Incentive plans: a project report on challenges in rolling out new plans

By Lars Rottschäfer and Dr. Martin Trayer, LL.M. (Edinburgh)

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Modifying an existing incentive plan is like walking on a tightrope – it requires keeping the right balance between preserving the flexibility required to adapt the plan to new challenges and addressing employee expectations. In recent years, German labor courts have taken a much stricter stance toward any caveats regarding performance-related pay. As a result, maintaining the right balance has also become a legal issue, and aligning company strategy, employee communication and legal requirements has become a key to safely reaching the other side. Recently, SGL Carbon Group successfully introduced new incentive programs. Below is a description of the project and the decisions that had to be made regarding the legal setup.

The project

SGL Group is one of the world’s leading manufacturers of carbon-based products, from carbon and graphite to carbon fiber and composites and is headquartered in Wiesbaden, Germany. The corporation has more than 40 production sites around the globe and a service network that covers over 100 countries. In order to secure the SGL Group’s long-term position in the market, the company decided in 2014 to implement an overall strategic realignment. One important element of this was redesigning the incentives and compensation program for global senior management, which comprised 190 managers in nine countries.

SGL decided to maintain the compensation components with base salary, short- and long-term incentive plans and supplementary benefits within the corporate retirement plan in Germany but to redesign the individual elements. The new compensation structure, which had also taken into account the results of a review of all senior management functions and the respective position evaluations, would be systematically linked to the company’s long-term strategy as well as be aligned with market-based compensation structures and mechanisms. In addition, the whole remuneration package would be less complex than before and as such easier to plan for both for the senior managers and SGL.

As part of restructuring of the organization, all senior management positions were reevaluated; and, starting in 2015, the internal grading system was simplified and eliminated the benefits levels. Base salaries were aligned with national and international standard market levels on the basis of recognized market studies and supported by internal salary bands. The bonus plan itself was replaced by a new short-term incentive plan, raising bonus potential to match market levels. The short-term financial control parameters were aligned with the company‘s business position with varying control parameters from year to year, depending on the short-term goals of the SGL Group or separate business units. The weighting of individual objective categories was standardized for all senior management levels. In the future, it would also be possible to considerably exceed financial objectives.

Since members of senior management make a significant contribution to the sustainable company success of SGL Group, a new long-term incentive plan was also introduced. With the SGL Performance Share Plan (PSP), senior managers would be motivated and encouraged to take a long-term perspective in their thinking, one that would be in line with stable company success. All previous equity-based long-term compensation elements would therefore now be focused on the SGL Performance Share Plan.

The introduction of new compensation plans was carried out on the basis of a comprehensive compensation concept called “Ready for tomorrow!” A communication strategy was designed to launch the new compensation package, including a broad range of initiatives to involve internal boards and committees. The concept comprised written communication from the CEO to managers as well as a series of global webinars held by human resources that explained the need for change. An important legal requirement was the short- and long-term incentive plans’ compliance with local regulations in every location worldwide. Compliance was ensured through local tax and legal country reports in the relevant jurisdictions.

Group versus local entity plan

A crucial decision right at the start of the project was which legal entity should issue the plans. In general, group plans increase identification with the parent company and ensure equal treatment of management worldwide. Senior managers are generally not, however, employees of the parent company, so the benefits would be issued by “a third party.” This is permissible under German law, but may cause legal or tax issues in other jurisdictions:

In Germany, the employer has full flexibility to decide whether bonuses or other benefits will be granted by the company or by the company’s parent company. The German Federal Labor Court (Bundesar-beitsgericht, BAG) held in 2003 that obligations arising from a share option plan issued by the parent company do not necessarily form part of the employment contract (BAG, decision dated February 12, 2003, File No. 10, AZR 299/02). If the plan is operated exclusively by the parent company or any other group company that is not the employer, a separate contract will be issued. Any claims arising from these plans have to be specifically directed to the parent company rather than the employing entity. For German managers, this means they may have to enforce their rights at the seat of the parent company, which – in case of a foreign group – may be outside Germany.

The concept of benefits provided to an employee by a third party is not, however, recognized in every jurisdiction. Some jurisdictions require that the employment contract (and the related documents) come from an employer based in the respective country. A plan operated by the parent company that is not the employer would obviously not meet these criteria. SGL therefore decided that the plan would become part of the existing employment relationship with the relevant legal entity, however the plan objectives would be determined by group strategy and the decisions of group management.

Discretionary versus legally binding plan

Often one of the most challenging questions for the plan issuer is how to ensure flexibility for future amendments to the plan while at the same time accommodating the need to effectively incentivize employees.

A fully discretionary plan provides maximum flexibility for the employer. The typical wording of a discretionary plan is that the employer is free to decide whether and in what amount a bonus will be paid. As a result, the decision on the amount of the bonus is left to the employer. Under German law, however, the employer is not entirely free in making this decision. The German Civil Code (Bürgerliches Gesetzbuch, BGB) stipulates that the decision must be fair and reasonable. Employees can challenge the employer’s decision in court. If the court finds the employer’s decision was not fair and reasonable, it can determine the amount on behalf of the employer (§ 315 [3] 2, BGB). In one reflection of this, BAG recently increased the employee’s bonus as the employer could not justify why the discretionary bonus could be reduced to zero when other employees still received a bonus (BAG, decision dated August 3, 2016, File No. 10, AZR 710/14).

From an employee’s or candidate’s perspective, a fully discretionary plan does not offer any predictability regarding the bonus amount. If an employer nonetheless decides to mention specific amounts in plan documents, the employment contract or a job offer may turn into a legal obligation. BAG held in 2013 that an employee who had been informed about a bonus amount that would be payable should he reach certain objectives could not be fully deprived of the results of his work – despite the discretionary language in the contract (BAG, decision dated February 20, 2013, File No. 10, AZR 177/12). As a result, discretionary plans may be a downside in the recruitment process since no figures can be guaranteed to the candidate.

A common way to solve this dilemma and preserve some flexibility is through binding but short-term plans or by building in significant discretionary factors. SGL decided, however, for a fully binding plan to increase commitment and predictability for its management. This meant that any change to the plan in the future would require the managers’ consent. Binding plans have had a history at SGL, so the managers had to give their consent when SGL introduced the new incentive plans. Through effective and comprehensive communication, SGL ensured a 100% acceptance rate for the new plans.

Good leaver versus bad leaver

A further challenge from a legal perspective is how to treat employees who leave before the end of the plan’s term. An employee leaving the company will no longer contribute to its success in the future. The employer may therefore wish to have the final say on whether or not to pay out an incentive. A common approach is to draw a distinction between “good” and “bad” leavers, the latter ones leaving on their own accord or having caused their dismissal by breach of contract or other misbehavior.

This point of view does not, however, take into account the employee’s efforts and achievements during the time the plan was in effect. BAG has taken the view that a plan regulation depriving employees of the results of their work when they leave before a defined date is invalid (BAG, decision dated November 13, 2013, File No. 10, AZR 848/12). The decision relates to a plan that was (at least partly) performance based and did not impact plans (solely) aiming at retention. According to the court, further exceptions may apply where the employee’s performance cannot be reasonably measured on a pro rata basis or has a particular value in a given time period such as, for instance, in a seasonal business. In an earlier decision back in 2008, the BAG had given wider discretion to employers issuing stock (whether real or phantom) or stock options (BAG, decision dated May 28, 2008, File No. 10, AZR 351/07). The court argued that the value of stock at a given time in the future is hardly predictable and thus the employee’s expectations do not need to be protected in the same way as with a bonus paid in cash. These considerations seem to hold true irrespective of the newer decision in 2013.

Works council participation

Introducing a new incentive plan may trigger participation rights of local employee representation such as those in a works council or union. These have to be considered when setting up the road map for such a plan and planning the timing for its communication and rollout. German works councils have a say in any changes to a current compensation and benefits plan pursuant to § 87 (1) No. 10 of the German Works Constitution Act (Betriebsverfassungsgesetz, BetrVG). Managing directors (Geschäftsführer) and senior executives (leitende Angestellte) are not, however, represented by a works council. For other management staff, SGL decided to have a formal agreement with the works council referring to the respective plan document of the short-term incentive plan (Betriebsvereinbarung).

Language requirements

Local language requirements can cause significant delay and additional translation costs. There are no such statutory requirements under German law that stipulate the plan’s language must be German. BAG held in 2014 that an employer may rely on the employee’s acceptance of an employment contract in German – even if the employee does not speak German. It is the employee’s responsibility to ensure he or she knows what he or she is signing (BAG, decision dated March 19, 2014, file No. 5, AZR 252/12). Other jurisdictions, however, require that documents governing employment need to be in the local language (such as under Polish or French law). Before rolling out the plan to other jurisdictions, such requirements need to be checked with local legal support.

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