On 13 January the Prudential Regulation Authority (‘PRA’) launched a new consultation introducing new rules on buy-outs of variable remuneration. This is the practice where firms recruiting staff, buy-out awards that have been cancelled by their previous employer.

The PRA aims to strengthen the Remuneration Part of the PRA Rulebook in order to discourage short termism and to promote effective risk management. The PRA already has in place certain rules enabling firms to reassess an employee or ex-employee’s entitlement to awards. Currently, deferral of variable remuneration is required to allow firms to reassess the nature, scale and outcomes of the risks taken and thereby adequately assess the performance of the individual. This is referred to as the principle of ex-post risk adjustment or malus and the rule operates to protect unvested or unpaid awards. The principle now also extends to allow for the clawback of awards that have already been paid or vested to employees (or former employees) for up to seven years from the award. In respect of senior managers, even more stringent requirements were put in place in 2015.

However, with this consultation the PRA is seeking views on how to deal with buy-outs by new employers of cancelled remuneration, which is seen as a loophole in that it prevents the old employer being able to operate the principles of malus or clawback.

Previously, there was a review to evaluate the most effective method of dealing with this loophole. The overall recommendation from this review was that applying malus to bought out awards was the best option. Other options were seen to have too many disadvantages. For example, banning buy-outs could be seen to be anti-competitive and put UK firms at an international disadvantage. Another option of requiring firms to retain unvested awards when employees leave a firm, was seen to reduce the retention effects of deferral, with individuals having less incentive to remain at firms.The FCA has decided not to consult alongside the PRA at this stage, although it has stated that it is following the consultation.

The proposed rules would apply to the same firms as those subject to the existing rules on deferral, malus and clawback. As such it will apply to all Material Risk Takers at PRA-regulated banks, building societies and designated investment firms. However, it would not apply to level three firms on proportionality grounds.

The mechanism by which this principle would work would be through a contract between the new employer and the employee providing for malus and clawback to be applied on the basis of a determination by the old employer. The old employer would then need to notify the new employer of the amount of appropriate malus or clawback. The grounds would need to be failure in risk management and could not consist merely of a material downturn in financial performance of the old employer (in order to prevent misuse of the rule by the employer). The old employer would be under a duty to act fairly and reasonably. This obligation is proposed to be enforced by the PRA providing for there to be a private right of action for damages through section 138D of the Financial Services and Markets Act 2000. The old employer would also be under an obligation to provide reasons to the former employee and allow the former employee to make representations as to why any proposed malus or clawback should not apply. There is also proposed an annual reporting obligation upon the old employer to report cases of malus or clawback against bought-out awards.

In terms of the new employer’s responsibilities, the new employer would be expected to act on receipt of notification from the old employer. The new employer would act as the claimant in a contractual claim against the employee, on the basis of the old employer’s notification, for those sums already vested. There would also be a proviso allowing for new employers to apply for a waiver where they believe that the old employer has been unfair or unreasonable.

There are certain issues that present themselves as a result of these proposals. Firstly, the old employer may be concerned that in disclosing the reasons for clawback, they may effectively be forced to share sensitive commercial information with the new employer. It is also questionable whether avoidance could be a problem, in that potential workarounds could be utilised by new employers, i.e. instead of buying-out awards, offering compensation in respect of these awards. Additionally, it is arguable that an old employer has little incentive to stir up trouble purely to deny an old employee an award. The counter argument to this, however, is that one incentive for the old employer might be to attempt to pass on some of the blame and distance itself from the old employee’s conduct. The practical effect of the provisions which are put into place will be very interesting to see.

The consultation will close on 13 April 2016 and views are sought as to how the legislation should be implemented.