Rights and Duties of the Supervisory Board in 2011

11.05.2011

[] Whereas the rights and duties of supervisory boards previously only attracted occasional interest, since the high profile corporate collapses and crises of the 1990s lawmakers have begun to take more interest in their role. The enactment of the Act on Control and Transparency in Business (Gesetz zur Kontrolle und Transparenz im Unternehmensbereich - KonTraG) in 1998 heralded the beginning of a tightening of duties and the extension of the area of responsibility of the supervisory board and its members. The idea was that the board should no longer consist of honorary members, but instead be made up of discerning advisers, who would be entrusted with responsible managerial tasks and advise management. This trend has been continued through the legislative amendments of the last two years, namely through the Act to Modernize the Law Governing Private Limited Companies and to Combat Abuses (Gesetz zur Modernisierung des GmbH-Rechts und zur Bekämpfung von Missbräuchen - MoMiG) of 23 October 2008, the Accounting Law Modernization Act (Bilanzrechtsmodernisierungsgesetz - BilMoG) of 25 May 2009 and, most recently, through the Act on the Appropriateness of Management Board Remuneration (Gesetz zur Angemessenheit der Vorstandsvergütung - VorstAG) of 31 July 2009. We now propose to briefly present those changes which are especially significant for supervisory board members in practice in 2011.

1. Amendments Introduced by the Act to Modernize the Law Governing Private Limited Companies and to Combat Abuses

The Act to Modernize the Law Governing Private Limited Companies and to Combat Abuses, which is mostly associated with amendments to the law governing private limited companies, also led to amendments of stock corporation law and in particular to an important extension of the supervisory board's catalogue of duties. As is the case with the shareholders in general meeting of a private limited company, where a stock corporation has lost its management, every member of its supervisory board is entitled pursuant to section 15(1) sentence 2 of the Insolvency Code (Insolvenzordnung - InsO) and, in the case of section 15a(3) of the Insolvency Code, obliged to petition for insolvency on behalf of the company if grounds for the initiation of insolvency proceedings exist.

The newly introduced section 15a of the Insolvency Code stipulates petitioning duties for all legal entities irrespective of their legal form; these were previously contained in individual legislation. The purpose of this amendment was to create a uniform duty to petition for insolvency for all legal entities, irrespective of their legal form, which also extends to foreign companies (Records of the Bundesrat (BR-Drs.) 354/07 (B), pp. 26-27). In the past, supervisory board members were limited to encouraging a petition from the executive decision-making body (management or managing directors), for example, by convening a general meeting pursuant to section 111(3) sentence 1 of the Stock Corporation Act (Aktiengesetz - AktG).

Of course an individual supervisory board member only has a duty to petition for insolvency if he knows the stock corporation has lost its management and if there are grounds for instituting insolvency proceedings (company's inability to pay debts as they fall due or overindebtedness, cf. sections 16-19 of the Insolvency Code). Loss of management is defined in section 10(2) sentence 2 of the

Insolvency Code as the lack of a representative organ; in this context, it is not enough if the representative simply cannot be reached (AG Hamburg NJW 2009, 304; Römermann NZI 2008, 641; Uhlenbrock/Hirte, § 15 marginal note 2A; for a view criticizing this and pointing out the dangers of abuse see Wälzholz, DStR 2007, 1914, 1916).

Furthermore, a supervisory board member will not have breached his duty to petition for insolvency if he can exonerate himself by proving that he did not have positive knowledge of either the grounds for petitioning for insolvency or the loss of management. According to the reasons provided by the government, simply the fact that he "should have known" is not enough to trigger such a duty (cf. Records of the Bundestag (BT-Drucks) 16/6140, pp. 55-56.). Conversely, a person who deliberately ignores knowledge of such circumstances remains obliged to lodge a petition (Records of the Bundestag op cit., p. 56). Moreover, a supervisory board member who knows that the company has lost its management will have a duty to check whether there are possibly grounds for petitioning for insolvency, and vice versa if he knows of grounds for petitioning for insolvency, he will have a duty to check whether the company has lost its management (Records of the Bundestag op cit, p. 55; Nerlich/Römermann/Mönning, § 15a marginal note 18.). Nevertheless, the knowledge of one supervisory board member of the actual requirements for initiation of insolvency proceedings will not be attributed to the other supervisory board members.

Where a statutory duty to petition for insolvency exists under the circumstances described, a supervisory board member who waits too long risks incurring a liability to the company's shareholders. This is because section 15a of the Insolvency Code is a protective act within the meaning of section 823(2) of the German Commercial Code (Bürgerliches Gesetzbuch - BGB). The (stricter) penal consequences of failing to lodge a petition are set out in sections 15a(4) and 15(5) of the Insolvency Code, which provides for the commission of an offence through negligence.

2. Amendments Introduced by the German Accounting Law Reform Act

In the course of a decision handed down at the beginning of the 1980s, the Second Civil Senate of the Federal Court of Justice (Bundesgerichtshof) interpreted section 111(5) of the Stock Corporation Act and the principle contained therein that supervisory board members must execute their functions personally in such a way as to mean that the members must possess a certain minimum amount of knowledge and ability, or at least be able to acquire such knowledge and ability, in order to be able to deal with the company's ordinary business without having to enlist the help of external experts (Federal Court of Justice, judgment of 15 November 1982 – II ZR 27/82, BGHZ 85, 293, 298 = NJW 1983, 991; cf. MüKo AktG/Kopff, § 107 marginal note 94). Section 100(5) of the Stock Corporation Act, which was amended by the Accounting Law Reform Act, adopts this principle.

According to that section, a listed company within the meaning of section 264 of the German Commercial Code (Handelsgesetzbuch - HGB) must fill its supervisory board with at least one member who is independent and who has expertise in the fields of accounting or auditing. How the supervisory board member acquired his expertise in one of the two areas is unimportant (cf. Munich Higher Regional Court, Preliminary Opinion of 28 April 2010 – 23 U 5517/09, NZG 2010, 784). In this context, a company now has the option pursuant to section 107(3) sentence 2 and 107(4) of the Stock Corporation Act of establishing an audit committee to monitor accounting processes and establishing other mechanisms for checking audits. Such committee must have at least one member who has the special qualifications called for by section 100(5) of the Stock Corporation Act.

Naturally, the provision only applies to supervisory board members who were appointed after the Accounting Law Reform Act entered into force (Hüffer, AktG § 100 marginal note 12. Art. 6(4) EGAktG). Nevertheless, future candidates should bear in mind that by assuming the post of expert supervisory board member they may also be increasing their own liability. The reason for this is that certain standardized duties of care may be owed when performing their functions, especially in relation to sections 116 and 93 of the Stock Corporation Act; above-average knowledge and experience would at the same time find its corollary in above-average liability (Kropff in FS K. Schmidt (2009), pp. 2022, 2039).

3. Amendments Introduced by the Act on the Appropriateness of Management Board Remuneration

In the wake of the financial crisis, public discussion has begun to focus on managers' salaries. Essentially, the central issue is always the appropriateness of salaries and the structure of performance-based salary components, i.e. bonuses.

The section at the heart of the new provisions is section 87(1) of the Stock Corporation Act. It prescribes the principles governing the payment of compensation to supervisory board members and, at the same time, imposes a legal duty on the supervisory board to ensure that compensation is in an appropriate amount (MünchKomm-AKtG/Spindler, § 87 marginal note 79). The section also contains specific criteria for determining the appropriateness of management board remuneration. To be appropriate, remuneration must be commensurate with the performance of the individual management board member and not exceed, without good reason, what is customary for the industry, size and country of the company concerned. In the case of listed stock corporations, the remuneration structure must be geared towards the sustainable development of the company. Variable remuneration components are to be determined using a multi-year performance base. Supervisory boards are obliged to agree upon possible limits for extraordinary occurrences.

As compared with the previous version of section 87(2) of the Stock Corporation Act, the amended version increases the authority of the supervisory board to reduce salaries if the stock corporation's financial situation deteriorates significantly. If it would be inequitable to continue to grant the compensation due to the deterioration in the company's situation, then the supervisory board is required to reduce the compensation with effect for the future; thus the previous requirement of materiality is no longer necessary (Hüffer, AktG § 87 marginal note 9). Furthermore, the supervisory board may also reduce a manager's pension as well as other related benefits during the first three years following his retirement.

If the supervisory board intentionally or negligently fails to determine the remuneration, the company will have a claim for damages pursuant to sections 116 and 93(2) of the Stock Corporation Act. This has now been clarified in section 116 sentence 3 of the Stock Corporation Act. Although section 116 sentence 3 only refers to section 87(1) of the Stock Corporation Act and thus to the determination of compensation, it would be reasonable to also regard failure to reduce inappropriate compensation pursuant to section 87(2) of the Stock Corporation Act as a breach of duty. If nothing else, the wording of section 87(2) of the Stock Corporation Act supports this view. Thus, the supervisory board has an ongoing duty to review the remuneration structure.

Finally, the significance of the new provision in section 107(3) sentence 3 of the Stock Corporation Act should not be underestimated: The option of having shareholders decide on remuneration, which used to be available, no longer exists. The decision on the appropriateness of management remuneration pursuant to section 87(1) and (2) of the Stock Corporation Act can no longer be delegated to a committee for a final review. It is now mandatory that it be decided by the full supervisory board.

4. Outlook

Supervisory board members now face a growing catalogue of duties. These begin with the necessity for at least one supervisory board member to be personally capable of reviewing the accounts or audit of the annual accounts and extend to the duty to check the appropriateness of the management board's remuneration (whose breach will result in a duty to pay damages) and the duty to petition for insolvency if the company has lost its management. If one reflects on the considerably more flexible soft law of the Corporate Governance Code, which has in the past often anticipated legislative changes, it seems safe to assume that supervisory board members will be subject to additional statutory duties and responsibilities in the future.

In light of this development, the legislature must of course be prepared to consider whether it is still appropriate for the office of supervisory board member to be designed as a typical secondary position or whether it is in fact high time that the terms for the exercise of such office were adjusted to the stricter set of duties that apply. Thus, for example, it would be logical in view of the more stringent requirements that now apply to further restrict the maximum number of supervisory board posts that a person may accept pursuant to section 100(2) of the Stock Corporation Act (as the German Corporate Governance Code in section 5.4.5 sentence 2 already does in certain cases) or to increase the number of meetings the supervisory board must hold (section 110(3) of the Stock Corporation Act).

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