German directors’ liability just got Vorst

A new law in Germany that came into force in July 2010 seeks to punish directors who are the subject of a valid directors’ and officers’ (D&O) insured claim by requiring they make a substantial personal contribution to the loss.

Germany’s Gesetz zur Angemessenheit der Vorstandsvergütung (Law on the Appropriateness of Managerial Remuneration) (VorstAG), was passed in August 2009 but only became effective from 1 July. One of its provisions is a compulsory deductible for board members of public limited companies that have a valid D&O claim of 10% of the value of the claim up to one and a half times a director’s fixed annual salary. With some directors, notably in the banking sector, clocking up an annual salary of €9m, the sums involved could be significant.

Germany’s move reflects government and public anger regarding the country’s banks’ conduct prior to and during the financial crisis. Germany has three types of banks, those in the private sector like Commerzbank and Deutsche Bank, co-operative (mutual) banks, and Landesbankes, which are independent but backed by regional governments and whose board members are often politically appointed.

Many of Germany’s banks (over 50%) are state-owned or mutuals. Some serve purely local communities, literally representing the place where ‘granny’ puts her nest-egg for safe keeping. And, in common with other banks, some bought paper relating to sub-prime mortgages and got their fingers burnt as a result.

Just like other western governments, the Federal German Government bailed them out. However, unlike those other governments, Germany decided to take things a step further and actually to punish the perceived guilty in the future with a new law that it clearly hopes will be a major disincentive for any reckless behaviour.

How effective will the new law be in practice? Well, the problem with any potentially draconian measures against directors – as seen in the past – is to make anyone approached to sit on a board very chary of doing so unless they know that they are not putting their personal assets at risk. This, along with an increase in lawsuits against companies, in fact, has been one of the reasons why D&O insurance, from its early beginnings as an almost exclusively US cover, has now become a ‘must have’ in Europe.

Beatrice Salter, XL Insurance’s chief underwriting officer for professional lines in continental Europe, told StrategicRISK that German directors now feel that they are under attack. “As a consequence of the new law, insurers have been investigating and coming up with policy forms or instruments which will step in in the event that a director or officer is subject to this new law,” she said. Interest in covering this new risk is coming not just from German national companies but from US and European multinationals with subsidiaries in Germany, she added.

Vorst AG contains additional provisions, some of which relate to directors’ remuneration and the need to ensure that this is in line with performance. Perhaps more than anything else, this legislation underlines the divide that exists between public expectation and unpalatable reality. It’s an issue, regardless of legislation, that the corporate world needs to tackle.

The reality is that banks are still rewarding employees with huge bonuses, despite the fact that some of those banks owe their continued existence to public funding. Companies’ CEOs who have demonstrably failed to achieve targets are still given ‘golden handshakes’ before they depart, perhaps to work the same reverse magic for other businesses.

It’s a nonsense that owes its survival to the boom years prior to recession. When investment returns and profits were generally good, everyone was prepared to turn ‘a blind eye’ to potential anomalies. Now the unfairness that is inherent in these types of circumstances is likely to come under much more scrutiny.

Legislation like Vorst AG is a genuine move to try to correct the status quo. But, in order to be most effective as far as publicly listed companies are concerned, the most likely effective initiative will come from their institutional shareholders. These have the power to ensure that companies are really well run – and they need to use it. When returns are good, it’s very tempting for such shareholders to just sit back instead of enquiring into corporate governance issues.

There’s a great deal of talk now about social unrest – and some firm evidence in the shape of the strikes that have occurred in a number of European countries recently. The backlash is going to become greater if corporate Europe doesn’t work at ironing out unfairness in the reward system.

For German company directors, the situation has just got so much Vorst! In the rest of Europe, without addressing the anomalies associated with corporate remuneration and directors’ personal accountability, life could become a lot harder for companies – and their risk managers.