First and foremost, the definition of corporate governance must be defined. Investopedia describes corporate governance as: “Corporate governance is the system of rules, practices, and processes by which a firm is directed and controlled. Corporate governance essentially involves balancing the interests of a company’s many stakeholders, such as shareholders, senior management executives, customers, suppliers, financiers, the government, and the community. Since corporate governance also provides the framework for attaining a company’s objectives, it encompasses practically every sphere of management, from action plans and internal controls to performance measurement and corporate disclosure.”
What is interesting about corporate governance is that each country has a different set of rules and best practices. These must not be confused with one another. Rules are mandatory, such as the legal structure of the company, while best practice are a set of guidelines that can voided if so, approved by the shareholder.
First to come back to the first point. Each country has a different set of rules and best practices that companies tend to adhere to. For example, Belgium companies until recently (and still almost all of them do), has a one tier board, while the Netherlands has a two-tier board. The difference? A one tier board consist of executive and non-executive directors combined. Executive directors typically consists of the CEO, CFO, COO etc. while the non-executive directors are ought to be outsiders. The emphasis is ought to be, because while best practice or law forbids direct relatives or ex-employees, non-independent non-executive directors sometimes have other connections, such as being a member of a mayor shareholder or the executive. In this way, companies can create an artificial board majority (being more than 50 percent) of non-independent members, while the board has a fiduciary duty to check the work of the executive directors.
Given that one-tier boards can display such vulnerabilities, some countries such as the Netherlands opt for a two-tier system. This system creates two boards: A Supervisory Board and the Management Board. The supervisory board consists only of elected non-executive directors and checks the management board that consists of executive directors.
What is important to note is that in both cases (one tier and two tier systems), the board(s) are elected and approved by the owners of the company for four years, the shareholders. The boards act as an agent for the shareholder and ‘manage’ the company. In return, they get paid or in corporate governance terms: remunerated. More on that later. The return for the shareholders is not only an increase in stock price with a good performing company, but also dividend. The dividend payment is proposed by the board and is subject to approval by the shareholders on annual general meetings. Annual general meetings are about informing and making decisions by shareholders on important topics such as dividend payments, share issuance and the consistency of board of directors and or the supervisory board.
Both one tier and two-tier board have in common that several committees are created as part of the corporate governance process. These committees primarily focus on Remuneration, Nomination and Audit committees. Remuneration committees are responsible for creating so called remuneration policies. Remuneration policies generally consists of multiple components: Base Salary, Short Term Variable Incentives (STIs), Long Term Variable Incentives (LTIs) perquisites and ‘other terms & conditions’. The Variable incentives are meant to incentivize performance by setting target objectives that executives need to achieve. Examples of short-term variable incentives can concern improvement of EBITDA, Profit, Revenue but also non-financial objectives such as injury rate. Long term variable incentives usually concern Total Shareholder Return but can also include other metrics if so desired by the supervisory board.
The latest development is the implementation of the European Shareholder Rights Directive 2.0 that primarily concerns the ‘other term & conditions’. With the implementation of the European Shareholder Rights Directive, companies now must put the implementation of the remuneration policy up for an advisory vote. This means that shareholders can apply retrospective scrutiny whether the link between pay and achieved performance was done adequately and transparently. Another change that I would like to highlight is the recommendation of introducing shareholding requirements for executive directors. While executive directors often get shares for the LTI plan that vest proportionally according to performance and are subject to a two-year holding period they can dispense of them at a later period. The problem arose that since executive directors are employed for four year terms before they are up for re-election, the vested shares (shares that are given to the directors) that are no longer subject to holding period can be sold immediately. However, if directors are performing badly in the long term and are re-elected, such holding period often expired and the damage has been done while the directors still sits on the board. Therefore, Shareholding requirements are put into place as long as the director sits on the board. This is combined with another interesting component, the claw-back policy. A claw back policy allows for the shareholding requirements and the paid remuneration to be confiscated in terms of malpractice by the directors.
Another common misperception of the remuneration policy is the sign on and severance agreements. The news often reports the stories of generous exit payments or sign on bonuses. However, these cases are either scarce or based on bad comparisons. According to best practice, a one-year payment of gross base salary should be provided if the contract is terminated early (and involuntarily.) Moreover, the market for good executives is highly competitive and are often subjects to non competes and cool down periods. Therefore, high sign on bonusses are often offered as compensation for the waiting executives must do before signing their new jobs. Moreover, these sign on bonuses are often subject to performance requirements and are not guaranteed to vest.
The entirety of the remuneration policy and the implementation thereof as disclosed are put up for votes during the annual general meetings, where shareholders can either adapt or refuse the policies. Even though shareholders might adopt these policies, the more discontent there is, the more likely they are to adapt these policies.
Even if shareholders might approve of a policy, other stakeholders, such as the government or society might show discontent. That is why, with the implementation of the Shareholder Rights Directive II companies are obliged to make a stakeholder assessment and take this into account. While this assessment remains vague for now it does already show impact with the CEO of KLM forfeiting his bonus. The pressure of civil society is therefore more and more taken into account when proposing policies.
All these elements combined of remuneration, dividend policy and Board consistency are just some of the most important elements of corporate governance. The essence of corporate governance is still primarily focused on keeping the company in control of the owners, the Shareholders. However, these shareholders realize more and more that other stakeholder influence their business as well and therefore it is in shareholders’ best interest to keep these stakeholders friendly.