Incentive compensation

Typical structures

What are the prevalent types and structures of incentive compensation? Do they vary by level or type of organisation?

The remuneration of executive board members usually consists of a fixed remuneration and a variable remuneration. Variable compensation typically includes both short-term incentives (STI) and long-term incentives (LTI).

A study by the auditing firm PWC published at the end of 2021 examined the composition of the remuneration of DAX (German stock index) executive boards. In recent years, the share of fixed remuneration at DAX companies has been relatively stable at 40 per cent compared to variable remuneration of 60 per cent. The variable remuneration takes into account not only the short-term but also the medium- and long-term development of the company. In 2020, the share of variable remuneration was 63 per cent to 37 per cent. In the MDax (stock index concerning German companies trading on the Frankfurt Stock Exchange), the LTI share fell by 1 per cent. Variable and fixed remuneration were in a ratio of 49 per cent to 51 per cent. In the SDax (stock index for small and medium-sized companies in Germany), the variable remuneration share was 59 per cent.

The German Corporate Governance Code (DCGK) stipulates in section G.18 that supervisory board members should receive a fixed and non-performance-related remuneration for their activities.

Managing directors and employees also often receive variable remuneration in addition to fixed remuneration. Usually, the variable remuneration is contractually agreed as a royalty, based on the profits of the company. It is useful to point out the assessment basis (eg, accounting and finance, earnings before interest and taxes).

If an employment contract is commenced during the course of the year, the variable remuneration is often granted pro rata temporis.

Deferral periods are explicitly regulated for financial institutes; for executive board members and risk-takers it is four or five years.

Restrictions

Are there limits generally on the amount or structure of incentive compensation? Are there limits that adversely affect the tax treatment of the compensation relative to the employer or the executive?

Absolute limits for variable compensation are regulated for financial institutions. The amount of variable remuneration for executive board members is limited in accordance with the so-called bonus cap. Financial institutions are prohibited from granting variable compensation to employees or members of the board of management that exceeds 100 per cent of the fixed compensation per year. With the approval of the shareholders’ meeting and provided that this is compatible with capital adequacy, variable compensation may be up to 200 per cent of fixed compensation.

Special rules also apply to listed companies. The Act Implementing the Second Shareholders’ Rights Directive introduced significant changes for the compensation of members of the executive boards of stock corporations, which have applied since 2021.

In accordance with section 87 of the German Stock Corporation Act (AktG) the renumeration system must now provide for the setting of the maximum compensation for members of the executive board. The maximum compensation includes fixed and variable compensation components, fringe benefits and pension commitments. The law stipulates that the total remuneration must be in proportion to the tasks and performance of the executive board member as well as to the situation of the company. Absolute limits are not specified.

There are no limits that affect the tax treatment.

Deferral

Is deferral and vesting of incentive awards permissible? Are there limits on the length or type of vesting and deferral provisions?

Deferral and vesting of incentive awards are mainly permissible.

A distinction must be made between executive board members, managing directors and employees.

Special regulations apply to executive board members and risk-takers of financial companies and executive board members of listed companies.

Financial institutions are obliged to defer part of the variable remuneration. This is provided for in section 20 of the Ordinance on the Supervisory Requirements for Institutions‘ Remuneration Systems (InstitutsVergV). These laws require that the payment of a significant part, being at least 40 per cent, of the variable remuneration of a risk-taker must be spread over a retention period of at least four years. Depending on the position, the tasks and the activities of a risk-taker, as well as the amount of the variable remuneration and the risks that a risk-taker can justify – the minimum limit of the retention period may be increased to up to five years and the minimum limit of the portion of the variable remuneration to be retained may be to up to 60 per cent.

Section 87a AktG contains special regulations for the executive boards of listed companies. Pursuant to section 87a(1) no. 5 AktG, the supervisory board decides on deferral periods for the payment of remuneration components. The deferral of variable remuneration components is typically regulated for a period of between two and four years. In addition, the DCGK contains recommendations for the remuneration of executive board members.

The deferral periods are intended to ensure the sustainability of the compensation systems in order to be able to react to changes in economic circumstances when paying out the compensation. The sustainable design of remuneration systems is achieved through a multi-year assessment basis. In this context, the remuneration system should not only be geared to the long-term development of the company in terms of time. Non-financial aspects, in particular social and ecological aspects, must also be taken into account to a greater extent.

The withholding of variable remuneration components can also be regulated in managing director contracts or in contracts with employees. In the case of standard contracts with employees, the case law on the effectiveness of a general standard terms and conditions must be followed. There is no fixed maximum vesting period. However, for standard employment contracts there has been a ruling on inappropriate discrimination according to section 307(1) of the German Civil Code for vesting periods over four years.

Are there limitations on the individuals or groups eligible to receive the compensation? Are there aspects of the arrangement that can only be extended to certain groups of employees?

There are no limitations on the group of employees eligible to incentive compensation. Usually, however, managing directors and senior executives are granted incentive compensation elements in their employment contracts.

Concerns based on section 87(2) AktG and the regulations of the DCGK are only applicable to members of the executive and supervisory board of stock corporations. Nevertheless, many big and, thus, co-determined limited liability companies do also apply the principles of the DCGK on a voluntary basis.

The German Banking Act prohibits members of administrative or supervisory bodies from receiving variable compensation components for their activities.

Recurrent discretionary incentives

Can it be held that recurrent discretionary incentive compensation has become a mandatory contractual entitlement? Is this rebuttable?

The recurring concession of discretionary incentive compensation may lead to a contractual entitlement to incentive compensation by implied alteration of the employment contract when usually granted three years in a row. The employer can prevent the emergence of entitlement for the future by direct indication to the employee.

Effect on other employees

Does the type or amount of incentive compensation awarded to an executive potentially affect the compensation that must be awarded to other executives or employees?

Generally speaking, employees assigned to the same tasks have to be paid equally unless there is a particular reason for certain unequal treatments. The legal foundation is the principle of equal treatment. For managing directors, this principle applies only restrictively.

If the managing director is a significant shareholder, this principle is not applicable to his or her advantage.

Even if this principle is applicable, it does not require the managing director to be awarded the same compensation. This is permissible as long as there are objective reasons for unequal compensation between two or more managing directors. In addition, agreements that are individually concluded do not fall under the aforementioned principle.

Mandatory payment

Is it permissible to require repayment of incentive compensation under certain circumstances? Are there circumstances under which such repayment is mandatory?

Repayment of compensation has to be individually agreed in the individual contract (clawback-clauses) and is – in general – not prevalent in Germany. These clawback-clauses allow, for example, the supervisory board of a stock corporation to cut variable remuneration. In addition, the supervisory board is obliged to reduce the total compensation including incentive awards of directors under the requirements of section 87(2) AktG.

Furthermore, the current version of the DCGK states under section G11 that, the supervisory board is entitled to retain or reclaim variable compensation, if this element is agreed upon in the respective employment contract.

Since 2017, these claw-back-clauses have been mandatory for so-called significant financial institutions in contracts with their executive board members and all the risk-takers. These claw-back clauses oblige financial institutions to reclaim variable remuneration already paid out on the basis of corresponding agreements if the board member or risk-taker was significantly involved in, or responsible for, conduct that led to significant losses for the financial institution or a regulatory sanction, or seriously violated relevant external or internal regulations regarding suitability and conduct.

Can an arrangement provide that payment is conditioned on continuing employment until the payment date? Are there exceptions?

The admissibility of such arrangements in employment contracts, so-called cut-off date clauses, has been the subject of a large number of decisions by the Federal Labour Court (BAG).

The permissibility of cut-off date clauses depends on the purpose pursued with the special payment. According to the case law of the BAG, special payments intended to remunerate work performance may not be made dependent on the existence of the employment relationship on a certain cut-off date. The same applies to special bonuses of a mixed nature which are intended to remunerate both work performance and company loyalty (so-called mixed clauses). If, on the other hand, the special payment is made exclusively to reward the employee’s loyalty to the company, it can be effectively linked to the achievement of a key date.

Employee stock options are a special challenge. The BAG judges employee stock options as a mere acquisition opportunity which does not enjoy the same protection under German labour law as secured remuneration components. Rather, the company issuing the option is free to stipulate that even after the expiry of the waiting period prescribed under section 193(2)4 AktG (four years under the current law), the employment relationship must continue without termination until a certain point in time in order to be able to exercise the option. A total commitment period of up to five years is considered permissible.

The drafting of such clauses is challenging for executive boards of listed companies and financial institutions. Since the entire remuneration system and also payment formalities must be oriented towards a sustainable corporate development (section 87 AktG/InstitutsVergV). Individual contractual provisions that link payments to certain conditions are difficult to harmonise with this principle.