the cap in obviously intended as 0.
8. Remuneration actually paid

Data on the level and structure of individual directors remu-
neration were collected from section II of the Remuneration
Report. As in the past, these data have been matched with
information drawn from Corporate Governance Reports, in

order to extract information about some relevant issues. The
Scheme attached to the Issuers Regulation involves the prepara-
tion of very complex tables and often to the duplication of
information already provided in other parts of the Report. The
average directors remuneration amounts to 229,000 h. This
varies greatly according to the size of the company (it is
403,000 h in the FTSE Mib, approximately 2.8 times more than
the average remuneration in the Small Cap, amounting to
142,000 h). Variations over time are generally not signicant.
Reports provide the number of directors who are beneciaries
of stock-based plans and of the fair value of such plans,
measured using the conventional criterion of the operating
cost borne by the issuer for the accrual year, pursuant to
international nancial reporting standards.
A very small number of directors (71 directors, that is, 3% of
the sample) receive equity compensation expensed in whole
or in part, during the scal year of reference. The number of
beneciaries is almost stable over time (76 directors in 2013,
that is, 3.1% of the aggregate). These amounts are quite consid-
erable (amounting to an average of 515,000 h, that is, more
than two times the global cash remuneration). The frequency
and amount of equity compensations vary according to the size
of the company. Cross-checking data of remunerations with
those concerning meeting attendance, we investigated the remu-
neration of the directors who did not take part in any meetings
during 2013. The goal was not to identify unjustied fees (com-
mitment for meetings, as mentioned earlier, does not measure
the actual commitment required to members of corporate
bodies) but to stimulate a reection on the most appropriate
parameters for the commensuration of fees. It is thus observed
that among the 15 (eight in 2013, 23 in 2012) directors that
attended no meeting (10 of which were due to appointments
near to the end of the year), one did not receive any compensa-
tion. Another 13 directors have received a low remuneration
(less than/equal to 10,000 h), possibly calculated in proportion
to their time in ofce.
9. Remuneration and directors role

The fees are signicantly different depending on the role. The
remuneration rank sees at the top MDs, who receive an average
remuneration of 846,000 h, followed by executive chairmen,
who receive about 25% less than MDs (645,000 h). The other
executive directors receive a remuneration which is approxi-
mately a little less than 60% of MDs remuneration (499,000 h).
There are then non-executive chairmen (302,000 h) and
deputy-chairmen (257,000 h). Even the following steps are

quite sharp: non-executive members of executive committees
receive on average 83,000 h. Other non-executive (76,000 h)
and independent directors (54,000 h) stand at the bottom of
the list. Both the amount of the remuneration and the struc-
ture of cash remuneration vary according to directors roles:
the remuneration of a MD is made on average for the
55% of a xed component, while bonuses account for 24%
and remunerations from subsidiaries for 11% (other items
account for smaller amounts). The remuneration of executive
chairmen is composed of higher xed components (68%),
much lower bonuses (5%) and fees from subsidiaries generally
comparable to those of the MD (11%). The remuneration struc-
ture of other executive directors is quite the same, even though
they receive a lower xed component (39%) and denitely
higher compensations from subsidiaries (31%). Non-executive
chairmen receive almost only xed compensation (84% of the
aggregate). Non-executive directors rarely receive bonuses and
other incentives; when this happens, small amounts are
involved. Non-executive directors (not independent), however,
receive signicant compensation from subsidiaries (23,000 h):
the weight of this component (31% of the aggregate) is basically
the same as for other executives.
The remuneration of independent directors varies according
to company size: among FTSE Mib companies the remuneration
slightly exceeds 100,000 h; in Mid Cap companies it is halved
(51,000 h) and in Small Caps remuneration decreases by 40%
(30,000 h). This trend reects probably not only the differ-
ent kinds of problems affecting rms that belong to different
index sections, but also a different depth in the application of
the Code recommendations that require a specic commitment
of independent directors. Global average remuneration of inde-
pendent directors is stable over time. Independent directors basi-
cally perceive additional compensation only for their
participation to committees and, however, for limited amounts
(16,000 h, that is, 29% of the aggregate). They never perceive
equity compensation.
It may be interesting to analyze together data concerning both
directors age and compensation, distinguishing them by role.
MDs and other executives are the youngest category (average
age of 56 years). Followed by other non-executives and
other independents (average ages of, respectively, 56.5 and
59 years). Directors belonging to other categories are generally
older (62 years for deputy chairmen, 68 for non-executive chair-
men, up to 71 for executive chairmen).
The survey by Assonime gives more analytical details but what

is relevant here is the generally positive conclusion that the Report
expresses about the situation observed. The document points out,
indeed, that the drafting of specic Remuneration Reports increased
signicantly the amount of information available to investors. The
disclosure level is often a best practice one: there are not many coun-
tries where similar information is available on an individual basis
(i.e., for each member of the administrative and control corporate
bodies). This is especially true for the so-called ex post information
(about the remuneration actually paid).
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Index
ABI Principles of Remuneration Annual Corporate Governance

(2011), 96n3 Report, 178179
Accounting regulation, 6768 Annual directors remuneration
Act to Improve Supervision of report, 110111
Board Remuneration and Annual general meeting (AGM),
Amendment of Further 111, 246, 247
Stock Corporation Law Annual remuneration report, 97
Provisions, 129 Antitrust law, 4
Adverse selection, 1314 Apply or explain approach, 98
Advisory vote, 113 Appropriateness of Management
Agency conicts, 1516 Boards Remuneration
Agency costs, 23 Act, 121, 123
Agency theory, 5, 11, 31, 133, 143 Audit committee compensation, 87
adverse selection, 1314 Awash International Bank (AIB),
collective action problem, 12 199
companys shareholders, 13
different agency conicts, 1516 [B]odies corporate, 199
key elements, 11 BaFin. See German Federal
and managerial compensation, Financial Supervisory
23 Authority (BaFin)
base salary, 26 Bank and banking holdings in Italy,
bonus, 26 139141
opportunism, 23 Bank directors remuneration, 203
principal-agent model, 23 Directives, 204
say on pay votes, 25 economic signicance, 205
short-termism, 25 in Ethiopia, 206
stock options, 2729 NBE, 203
strengthening shareholders Banking Business Proclamation No.
voting rights, 24 592/2008, 197
moral hazard, 1415 Basel Committee on Banking
AGM. See Annual general meeting Supervision (BCBS), 207,
(AGM) 214
AIB. See Awash International Bank Base salary, 26, 103
(AIB) BCBS. See Basel Committee on
Alternative Mechanism, 5 Banking Supervision
Annual bonus plan, 103104 (BCBS)
255
256 INDEX
Big bath accounting, 38 Corporate Governance

Big BathCap earnings Committee, 245
manipulation, 37, 38 eventual caps, 249
Binding vote, 112 parameters, 247248
BIS. See Department for Business, remuneration and directors role,
Innovation and Skills (BIS) 250251
Black-Scholes formula (1973), 105 remuneration policy, 246247
Blue Ribbon Commission, 74, 80 Remuneration Reports, 246
Board independence from CEO, short-and mediumlong-term
8384 oriented variable
Board overlaps, 84 components, 248249
Body corporate directors, 199 survey by Assonime, 252
Civil Code, 202 Circular 4/2011, 166
Commercial Code, 200 Classical contracts, 8
defendant, 201 Classical rm, 5
Federal High Court, 201 Coase Theorem, 8
National Bank, 203 Code of Self-Discipline of Listed
NIB, 199 Companies, 135136
Bogey, 37 Codes of Good Governance,
Bonus, 26 159160
awards, 65 Collective action problem, 12
Bonus-Malus system, 37 Collective production, 1618
Borsa Italiana, 135n1 Combined Code on Corporate
Boundary systems, 18 Governance (1998),
Bounded rationality, 10 9899
Commercial Code, 185, 190191,
Cadbury Report, 95 192, 196, 198199
Capital Requirements Directive Committee of European Banking
(CRD), 238 Supervisors (CEBS), 139,
Capital Requirements Directive III 164, 165, 238
(CRD III Directive). See CEBS Guidelines, 96n1
Third Capital Requirement Community Recommendation 913/
Directive (CRD3) 2004, 232
CD&A. See Compensation Companies Act. See Ley de
Discussion and Analysis Sociedades de Capital
(CD&A) (LSC)
CEBS. See Committee of European Company law, 4
Banking Supervisors Compensation
(CEBS) committees, 77, 8283
CEO compensation system, 59, 60 consultants, 83
balance of power, 62 equity, 7980
literature on, 6062 equity-based, 28, 31
plans, 61 See also Executive compensation
See also Executive compensation Compensation Discussion and
CG Code, Italian remuneration Analysis (CD&A), 76
reports to, 244 Complete contract, 9
Index 257
Comply or explain approach, characteristics of rms adopting

100n7, outside director stock-
136, 137 option plans, 8182
Conference Board survey, 80 compensation
Consob Legislative Decree No. 58 committees, 8283
of 24 February (1998), consultants, 83
136138 Diagnostic control systems, 1718
Consob Scheme, 246247 Director, 198
Contract, 10 Director compensation guidelines,
Corporate governance, 3, 7, 5051 75
changes in, 51 Directors remuneration
elements of nancial institutions, agency theory and managerial
4850 compensation, 23
proposals, 4 base salary, 26
rules, 135 bonus, 26
See also Financial governance opportunism, 23
Corporate Governance Annual principal-agent model, 23
Report, 162, 178 say on pay votes, 25
Corporate social performance, 90 short-termism, 25
Corporate social responsibility stock options, 2729
(CSR), 15, strengthening shareholders
36, 39 voting rights, 24
CRD3. See Third Capital boards role in, 67
Requirement Directive current intrinsic motivator,
(CRD3) 3031
CSR. See Corporate social design, 6566
responsibility (CSR) employee motivation, 29
Current intrinsic motivator, 3031 in Ethiopia
Commercial Code, 185
DAB plans. See Deferred annual emerging separation of
bonus plans (DAB plans) ownership and control,
DAX, 123, 125 187190
Decisive elements, 143 Ethiopian companies prole,
Defendant, 89 186187
Deferred annual bonus plans (DAB non-nancial and nancial
plans), 104 companies, 188
Department for Business, in Ethiopian share companies,
Innovation and Skills 190
(BIS), 112, 114 challenges, 195207
Detailed audit nancial design, 192194
information, 111 regulation, 190192
Determinants of director reporting, 194
remuneration, 8185 factors, 6667
and board independence from in Germany
CEO, 8384 challenges, 128130
board overlaps, 84 design, 122126
258 INDEX
regulation, 119122 market reaction to adding

reporting, 127128 equity to director
in Italy, 133134 remuneration plans,
design schemes, 142146 8586
regulation, 134142 regulation and reporting, 758
reporting, 146152 shareholder lawsuits, 8990
and motivation, 21 well-balanced packages, 31
executive contracts, 21 Directors Remuneration Report
high-powered incentive Regulations (2002), 95,
contracts, 22 110111
shareholders, 22 Directors Remuneration Reporting
participation of employees, Reform (2012), 111113
207210 Discounting, 5253, 55
policy, 6465 functions, 53
in Spain, 157 Dismissal of executives, 21
annual report on remuneration Dividend paying, 89
of directors, 179180 Dodd-Frank Act, 75, 76
board structure in, 168 Dodd-Frank Financial Reform bill,
recommendations to directors 25
remuneration in, 158
regulation for nancial Earnings before interest and tax
institutions, 163166 (EBIT), 26, 123
remuneration challenges, Earnings management, 87
180181 EBA. See European Banking
remuneration design, Authority (EBA)
169176 EBIT. See Earnings before interest
remuneration regulation, and tax (EBIT)
157163 Economic contract, 10
remuneration reporting, Economic Value Added (EVA), 123
176180 Employee motivation, 29
takeover threats, 3031 Enel CEO, 151
in United Kingdom Enel Remuneration System (2013),
challenges, 113115 149152
design, 103110 Enterprise and Regulatory Reform
regulation, 95103 Bill (2013), 115
reporting, 110113 Epitomes of transformative CSR,
in United States, 73 36n1
Blue Ribbon Commission, 74 Equity-based compensation, 28, 31
challenges, 9192 Equity-based pay models, 230
corporate social performance, Equity compensation, 7980
90 ESMA. See European Securities and
design, 7881 Markets Authority
determinants, 8185 (ESMA)
dividend paying, 89 ESOs. See Executive share options
empirical evidence on, 81 (ESOs); Share option plans
nancial reporting, 8788 (ESOs)
Index 259
Ethiopian Commercial Code. See European Parliament and

Commercial Code Council, 214
European and German regulation implementation of remuneration
of remuneration system regulations in Germany,
incentive-compatibility, 220 219220
incentive-compatible incentive-compatibility of
remuneration system, 221 European and German
European and international regulation of
recommendations, remuneration system, 220
164165 incentive-compatible
European approach to directors remuneration system, 221
remuneration regulation prerequisites of incentive-
Action Plan, 226227 compatible remuneration
action plan, 231 system, 215216
EU interventions, 237244 regulative remuneration
European Commission, 225, 227 standards of EU,
Italian Remuneration reports to 216219
CG Code, 244 European Securities and Markets
Corporate Governance Authority (ESMA), 216
Committee, 245 European Union interventions, 237
eventual caps, 249 Action Plan, 243
parameters, 247248 Directive 2007/36/EC, 244
remuneration and directors European Parliament, 241242
role, 250251 golden parachute, 240
remuneration policy, 246247 Recommendation, 239
Remuneration Reports, 246 Recommendation for Financial
short-and mediumlong-term Institutions, 239240
oriented variable Rem. HLP, 238
components, 248249 EVA. See Economic Value Added
survey by Assonime, 252 (EVA)
literature review, 228231 Executive and non-executive
Recommendation 2004/913/EC, directors, 198199
232233 Executive compensation, 133134
Recommendation 2005/162/EC, and motivation, 3637
235237 plans, 3738
remuneration redening performance
of individual directors, 234235 evaluation in age of
policy, 233234 sustainability, 38
share-based remuneration, 235 CSR, 39
See also Directors remuneration hypotheses, 40
European Banking Authority Puma innovative accounting
(EBA), 216 system for sustainability,
European Commission, 225, 227 40
European Community, 225 in 21st century, 3536
European legislation to German See also CEO compensation
implementation, 213 system
260 INDEX
Executive contracts, 21 Financial Stability Board (FSB),

Executive directors benets 213n1
provision, 65 Financial Stability Forum (FSF), 164
Executive remuneration in FTSE Firm size, 66
250 companies, 114 Fixed annual remuneration, 192
Executive share options (ESOs), 97 Fixed compensation package
Exercise barriers, 123 design, 144145
Explicit incentives, 21 Fixed remuneration, 169, 171
Exponential discounting, 5354 Fraudulent nancial reporting, 87
Extrinsic motivation, 23, 29 FRC. See Financial Reporting
Council (FRC)
Federal Supreme Court Cassation Free riding, 12
Division, 201n42 French Law, 229
FEDEX days, 37 FSA. See Financial Service
Financial companies, 47 Authority (FSA)
crisis and effects on FSB. See Financial Stability Board
remuneration governance (FSB)
in nancial institutions, FSF. See Financial Stability Forum
4850 (FSF)
European initiatives for FTSE All-Share Index factsheet,
enhanced governance and 109110
remuneration, 5051 Full value shares, 79
nancial governance, 47
remuneration, 5155 GCCG. See German Code of
See also Industrial companies Corporate Governance
Financial governance, 47 (GCCG)
See also Corporate governance General shareholders meeting
Financial institutions, 48 (GSM), 192
corporate governance elements German Code of Corporate
of, 4850 Governance (GCCG), 121,
crisis and effects on 122, 124, 126127
remuneration governance German Commercial Code, 127
in, 48 German Corporate Governance
pre-and post-crisis remuneration Code. See German Code
governance, 50 of Corporate Governance
stakeholder groups, 49 (GCCG)
Financial reporting, 8788 German Federal Financial
Financial Reporting Council (FRC), Supervisory Authority
9899 (BaFin), 216
May 2010 consultation German Government passed the
document, 100101 Management Board
September 2012 consultation Remuneration Disclosure
document, 101 Act. See
Financial scandals, 39 Vorstandsvergtungs
Financial Service Authority (FSA), Offenlegungs-gesetz
96n1 (VorstOG)
Index 261
German law, 229 Incentive-compatible remuneration

German Stock Corporation Act system prerequisites,
(GSCA), 119120, 122, 215216
126 Incentive pay, 2122
Germany Incomplete remuneration contracts,
German Prime Standard, 126, 9
127 bounded rationality, 10
German two-tier system, complete contract, 9
119120 nexus of contracts, 1011
implementation of remuneration See also Directors remuneration
regulations in, 219220 Independent director compensation,
Gesetz zur Angemessenheit der 87
Vorstandsvergtung Independent non-executive
(VorstAG), 121, 123 directors (INEDs), 97
Gesetz zur Verbesserung der Individual bonus decisions, 65
Kontrolle der Individual directors remuneration
Vorstandsvergtung und of, 234235
nderung weiterer Industrial companies, 59
aktienrechtlicher accounting regulation, 6768
Vorschriften (VorstKoG), CEO compensation system, 59,
129 60
Golden parachutes, 174175 directors remuneration
Government-owned unlisted boards role in, 67
companies, 141142 design, 6566
Greenbury Report (1995), 95, factors, 6667
9697 policy, 6465
GSCA. See German Stock research design, 62
Corporation Act (GSCA) results, 6264
GSM. See General shareholders See also Financial companies
meeting (GSM) INEDs. See Independent non-
executive directors
Hampel Report (1998), 98 (INEDs)
Higgs Report, 99 Initial public offering of shares
High-level Principles for (IPOs), 187
Remuneration Policies Interactive control systems, 18
(Rem. HLP), 238 International Financial Reporting
Hostile takeovers, 30 Standards (IFRS), 67, 68
Hyperbolic discounting, 54 International Monetary Fund
(IMF), 213n1
IFRS. See International Financial Intrinsic motivation, 23
Reporting Standards IPOs. See Initial public offering of
(IFRS) shares (IPOs)
IMF. See International Monetary ISVAP Regulation, 141
Fund (IMF) Italian compensation discipline, 135
Implementation report, 112 Italian economic system, 134
Implicit incentives, 21 Italian listed companies, 135139
262 INDEX
Italian ownership structure, 134 pension awards, 123124

Italian Stock Exchange. See Borsa pre-dened objectives, 122123
Italiana range of board remuneration of
Italian unlisted companies, 142 companies, 125126
share-based compensation, 123,
Law 2/2011, 165166 126
Ley de Sociedades de Capital Management-by-objectives plans
(LSC), 158 (MBO), 248
Royal Legislative Decree 1564/ Market dichotomy, 89
1989, 159 Market for corporate control, 30
Spanish legislation, 157158 MBO. See Management-by-
Listing Rules (2004), 96n2, 98 objectives plans (MBO)
London Stock Exchange (LSE), MDAX, 123, 125
98n4, 206 Mediumlong-term oriented
Long-term compensation, 66 variable remuneration,
Long-term incentive plans (LTIPs), 248249
97, 105, 114, 127, 128, 248 Meeting fees, 79
CEO compensation in UK listed Microeconomics, 6
companies, 108, 109 Mid-term incentive plan (MTI
executive average compensation in plan), 127, 128
UK listed companies, 109 Ministry of Commerce and
executive compensation, 110 Industry, 192
executive directors Mixed remuneration design,
remuneration, 106108 193194
FTSE All-Share Index factsheet, Monetary compensation
109110 components, 124
percentage of using LTIPs in Moral hazard, 1415
FTSE 100 companies, 106 Motivation, 23
share grants, 105 theories, 215216
Long-term performance MTI plan. See Mid-term incentive
measurement, 65 plan (MTI plan)
LSC. See Ley de Sociedades de Multi-annual variable
Capital (LSC) remuneration, 172
LSE. See London Stock Exchange limits, conditions, and
(LSE) constraints, 173
LTIPs. See Long-term incentive LSC, 174
plans (LTIPs) Multitasking, 27
Management, 1618 NACD. See National Association of

compensation plans, 37 Corporate Directors
Management board remuneration, (NACD)
122 NASDAQ, 112n16
nancial crisis effects, 124125 National Association of Corporate
GCCG, 122, 124 Directors (NACD), 74
monetary compensation National Bank of Ethiopia (NBE),
components, 124 185
Index 263
NBE. See National Bank of theory models, 5

Ethiopia (NBE) Privatization and Public Enterprises
Neo-classical contracts, 8, 9 Supervising Agency
Neo-classical economics, 4 (PPESA), 187
Net present value (NPV), 52 Production costs, 6
New Regulations, 139140 Proportionality principle, 140
New York Stock Exchange (NYSE), Puma innovative accounting system
59, 62, 63, 64, 112n16 for sustainability, 40
Nexus of contracts, 1011
Nib International Bank (NIB), 199 Quasi-hyperbolic discounting, 54,
NPV. See Net present value (NPV) 55
NYSE. See New York Stock Quoted companies, 112n16
Exchange (NYSE)
Recommendation 2004/913/EC,
Opportunism, 23 232233
Organization for Economic Recommendation 2005/162/EC,
Cooperation and 235
Development (OECD), individual remuneration, 237
206n63 remuneration committee, 236
Ownership, 67, 105 Regulation for nancial institutions
in Spain, 163, 164
Pay for performance culture, 145 Circular 4/2011, 166
Pay-performance link, 3738 European and international
Pay-performance sensitivity, 28 recommendations,
Pension 164165
awards, 123124 Royal Decree 771/2011,
plans, 174 165166
rights, 103n9 Sustainable Economy Act,
Performance evaluation in age of 165166
sustainability, 38 Regulative remuneration standards
CSR, 39 of EU, 216
hypotheses, 40 Directive 2013/36/EU, 218
Puma innovative accounting functions and prerequisites of
system for, 40 remuneration systems, 217
Performance measures, 65 long-term oriented risk
Performance share grants, 105 management strategies,
Phantom stock, 37 219
Policy report, 112 remuneration policies, 217
Post-crisis remuneration Relational contracts, 8, 9
governance, 50 Rem. HLP. See High-level
PPESA. See Privatization and Public Principles for
Enterprises Supervising Remuneration Policies
Agency (PPESA) (Rem. HLP)
Pre-crisis remuneration governance, Remuneration, 3, 7, 51, 229
50 alternative discounting
Principal-agent model, 23 functions, 53
264 INDEX
of directors, 138 average remuneration per

discounting, 5253 director, 175
evaluation, 55 practice, 175176
exponential discounting, 5354 prot sharing, 173
hyperbolic discounting, 54 remuneration policy for
policy, 110111, 233234 directors, 166169
challenges for, 115 remuneration systems elements
practices, 51 in, 169175
quasi-hyperbolic discounting, 54, systems of remuneration to
55 directors, 170
structuring variable bonuses over in United Kingdom
time, 52 annual bonus plan, 103104
systems, 133, 216 base salary, 103
Remuneration challenges ESOs, 104105
in Ethiopia, 195 LTIPs, 105110
bank directors remuneration, in United States, 78
203206 Conference Board survey, 80
body corporate directors, equity compensation, 7980
199203 meeting fees, 79
executive and non-executive perquisites, 80, 81
directors, 198199 survey of rms, 78
lack of legal requirement for Remuneration Disclosure
Remuneration Committee, Requirements (2010),
206207 96n1
privileges, 195198 Remuneration regulation, 9596
in Germany, 128130 in Ethiopian share companies,
in Spain, 180181 190192
in United Kingdom in Germany
challenges for remuneration German two-tier system,
policy, 115 119120
problems in UK executive management board and
remuneration, 113115 supervisory board,
in United States, 9192 120122
Remuneration committee, 110 in Italy, 134135
lack of legal requirement for, bank and banking holdings,
206207 139141
Remuneration design, 103 government-owned unlisted
in Ethiopian share companies, companies, 141142
192194 Italian compensation discipline,
in Germany 135
management board listed companies, 135139
remuneration, 122126 unlisted companies, 142
supervisory board in Spain, 157
remuneration, 126 Codes of Good Governance,
in Italy, 142146 159160
in Spain for companies, 157
Index 265
LSC, 157159 Royal Assent, 115

regulations, 163 Royal Decree 1362/2007, 163
Securities Market Act, Royal Decree 771/2011, 165166
162163
Sustainable Economy Act, Samuelsons model, 53
161162 Sarbanes-Oxley Act (2002), 77
in United Kingdom, 9899 Say on pay
Combined Code on Corporate remuneration, 111
Governance (1998) system, 161
Greenbury Report (1995), tool, 135
9697 votes, 25
UK Corporate Governance SDAX, 124125
Code (2010 Code), SEBI. See Securities and Exchange
99101 Board of India (SEBI)
UK Corporate Governance SEC. See Securities and Exchange
Code (2012 Code), Commission (SEC)
101103 4 One-third Participation Act,
CD&A, 76 29 Co-Determination Act, 120
compensation committees, 77 107 GSCA, 120
NYSE and NASDAQ, 75 Securities and Exchange Board of
SEC, 756 India (SEBI), 207
Remuneration reporting Securities and Exchange
in Ethiopian share companies, Commission (SEC), 25, 75
194 Securities Market Act, 162163
in Germany, 127128 Sensitivity of pay, 21
in Italy, 146147 Share-based compensation, 123,
2013 Enel Remuneration 126
System, 149152 Share-based remuneration, 235
Telecom Italia 2012 Share-option-based pay, 230
Remuneration Scheme, Share option plans (ESOs),
147149 104105
in Spain, 176180 Shareholder(s), 22
in United Kingdom, 111113 lawsuits, 8990
2012 Directors Remuneration shareholder-manager agency
Reporting Reform relationship, 14
Directors Remuneration Report vote, 111
Regulations (2002), Shirking, 16, 17
110111 Short-term remuneration schemes,
CD&A, 76 Short-term-oriented variable
NYSE and NASDAQ, 75 remuneration, 248249
SEC, 756 Short-termism, 25
Responses to shirking, 17 Smith Report, 99
Return on Assets (ROA), 123 Soft landing mechanisms, 230
Return on Net Assets (RONA), 123 Stakeholder(s), 1516, 205
266 INDEX
impact of director remuneration, Toronto Stock Exchange (TSX), 59,

9091 62, 63, 64
groups, 49 Transaction-cost economics, 6
model, 16, 208 Trattamento di ne mandato
Stakeholders Interests, 49 (TFM), 249
theory, 40 TSX. See Toronto Stock Exchange
Standardization, 105 (TSX)
Statutory dividend, 208209 2008 Code, 99n6
Stewardship Code (2010), 99n6 2010 Code. See UK Corporate
Stock markets reaction, 8586 Governance Code (2010
Stock options, 27, 7980 Code)
equity-based compensation and
pay-performance UK Corporate Governance Code
sensitivity, 28 (2010 Code), 99101
multitasking, 27 UK Corporate Governance Code
packages, 146 (2012), 101103
senior management pay at public UK executive remuneration,
companies, 29 problems in, 113115
Stock-appreciation rights, 79
Strengthening shareholders voting Variable annual remuneration,
rights, 24 171172
Strike price, 80 VorstAG. See Gesetz zur
Structuring variable bonuses over Angemessenheit der
time, 52 Vorstandsvergtung
Supervisory board remuneration, (VorstAG)
126 Vorstandsvergtungs
Sustainable Economy Act, Offenlegungs-gesetz
161162, 165166 (VorstOG), 121
VorstKoG. See Gesetz zur
Takeover threats, 3031 Verbesserung der
Target-based bonuses, 26, 27 Kontrolle der
TecDAX, 124125 Vorstandsvergtung und
Telecom Italia 2012 Remuneration nderung weiterer
Scheme, 147149 aktienrechtlicher
TFM. See Trattamento di ne Vorschriften (VorstKoG)
mandato (TFM)
Theory of rm, 46 Walker Review (2009), 100n7
Coase Theorem, 8 Well-balanced packages, 31
production costs, 6 Windfalls in equity-based plans,
situations in market transactions, 230
7 Worldwide Total Remuneration
Theory of property rights, 7 Report, 143
Theory of team production, 17
Theory of transaction costs, 8 Year-on-year performance, 109n13
Third Capital Requirement Directive
(CRD3), 96n1, 139 Zero transaction costs, 30

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The Theory and Practice of Directors

New Challenges and Opportunities

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British Library Cataloguing in Publication Data

Certificate Number 1985

Section I Theory of Corporate Governance and

CHAPTER 1 Corporate Governance and Remuneration

Management and Collective Production 16

CHAPTER 2 Directors Remuneration and Motivation

CHAPTER 3 Executive Compensation in the 21st Century:

Section II Cross-Industrial Remuneration

CHAPTER 4 Financial Companies

CHAPTER 5 Industrial Companies

Section III Cross-Country Remuneration

CHAPTER 6 Directors Remuneration in the United States

Summary of Determinants of Director Remuneration 84

CHAPTER 7 Directors Remuneration in the

CHAPTER 8 Directors Remuneration in Germany

Remuneration Challenges 128

CHAPTER 9 Directors Remuneration in Italy

CHAPTER 10 Directors Remuneration in Spain

CHAPTER 11 Directors Remuneration in Ethiopia

Participation of Employees Other than Directors on Annual

CHAPTER 12 Reviewing Institutions Remuneration

CHAPTER 13 The European Approach to Regulation of

Marco Artiaco University of Rome Tre, Rome, Italy

Christoph Deutsche Bundesbank University of

sector, increased xed managerial pay within the payment structure

2013). This illustrates two Corporate Governance issues, one being

University in Sharjah) covering Directors Remuneration and

Dr. Marco Artiaco, Professor of Economy and Management at the

Director Remuneration is a Matter of

EU Commission Recommendation of April 30, 2009, comple-

Legislation on Directors Remuneration

Corporate Governance Codes

and to obey to the rules. In some other countries, there is a legal

Remuneration Should Be Guided by

It is the responsibility of the Boards directors to adjust the

An increase of the transparency on pay was therefore needed. It

Some of the Experience of Member

Three Recommendations on Disclosure

be mandatory for all listed companies in the EU.7 Disclosure of the

Remuneration Should Promote the

primary purpose of termination payments as a safety net in case of

will be complied with and what procedures would need to be fol-

Remuneration Policies in the Financial

Dr. Rado Bohinc

Udo C. Braendle and

should watch over it with the same anxious vigilance [as if

Theories of the rm are ways of conceptualising the rm and under-

In a free market environment the answer must lie in signicant

that look at rms as important entities as they explain why a rm

The Theory of the Firm The Theory of

bargain with other parties such as directors, employees, suppliers

Beyond the Firm and Market Dichotomy

A neo-classical contract, however, leaves some terms open. Here

Incomplete Remuneration Contracts

contract of a chief executive in a company. It would be impossible

specied in the contract. The resulting institutional design constitu-