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E-MailAvi Licht is Deputy attorney general, and Ronnie Talmore and Haim Sachs are attorneys at the Ministry of Justice, Israel. The writers of this post advised the committee established by the Justice Minister in the formulation of Israel’s Executive Compensation Reform.
Foreword
The issue of executive compensation has been on the forefront of corporate governance discussion around the world in the past few years. Israel is no different. In previous years there was a significant rise of executive compensation in public companies that cannot be explained or linked to the companies’ performance.
Like many capital markets in continental Europe and other countries around the world, [1] most of the companies traded on the Tel-Aviv Stock Exchange have a controlling shareholder. A significant portion of these companies are controlled by a limited number of business groups, the majority of which are characterized by pyramid control structures.
Concentrated ownership and dominance of company groups raise a key agency problem: the relationship between controlling shareholder and the minority shareholders. The issue of protection of minority shareholder rights and the prevention of abuse of the controlling power is therefore a subject of main consideration in Israel.
Israel’s Companies Law is regarded as having one of the most robust legal frameworks for protecting minority shareholders’ rights in the world. The OECD has recently commented that “Israel has broadly implemented the OECD Principles relevant to the prevention of the abuse of related party transactions, with one of the most elaborate systems of disclosure and review among OECD countries reviewed.” [2] Indeed, the protection of minority shareholders was notably enhanced in amendments to the Companies Law over the last two years. Pyramidal structures are the subject of a proposed bill, which sets forth, inter alia, structural changes to pyramidal groups eliminating the ability to construct pyramidal structures with more than two tiers.
The recent amendment to the Companies Law regarding executive compensation in public companies was drafted due to a concern in the ownership structure and the need to safeguard minority rights.
Executive Compensation Reform — Amendment 20 of the Companies Law
In April 2010 the Israeli Government set up a committee headed by Justice Minister Professor Yaakov Ne’eman to report on executive compensation and recommend changes that would restrain excessive compensation. The committee published its recommendations in February 2011. Following the recommendations and after further extensive deliberation, the Justice Ministry published a bill proposal. The bill was approved by the Parliament and took effect on December 12, 2012.
The reform is based on an extensive review of compensation reforms, especially in the U.S., the UK, and on the recommendation of standard setters such as the OECD Principles of Corporate Governance [3] and the EU Directive on Directors Remuneration. Nevertheless, as already mentioned, the reform includes unique aspects that are suited to the characteristics of the Israeli market described above.
The basic policies common to all recent reform agendas on this issue are effective shareholder participation, and the alignment of executive and board compensation policy with long-term interest of the company and its shareholders.
The Israeli framework takes shareholder participation and compensation policy alignment seriously. Compensation policy requires shareholders’ vote prior to its final approval, and CEO compensation agreements are brought before the shareholder meeting for approval before the agreement can be finalized by the board. This distinguishes the Israeli ‘say on pay’ model from the U.S. and UK’s models, which enable shareholders to express their opinion only ex post. Further, variable components of the compensation agreement are scrutinized in order to ensure that executive and director pay is linked to their contribution to the company’s performance and long term interest.
Nonetheless, the reform retains the basic tenets of corporate law. The board retains the key function of selecting, compensating and monitoring the company’s executives, while giving the shareholders the ability to effectively state their opinions in ‘real time’, enabling the board to be responsive to the shareholders’ concerns and views on this critical issue. These aspects are the corner stones of the reform and will be elaborated further below.
The amendment sets out the following corporate governance rules relating to the approval of executive compensation and the formulation of compensation policies:
Compensation policy and structure:
Compensation Policy: The main objective of the compensation policy is to promote the long term goal of the company, set adequate incentives linked to the company’s performance and “risk appetite”, and, in short, link pay to performance.
The policy will take into account the company’s goals, size and activities, and will ensure proper incentives for the executives. In addition, the company must take the following issues into consideration when formulating the compensation policy:
The executive’s education, qualifications, professional experience and achievements; the executive’s position within the company, the scope of his responsibilities and previous terms of compensation; the proportionality of compensation within the company – namely the executives’ pay in relation to the average and median pay of other employees in the company, including contract workers. Contract workers are required to be included in order to avoid incentives to employ low salaried workers as contract workers.
In addition, termination payments (“golden parachutes”) should be granted on the basis of the term of employment, the company’s performance during that term, and the departing executive’s contribution to the company, in order to ensure that termination payments do not reward failure. To avoid the use of compensation norms in peer companies that cause a steady rise in pay for all executives (“the ratchet effect”), pay in other companies is not one of the required considerations.
Caps on variable components: Variable components require special attention as they are critical to the alignment of the company’s directors and executives with the company’s performance. To this end, an important feature of the compensation policy is the requirement that the company contemplate whether to authorize the board to have full discretion to lower the variable compensation components and whether to set a maximum limit (cap) on the actual variable components based on stock, when paid. All other variable components must have a clear cap. These requirements enable the board to monitor the actual variable components of pay when they are granted by the company and ensure that they do not result in excessive compensation.
In addition, the company is required to include the following provisions in the compensation policy: The award of variable components must be based on long term and measurable performance criteria; and the company must set itself a balance between fixed and variable pay.
The compensation policy must contain a ‘claw back’ provision requiring the executive to return compensation that was awarded on the basis of an accounting restatement; and share based compensation should be linked to long term performance, and there should have appropriate vesting periods.
Approval Procedure:
Compensation committee: All public companies and bond companies are required to establish a compensation committee. The committee will be made up of at least three directors, with a majority of outside directors. [4] The remaining directors must be independent and their compensation is to be subject to regulations regarding outside director compensation (i.e. – all members will be directors who have no personal interest in the compensation policy). The committee is authorized to recommend the company’s compensation policy to the board of directors, and to approve the compensation of the CEO, the directors and corporate officers. Therefore, the board of directors retains the duty to determine the compensation policy, but it must do so on the basis of the compensation committee’s recommendations.
“Say before pay” rules: The compensation policy recommended by the compensation committee is to be approved by the board and then, before it takes effect, by the general meeting in a non-binding vote. If the majority of the minority shareholders do not approve the policy, the policy will be returned for further deliberation by the board, taking into account the rejection of the policy by the minority shareholders. The board may ultimately approve the policy despite the minority’s disapproval, if it finds that the policy is in the company’s best interest. As for companies held through a pyramid structure, see below.
The compensation policy must be approved at least every three years. The board is required to reevaluate the policy from time to time and if a material change occurs.
CEO Pay: The amendment sees the CEO compensation as a point of reference for the compensation of other senior executives in the company, and hence requires special review by the shareholders. One of the unique features of the framework is the entitlement of the shareholder to an advisory vote prior to the authorization of the CEO’s pay or material changes to it. In addition, the CEO’s compensation and the incentives therein should be strongly linked to the performance of the company, and therefore the shareholders should be able to express their views by way of an advisory vote.
Thus, the CEO’s compensation is subject to an approval by the majority of the minority shareholders in the general meeting after its approval by the compensation committee and the board of directors, whether or not it meets the compensation policy.
The need for prior approval by shareholders may have negative effects on the company’s ability to negotiate employment contracts with outside candidates for CEOs. In order to mitigate this risk the compensation committee is authorized to exempt an agreement with an outside candidate from the shareholders’ approval if it is convinced that the approval by the shareholders will frustrate the appointment, provided that the agreement conforms to the compensation policy.
Say on executive pay: Executive pay will be approved by the Compensation Committee and the board of directors in compliance with the compensation policy. The committee and the board may derogate from the policy under special circumstances – in this case the compensation agreement must be approved by the shareholders in a non-binding vote (as stated earlier regarding shareholder approval of the compensation policy).
Pay in pyramid-held companies
One of the unique features of the reform is its special attention to companies held through a pyramidal structure. The issue of business groups and pyramidal structures has been recently reviewed by an inter-governmental committee on Enhancing Competitiveness in the Israeli Economy that was appointed by the government in October 2010 in order to examine the existing structure of the Israeli market and its effect on the level of competition, in light of the multitude of business groups in Israel.
The Committee found that one quarter of all the companies listed for trade in Israel belonged to approximately 25 major business groups and that their portion of the market share (excluding Teva Pharmaceuticals Ltd) was almost 70%. The complex structure of business groups, which generally includes a pyramidal holding structure, makes it possible to achieve actual control of large companies through a relatively small investment. The ability to control complex structures of companies by means of a relatively small investment in capital raises significant concerns of detriment to investors and competition, and encourages excessive risk-taking by the owners of the business group, thus affecting the stability of the economy. [5]
The Committee proposed, inter alia, imposing a structural change to multi-level pyramid structures, which eliminates the ability to construct pyramidal structures with more than two tiers (while existing structures will be allowed to retain three tiers). The Committee also recommended additional corporate governance measures to reduce the potential for damage to investors as a result of such structures. The first step for reducing the inherent risks posed by this control enhancing mechanism has been adressed in the executive compensation reform and will be outlined below.
The Committee’s recommendations were adopted by the government and included in a draft Law for the Promotion of Competition and Reduction in Concentration, 2012. The draft law was approved by the Israeli Parliament in its first reading and is awaiting parliamantry deliberations.
The executive compensation reform stipulates that in a company with three or more tiers of the pyramidal structure (i.e., a public company that is controlled by a public or debenture company that is itself held by a public or debenture company, all of which are controlled by a controlling shareholder) the board of directors will not be able to deviate from the general meeting’s vote. This means that the majority of the minority shareholders’ vote in the general meeting will be binding and not advisory, both on policy and on pay.
The reason for this distinction is because unlike regular public companies that have majority shareholders, who are strongly incentivized by their investment in the company not to pay executives excessively, a shareholder who controls the company through a pyramidal structure does not bear the majority of the cost and therefore does not have an equal incentive. In this case, the non-controlling shareholders should be able to effectively review executive compensation.
Endnotes
[1] Rafael La Porta, Florencio Lopez-deSilanes & Andrei Shleifer “Corporate Ownership Around the World” Journal of Finance (2006).
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[2] OECD (2012), Related Party Transactions and Minority Shareholder Rights, OECD Publishing, page 104. http://dx.doi.org/10.1787/9789264168008-en
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[3] OECD Principles of Corporate Governance (2004).
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[4] In order to qualify as an ‘outside director’ the director must be independent of both the controlling shareholder and the company’s executives.
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[5] The Committee on Increasing the Competitiveness in the Economy: Final Recommendations and Supplement to the Interim Report, page 13.
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One Comment
This compensation reform is a huge step forward in overcoming agency conflicts over remuneration and helps restore shareholder primacy over the corporation.
If only the reform’s intent was extended to the core funcction of most corporate law – that of having the for-profit entity serve the objectives of it owners.
Intuitively one would expect that small organisations with few shareholders are more “in-touch” with their owners’ objectives than larger organisations. One would further expect that the larger the organisation and the greater the number of shareholders, then the less able the organisation is to keep “in-touch” with all shareholder objectives.
Unfortunately, experience and reality show that companies, irrespective of size, are not immune from the lack of congruence between owner objectives and corporate actions.
The majority of companies are small businesses that have one or a small number of people carrying out the roles of managers, directors and owners simultaneously. One would expect that since one person carries out all three roles then “knowledge” would be “perfect” and congruence would be maximised.
Most small businesses actually have difficulty in ensuring congruence because they are too involved in operational management. It is easier to change the objective than to change the operational, marketing or business realities that threaten incongruence.
Generally boards and management of large corporations maintain that since they have many shareholders with varying objectives and they can’t effectively ask shareholders what they want; the board has the responsibility to define the core deliverables of the organisation. These deliverables are intended to keep shareholders satisfied. Such presumptions by boards are often misplaced because they are subjectively derived. The demonstrable fact is that many (most?) corporations do not know what their owners want in any realistic, practical and measurable way.
In the case of medium size companies where management may be divorced from directorship and/or ownership, it is common to find organisations intent on striving to maximise generic outcomes rather than satisfy specific owner objectives. Certainly, a large part of this lack of congruence is caused by management failing to ask owners what they want; but equally at fault, are owners who have not made the effort of telling management in realistic and measurable terms what it is that they desire from their involvement in the company.
Very few companies, irrespective of size, really know what their owners want. In the case of small business, the owner/manager has rarely defined what it is that is wanted so that it becomes the principal driver of business performance.
The solutions are clear and easy: if you are an owner, even of the largest corporation, make sure that the board and/or management knows what you want in terms of value, benefit, growth and risk. Also identify your objectives in terms of environment, ethical activities and governance issues such as related-parties transactions.
If you are a director or senior manager, ask your owners what they want as an outcome.
If you are an owner/director/manager, then be honest with yourself and what you are doing operationally. Is the company that you run giving or likely to give you the outcome you seek? If not, then its time to assess the options.