Background
Following intensive media scrutiny over senior executive salaries and the numerous legislative proposals relating to the issue, on November 5, 2012, the Knesset approved Amendment 20 to the Companies Law-1999 (the “Amendment”), addressing the compensation and salary approval process for senior executives in public companies and private companies with publicly traded debt (each a “Reporting Company“).
Primary Provisions
A) Compensation Policy
According to the Amendment, a Reporting Company’s Board of Directors is required to formulate a compensation policy addressing the remuneration of company officers, based on the recommendations made by the Compensation Committee. The compensation policy is required to be approved in advance by company shareholders, as described further below, in contrast to American and British models, in which compensation policies are approved ex post by company shareholders.
A compensation policy should take into account the advancement of the company’s long-term goals, the creation of proper incentives for company officers in view of the company’s risk management policy, and the company’s size and activities. The Amendment requires that compensation policies address various criteria regarding the terms of office and employment of company officers (such as an officer’s education, professional experience and qualifications), and in particular, the proportionality between the salaries of company officers and the salaries of other company employees (including contract workers).
Specific provisions regarding the calculation of variable salary components are required to be included in the compensation policies. Under the Amendment, variable salary components must be capped, and based on measurable criteria and long term performance. Only the insubstantial parts of the variable salary components may be awarded on the basis of non-measurable criteria, by taking into account the officer’s contribution to the company. This requirement is likely to have a significant impact on companies’ existing compensation policies and if narrowly interpreted, only 5-10% of a bonus may be based on evaluation criteria which cannot be measured objectively.
B) Say on Pay System
Additionally, the Amendment implements a modified version of the “Say on Pay” approach that has been adopted in the United States and United Kingdom. Under the Amendment, a Reporting Company’s overall compensation policy, as well as the compensation of its Chief Executive Officer, must be approved by the majority of the non-controlling shareholders at a shareholders’ meeting. If the shareholders’ meeting does not approve, the compensation can still be approved, provided that the Compensation Committee and the Board of Directors re-consider the compensation and approve it with reasons supporting their decision. With respect to director compensation, the approval of a simple majority of shareholders in the shareholders’ meeting is required. The compensation of all officers must comply with the Reporting Company’s compensation policy; under special circumstances however, the Amendment permits the approval of specific compensation agreements that deviate from the compensation policy, provided that appropriate approvals have been obtained. The “Say on Pay” system may be viewed as striking a balance between non-controlling shareholders and the Board of Directors by limiting the power granted to minority shareholders to determine officer compensation, while ensuring that the controlling shareholders and Board of Directors take the non-controlling shareholders’ views of this matter into account.
C) Compensation Committee
The Amendment mandates that a Reporting Company’s Board of Directors establish a “Compensation Committee” consisting of at least three directors. All of the Reporting Company’s external directors must serve on the committee and constitute a majority. The remaining committee members must be directors whose compensation is consistent with the regulations governing the compensation of external directors in a public company. An individual who is not eligible to serve on the company’s audit committee is not eligible to serve on the Compensation Committee. Among its functions, the Compensation Committee is responsible for providing the Board of Directors with recommendations regarding the Reporting Company’s compensation policy as it pertains to all of the Reporting Company’s officers, in accordance with the principles outlined in the Amendment; examining the application of the compensation policy and whether it should be updated; approving the employment terms of Reporting Company officers; and deciding whether the employment terms of a candidate for the position of CEO should be brought to a shareholders’ meeting for approval.
D) Public Subsidiary Company
The Amendment defines a “Public Subsidiary Company” as a public company that is controlled by a Reporting Company that in turn is controlled by a Reporting Company controlled by a controlling shareholder. In companies with this pyramidal structure, a controlling shareholder’s ability to control may well exceed its capital interest in the company. Consequently, there is a greater risk that lucrative employment conditions will be approved, and that these conditions will incentivize company officers to advance interests that are not necessarily in line with the best interests of the company. As a result, the Amendment strictly mandates that in the case of a Public Subsidiary Company, in contrast to a Reporting Company, a compensation policy or the employment terms of an officer that deviate from the compensation policy must be approved by the majority of the non-controlling shareholders in the shareholders’ meeting, and such approval shall be binding. These requirements constitute the first practical application of the recommendations made by the Economic Concentration Committee of the Ministry of Finance in connection with pyramid companies.
E) Transition Period
Having entered into effect on December 12, 2012, the Amendment stipulates that Reporting Companies adopt a compensation policy within nine months (by September 12, 2013). Until that time, the employment terms of a Director or Chief Executive Officer are required to be approved in accordance with the provisions of the Amendment. The employment terms of other officers need only be approved by the Compensation Committee and the Board of Directors.
Implementation Issues
The practical implementation of the Amendment raises a number of issues.
First, it is not entirely clear how detailed a Reporting Company’s compensation policy must be. We anticipate that companies generally will aim to avoid drafting detailed compensation policies, in order to provide themselves enough flexibility to approve individual compensation plans and to avoid exposing company business secrets contained in various compensation criteria.
Second, a Reporting Company’s Board of Directors may face legal exposure in the event that it deviates from the non-binding position expressed in a shareholders’ resolution, if the position of the shareholders is viewed as constituting an objective standard for making a reasonable decision. It is possible, however, that in view of the balances reflected in the Amendment, shareholder resolutions in this context will be viewed as “recommendations” that do not bind the directors.
Third, in view of the language of the Amendment, it appears that a deviation from the mandatory principles of the compensation policy is not permitted, even if the deviation is approved by the shareholders.
Finally, it is not clear how institutional investors and the companies that advise them will view the proposed changes to the company compensation policies brought before them for shareholder approval. Generally, voting by shareholders of public companies is based significantly on the voting polices of institutional investors and, as a result, on the advice provided by the consulting companies advising such investors. Consequently, the Amendment may have the effect of increasing the influence of these consulting companies and we think it likely that shareholders of many Reporting Companies will approve or reject compensation policies with a view to guidelines formulated by the consulting companies.
Conclusion
The Amendment is expected to have a considerable effect on the process of approving salaries and bonuses in Reporting Companies, even during the transition period prior to its implementation. Many Reporting Companies have already commenced implementation of the Amendment’s requirements, particularly by appointing a Compensation Committee, adopting a compensation policy, and determining bonus milestones for the 2013 year during the transition period.
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