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Leonardo Sforza
Leonardo Sforza leads the Brussels office of MSLGROUP, Publicis strategic communications and engagement group. With more than 25 years experience in corporate strategy and public affairs, he advises organizations on EU policy issues and all aspects of multi-stakeholder communication. Before joining MSLGROUP, Mr Sforza was the Head of Research and EU Affairs at Aon Hewitt, where he pioneered thought-leadership projects on corporate governance, people management and cross-border pension instruments. In 2012 he was named Consultant of the Year by financial magazine PLANSPONSOR Europe. Since 2005 he has chaired the scientific committee of the European Club for Human Resources and is a member of the European Corporate Governance Institute. Mr Sforza has a postgraduate degree in Law (summa cum laude) from the University of Bari and his working languages are English, French and Italian.

Over the last decade directors remuneration has become a hot issue for policy makers and supervisory authorities, from Brussels to Washington and from Beijing to Brasilia. When one looks at what has been achieved in terms of statutory or soft law requirements, what is on the agenda for legislators and what still needs to be delivered in practice, directors remuneration is likely to remain an issue under increasing scrutiny from policy, investor and public opinion perspectives. This time, Europe seems to be leading the way in addressing executive compensation and corporate governance policies. The diversity of corporate governance models, and shareholding and management cultures/structures, may have been a source of inspiration, rather than a barrier, for such developments. At the initiative of both the European Union (EU) institutions and the 28 EU countries and following direct citizens pressure in leading business-friendly Switzerland,* changes in policy are well under way in this area, with more to come soon. More importantly, changes in the direction of enhanced corporate governance in practices and behaviours are also expected to follow, though not without pain. There are two major risks to avoid in this process of reform that is under way but still has a long way to go. First, the temptation of regulators to shift from a framework of principles and key objectives of reference for the legitimate convergence of good governance to a prescriptive one-size-fits-all rule book that risks becoming another tick-box exercise deprived of substance. Second, there is a risk that public opinion and policy representatives view the debate about excessive pay only through the lens of demagogy by placing all executives, irrespective of their performance and the sustainable value created for shareholders and stakeholders in general, in the same category, labelling them fat cats. The all too many examples of executives being rewarded for failure and receiving substantial increases in their pay packages over the recent past1 may well justify this sentiment. Nevertheless, this should not stop us from addressing the whole question of executive compensation in relation to a greater array of factors

that range from the business rationale beyond a compensation package to the role of shareholders in the decision-making process; from the nature and scope of performance indicators applicable throughout the organization to employee reward practices and financial participation in business results; from moral hazard in executive compensation and earnings management2 to the role of the supervisory authorities in preventing and mitigating such risks. Albert Einstein, once questioned about the meaning of success, wisely said, Try not to become a man of success, but rather try to become a man of value, certainly not thinking in terms of the pay packet a recommendation that everyone, not just executives, would be well advised to follow. What that value consists of can be debated, ranging from the narrow shareholders value creation theory, celebrated by Milton Friedman in a famous article of the 1970s in The New York Times Magazine, to the broader stakeholders value creation model more widely accepted in modern corporations3. I would add to the

* Following the results of a Federal referendum held in March 2013, Switzerland held a plebiscite to give shareholders an absolute binding vote on executive pay. The measure, known as the Minder Initiative, was passed with a 67.9% majority, spurring a new regulatory framework on executive compensation. For further information, please see Switzerland Leads the Way in Executive Compensation & Corporate Governance by Piero Marchettini, B & C International, May 2013. At the time of writing, there were more than 7.2 million referenced articles on Google concerning executive reward for failure. The Top 10 in 1986 on the Forbes list of the highest-paid CEOs earned, in aggregate, US$57.88 million while the 10 highest paid in the 2012 Forbes list earned US$616.40 million in total, or 10.65 times the amount in 1986. Over the same period, the consumer price index variation was no more than 103%.

BOX 1

Current Members of the FSB I I I I I I I I India Indonesia Italy Japan Korea, Rep. of Mexico Netherlands Russia I I I I I I I I Saudi Arabia Singapore South Africa Spain Switzerland Turkey United Kingdom United States

I I I I I I I I

Argentina Australia Brazil Canada China France Germany Hong Kong

completed the implementation of the FSB Principles and Standards (P&S) in their national regulation or supervisory guidance. The focus now is on the effective supervision of the implementation of these rules by relevant companies.
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aspiration of being a person of value the objective of also being a person of values, with the emphasis on the s. Many of these developments are designed to tackle the most critical aspects from both a general interest and a market perspective. We will focus on those emanating from supranational bodies and institutions, in particular the Financial Stability Board (FSB) and the European Union, given their broader and effective reach.

THE ACTIONS AND IMPACT OF THE FSB

In the context of the G20 agenda, although the last summit in St Petersburg was dominated by the dramatic situation in Syria, a group of diligent Sherpas under the remit of the FSB prepared an accurate and thoughtful report on the state of implementation of its principles for sound compensation practices and standards among the 24 FSB member jurisdictions. The G20 London summit of 2009 decided to establish the FSB as a successor to the Financial Stability Forum, the latter having been founded in 1999 to promote international financial stability and facilitate discussion and co-operation on the supervision and surveillance of financial institutions involving Finance Ministers and Central Bank Governors of the G7 countries and other industrialized economies. BOX 1 above provides a list of current members of the FSB. The following organizations also take part in the FSBs work: the Bank for International Settlements, the European Central Bank, the European Commission, the International Monetary Fund, the Organisation for Economic Co-operation and Development and The World Bank4. Under the chairmanship of Mario Draghi in 2009, Governor of the Bank of Italy at the time, one of the very first documents adopted by the FSB and with which the G20 members committed themselves to complying was a set of Principles for Sound Compensation Practices and Implementing Standards*5. The second progress report, finalized in August by the FSB Compensation Monitoring Contact Group, focuses on the remaining gaps and obstacles to its full implementation while analysing some of the key challenges and evolving practices in this area. The main findings of the FSB report seem encouraging on the state of progress of national implementation, although the remaining work on the ground is still material from a supervisory and corporate practice perspective. In particular, the principal findings of the review covered by the report are as follows:
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The disclosure of compensation practices has improved. Most jurisdictions report that the majority of the supervised companies now disclose significant and detailed information on compensation structures in annual remuneration reports. Most authorities are of the view that the implementation of the P&S and related supervisory action, among other factors, has had a heavy impact on changes in compensation practices for supervised institutions. Reported trends since the 2011 peer review suggest that most compensation structures are being revised in the direction indicated by the P&S. Most jurisdictions report increases in (a) the percentage of pay that is deferred and/or (b) longer periods of deferral; increases in the use of equity as a form of compensation; and increased use of malus clauses for both (a) financial performance and (b) compliance or behaviour issues. Several authorities note that companies still express some level playing-field concerns regarding jurisdictions that may not have fully implemented the P&S or that do not supervise companies adequately for this purpose. Meanwhile, national authorities do not acknowledge, in the absence of any real evidence, that the implementation of the P&S has impeded or diminished the ability of supervised institutions to recruit and retain talent. The Bilateral Complaint Handling Process, which the FSB initiated for addressing level playing-field concerns, has not so far been activated by companies in FSB member jurisdictions. Certain regulatory initiatives currently being implemented could materially change compensation structures in some FSB member jurisdictions. In particular, the adoption by the EU of the fourth Capital Requirements Directive (CRD IV) includes requirements on compensation structures that go

With the only exceptions being Argentina and Indonesia, all FSB member jurisdictions have now

* The FSBs October 2011 thematic peer review on compensation set out several recommendations to support the full and effective implementation of the Principles and Standards by both national authorities and companies. The G20 leaders in Cannes called on the FSB to: undertake an ongoing monitoring and public reporting on compensation practices focused on remaining gaps and impediments to full implementation of these standards and carry out an ongoing bilateral complaint handling process to address level playing field concerns of individual firms. The FSB has established a Compensation Monitoring Contact Group that is responsible for monitoring and reporting to the FSB on national implementation of the P&S. The first implementation progress report in this area was published in June 2012. In addition, a Bilateral Complaint Handling Process was launched in April 2012, which establishes a mechanism for national supervisors from FSB member jurisdictions to bilaterally report, verify and, if necessary, address specific compensation-related complaints by financial institutions based on level playing-field concerns.

beyond those in the P&S. The implementation of the Directive will foster the convergence of compensation practices for all credit institutions and designated investment management firms operating in the European Economic Area. At the same time, concerns have been expressed, especially by a few non-EU FSB member jurisdictions, about the prescriptive nature of these requirements. In particular, these jurisdictions suggest that the introduction of a limit on the ratio between fixed and variable compensation for material risk takers (MRTs) may have unintended consequences, such as creating obstacles to the ability of internationally active companies to implement a global approach to compensation structure and adopting a larger proportion of fixed compensation in their EU operations. These issues are also relevant to ensuring a level playing-field.
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The report concedes that further work is needed on the identification criteria for MRTs. This is an area where there is a broad range of practices across jurisdictions and companies, partly due to differences in relevant national regulations and supervisory guidance and partly because of the different size, nature or complexity of institutions. It is not yet clear whether the diversity in practices and experimentation among companies and jurisdictions is leading to significantly different outcomes or which approaches are most effective.

The European Commission, by adopting its temporary State aid rules for assessing public support to financial institutions during the crisis, is aiming to improve the restructuring process, and the level playing-field, for banks. In particular, banks will be required to work out a sound plan for their restructuring or orderly winding down before they can receive recapitalization funds or asset protection measures. Moreover, in the case of capital shortfalls, bank owners and junior creditors will be required to contribute first, before the banks can ask for public funding. In this context, a full section of guidelines is dedicated to compensation*6. In this respect, the rules provide that failed banks should apply strict executive remuneration policies. The new Banking Communication sets a cap on total remuneration as long as the entity is being restructured or is reliant on State support. This is supposed to give management the appropriate incentives for implementing the restructuring plan and repaying the aid. The rules apply for as long as market conditions dictate. The Commission may revise them as necessary, notably in the light of the evolution of the EU regulatory framework for banking.

Remuneration and Capital Adequacy for the Banks

More broadly, in relation to the financial services sector, the Commission presented legislative proposals empowering national supervisors to oblige financial institutions to implement remuneration policies consistent with effective risk management. Indeed, new provisions on remuneration in the financial services sector were adopted on 17 July 2013 when the latest amendment to the CRD IV was made. In addition, the Commission said that similar legislative initiatives in other financial sectors, such as insurance, should be considered. The CRD IV package which transposes via a Regulation and a Directive the new global standards on bank capital (commonly known as the Basel III agreement) into the EU legal framework came into force on 17 July 2013. The new rules, which will apply from 1 January 2014, tackle some of the vulnerabilities shown by the banking institutions during the crisis, among which are remuneration policies.

Irrespective of national implementing progress reported by the FSB and regardless of local corporate culture, there is no more room for directors to cut corners or to perform their tasks without embedding high standards of governance into business decisions and practices throughout the organization.

THE EUROPEAN UNION AGENDA

The European Union, mainly at the initiative of the European Commission, its executive arm, has been tackling the issue of directors compensation as part of the broader process of modernizing company law with a view to enhancing corporate governance in listed companies. However, as already mentioned in the context of the FSB report, most of the binding measures taken are more prominently addressed to the banking and financial services sector, where related pay policies and practices have been identified as one of the critical causes of the last financial crisis.

Pay Constraints on Banks under Public Rescue Plans

An important, compelling illustration of the European Commissions determination can be found in the guidelines adopted last July by the Commission on crisis rules for banks and by their immediate application one week later in relation to the rescue package granted by Italy to the bank Monte dei Paschi di Siena (the oldest bank in the world, active since 1472). In this context, Joaqun Almunia, Vice President of the EC responsible for competition policy, in a polite but firm letter to the Italian Minister for the Economy considered inappropriate and clearly challenged the compensation package put forward by the Board of the Bank, among other controversial points raised regarding the Monte Paschis rescue plan which had been submitted by the national authority for EU clearance.
* The EC Communication adopted on 11 July 2013 replaces the 2008 Banking Communication and supplements the remaining crisis rules. The combined revised rules define not only the common EU conditions under which member states can support banks with funding guarantees, recapitalization or asset relief but also the requirements for a restructuring plan. In 2008-09, following the collapse of Lehman Brothers, the Commission adopted a comprehensive framework for co-ordinated action to support the financial sector during the crisis, so as to ensure financial stability while minimizing distortions of competition between banks and across member states in the Single Market. It spells out common conditions at EU level for access to public support and the requirements for such aid to be compatible with the internal market in the light of State aid principles. It comprises the Banking Communication, the Recapitalisation Communication, the Impaired Assets Communication and the Restructuring Communication.

The Directive complements the Recommendation by implementing international standards and practices at EU level through the introduction of an express obligation on credit institutions and investment management firms to establish and maintain, for categories of staff whose professional activities have a material impact on their risk profile, remuneration policies and practices that are consistent with effective risk management. In particular, the Directive specifies clear principles on governance and on the structure of remuneration policies; makes the distinction between fixed remuneration and variable remuneration, with a maximum ratio set between the two; assigns the task to the management bodies to adopt and periodically review the remuneration policies in place; and ensures that competent authorities have the power to impose qualitative or quantitative measures on the relevant institutions7.

However, a study for the Commission published in 2009 revealed significant shortcomings in applying the comply or explain principle that reduce the efficiency of the EUs corporate governance framework and limit the systems usefulness. In particular, the study revealed that, in over 60% of cases where companies chose not to apply recommendations, they did not provide sufficient explanation11.

Other EC Responses to the Financial Crisis

The financial crisis showed up serious weaknesses in the way in which financial markets were regulated and supervised. There is a broad consensus that compensation schemes based on short-term returns, without adequate consideration for the corresponding risks, contributed to the incentives that led financial institutions engagement in over-risky business practices. In addition, wider concerns have been voiced about substantial increases in executive remuneration, the increased importance of variable pay in the composition of directors compensation packages and an alleged short-term focus of remuneration policies across all sectors of the economy. Within this context, in April 2009 the Commission adopted two complementary Recommendations on remuneration policies that are still valid. These deal, on the one hand, with the regime for the remuneration of directors of listed companies and, on the other hand, with the remuneration policies in the financial services sector12. In a second phase, for companies listed on the stock exchange, the Commission published an Action Plan on European company law and corporate governance in December 2012, following the Green Paper (in 2011) and the public consultation (in 2012). It identifies three main lines of action: enhancing transparency; engaging shareholders; and supporting companies growth and competitiveness. As announced in the Plan, the Commission will propose an initiative later in 2013, possibly through an amendment of the Shareholders Rights Directive, to improve transparency on remuneration policy and to make it compulsory to grant shareholders the right to vote on the remuneration of directors13. The forthcoming Commissions commitment on this front has been more recently confirmed in the response given by the executive EU agency to a parliamentary question raised by MEP Marc Tarabella earlier in 2013. In particular, the new European Commission proposals will address how to improve the functioning of the comply or explain approach within the EU corporate governance framework. This should help to address the alleged problem of the low quality of corporate governance explanations provided by some companies departing from corporate governance code provisions. Currently, they often provide no or insufficient explanations. This makes it difficult for investors to judge the appropriateness of the companys corporate governance arrangements and to assess whether the company has good reasons not to comply with a given arrangement. As mentioned earlier, the advantage of the comply or explain

EU Clairvoyance on Compensation and Governance

It is worth remembering that the work of the European Commission in the area of directors compensation, even beyond financial services, goes back to 2002 well before the 2008 crisis. The seeds of todays developments can be found in the report of a High Level Group of Company Law Experts appointed by the Commission that focused on corporate governance pitfalls and remedies in the EU8. In 2003, less than a year after the experts report, the Commission adopted an Action Plan on modernizing company law and enhancing corporate governance in the European Union, recognizing the need for shareholders to be able to fully appreciate the relationship between the performance of the company and the level of remuneration of directors, both ex-ante and ex-post, and to make decisions on the remuneration items linked to the share price9. The Action Plan was followed in 2004 by a wide consultation process and a specific Recommendation on directors remuneration. It recommended member states to ensure that listed companies disclose their policy on directors remuneration, that shareholders are informed of individual directors remuneration packages and are given adequate control over these matters, including share-based remuneration schemes. The 2007 report on the application of the Recommendation shows that corporate governance standards had been improving and that transparency standards were more widely followed. Meanwhile, the more controversial issue of a shareholders vote on pay remained untackled in several member states10. The corporate governance framework for listed companies in the European Union is based to a large extent on soft law, namely corporate governance codes. While these codes are adopted at national level, Directive 2006/46/EC requires that listed companies refer to a code in their corporate governance statement and that they report on their application of that code on a comply or explain basis. This approach means that a company choosing to depart from a corporate governance code has to explain which parts of the code it has departed from and the reasons for having done so. The advantage of this method is its flexibility, as it allows companies to adapt their corporate governance practices to their specific situation in relation to their size, shareholding structure and sector of activity.

approach is that it allows companies to adapt their corporate governance arrangements to their specific needs. Companies may have very good reasons for non-compliance; however, in this case they should be clearly indicated. Insufficient or generic information does not make it possible to assess whether or not the company has good reasons for noncompliance. The legal nature and scope of forthcoming initiatives have not yet been finalized but we can anticipate that most of the European Commissions consideration and guidelines presented above will materialize in a new,

more powerful proposal. Executives of listed companies, investors, national bodies in charge of updating and monitoring the corporate governance codes and their respective advisers need to stay tuned for what will come next from Brussels in this area and assess the implications in their respective contexts. Moreover, they must not hesitate to speak up, giving their perspective to EU representatives and making their voices heard during the decision-making process. Irrespective of how good the guidelines and rules will end up as being in this area, business leaders today are more than ever in the driving seat to restore trust while safeguarding their own priceless reputations.

References
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Richard Flinger, Is the end of gigantic, unfair, and absurd CEO pay near?, Forbes, 18 March 2013. Bo Sun, Executive Compensation and Earnings Management Under Moral Hazard, for the Board of Governors of the Federal Reserve System, International Finance Discussion Papers, No. 985, December 2009. See especially Lynn Stout, Shareholder Value Myth: How Putting Shareholders First Harms Investors, Corporations, and the Public, 2012. Implementing the FSB Principles for Sound Compensation Practices and their Implementation Standards, Financial Stability Board, 26 August 2013. FSF Principles for Sound Compensation Practices, Financial Stability Forum, 2 April 2009 and, for further information on compensation monitoring by the FSB, see Compensation Monitoring, Financial Stability Board. State aid temporary rules established in response to the economic and financial crisis, Official Journal of the European Union, European Commission, Vol. 56, C 216, 30 July 2013. Directive 2013/36/EU of the European Parliament and of the Council, Official Journal of the European Union, Vol. 56, L 175, 27 June 2013 and Regulation (EU) No. 575/2013 of the European Parliament and of the Council, Official Journal of the European Union, Vol. 56, L 176, 27 June 2013. Report of the High Level Group of Company Law Experts on a Modern Regulatory Framework for Company Law in Europe, The High Level Group of Company Law Experts, 4 November 2002. Modernising Company Law and Enhancing Corporate Governance in the European Union A Plan to Move Forward, Commission of the European Communities, 21 May 2003. Report on the application by Member States of the EU of the Commission Recommendation on directors remuneration, Commission of the European Communities, 13 July 2007. Monitoring and Enforcement Practices in Corporate Governance in the Member States, European Commission, 23 September 2009. An assessment of the level of implementation of these recommendations is included in the ECs report covering measures taken by EU member states to promote their application. See Report from the Commission to the European Parliament, The Council, The European Economic and Social Committee and the Committee of the Regions, European Commission, 2 May 2010. Action Plan: European company law and corporate governance a modern legal framework for more engaged shareholders and sustainable companies, European Commission, 12 December 2012.