The European Commission this week approved a corporate governance package, which for the first time includes a “say on pay” provision that strengthens shareholders' weight on executive compensation throughout the 28-nation bloc.

The commission's proposal would affect about 10,000 companies listed on European stock exchanges. The package consists of revisions to the Shareholders Rights Directive, increased reporting requirements for corporate governance, and a new directive to allow small and medium-sized enterprises (SMEs) to set up cross-border companies more easily.

“The last years have shown time and time again how short-termism damages European companies and the economy. Sound corporate governance can help to change that,” Internal Market and Services Commissioner Michel Barnier said in a statement. “Today's proposals will encourage shareholders to engage more with the companies they invest in, and to take a longer-term perspective of their investment. To do that, they need to have the rights to exercise proper control over management, including with a binding ‘say on pay.'”

Regarding the Shareholders Rights Directive, lawmakers said the revisions would help solve shortcomings that exist with listed companies and their investors, especially institutional investors. Too often in recent years those investors supported excessive short-term risk, failed to closely monitor the companies they invest in, or cared more about share price movement, the commission said. To encourage investors to take a longer-term view, new requirements are proposed for greater transparency from institutional investors and asset managers on investment and engagement policies. Also proposed is an easier process for investors to exercise their rights in cross-border situations, and greater transparency from proxy advisors on conflicts of interest as well as rationales for voting recommendations.

On the binding “say on pay” provision, companies would be required to provide greater transparency on and justification for their remuneration policies.

Under the proposal, shareholders would have the right to approve the remuneration policy of directors every three years, in addition to annual votes on advisory reports that would explain directors' pay packages. The proposal stops short of any EU-wide compensation cap. However, each company's policy, which would be subject to a binding vote from shareholders, must include a defined maximum level for executive pay. The policy and report would need to provide a justification on how the pay package aligns with a company's long-term interests. It also would have to explain how the policy takes into account pay and employment conditions of other employees, and provide the ratio between pay of average employees versus executives.

In cases of new hires, the board would be allowed to exceed the policy's maximum level only with prior or ex post approval by shareholders. It would up to Member States to determine the process for cases in which shareholders reject a remuneration policy.

Lawmakers said too often there has been a “mismatch between executive pay and performance.” Currently, 15 Member States require a company's remuneration policy to be disclosed, and only 11 require disclosure of individual director's pay. Thirteen of the 28 bloc members give shareholders the ability to vote on directors' remuneration policies or company report, the commission said.

In France, which has no “say on pay” law, the average remuneration of directors increased by 94 percent from 2006 to 2012, while average share price of those companies dropped by 34 percent during the same period, according to the commission's impact study. In Italy, average share price dropped by 130 percent from 2006 to 2011, while director pay increased by an average of 29 percent. After Italy's implementation of an advisory say on pay in 2011, the average share price increased by 10 percent while director pay increased by 1 percent, the commission reported.

Sweden has had a binding say on pay law since 2010. Since then, average share price of listed companies increased by 16 percent while director pay increased by 18 percent, according to the commission.

The directive also gives shareholders the right to vote on related party transactions involving more than 5 percent of a company's assets. The controlling shareholder would be excluded from the vote. The proposal also calls for independent third party valuations of transactions involving more than 1 percent of a company's assets.

On corporate governance reporting, the commission is proposing to improve the existing “comply or explain” approach by providing additional guidance on how companies should explain deviations from relevant codes. The commission said it is important to maintain the same approach to allow companies needed flexibility, but too often those explanations are not adequate. The added guidance, along with a request for listed companies to report how they follow corporate governance codes in different areas, should improve the quality of reporting, lawmakers said.

The commission's reporting recommendation is non-binding. Member States have been asked to inform the commission of actions taken to address the recommendation within a year.

The Single-Member Companies Directive proposed by the commission would streamline the process for SMEs to create and register companies and subsidiaries. Member States would need to create a company law form for single-member private limited liability companies with a common, EU-wide label of Societas Unius Personae, and allow online registration rather than forcing the company founder to register in person. The proposal would include a template for articles of association, a minimum capital requirement of €1, and adequate creditor protection with balance sheet tests and solvency statements.

Both proposed directives are subject to approval of the Council and European Parliament. If adopted, Member States would be required to implement the package into their own legal codes.

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