The FSA's consultation paper CP09/10, entitled "Reforming remuneration practices in financial services", made its appearance in the wake of the publication of the Turner Review and associated discussion paper this month. Both the proposals on which the FSA is consulting, and the consultation timeline, have moved on from proposals made when a draft Code of Practice was published in February.
The FSA now proposes to incorporate the Code within the FSA Handbook, with a rule (supported by evidential provisions and guidance) imposing a general requirement to establish, implement and maintain remuneration policies, procedures and practices that are consistent with, and promote, effective risk management. This means that firms which breach the rule may be subject to disciplinary action.
The FSA intends that the requirements in the Code will initially apply to the larger banks, building societies and broker dealer firms. The FSA estimates that this narrower grouping would cover some 48 firms - 24 UK banks, 10 other banks in the UK which are part of larger banking groups, 3 building societies and 11 broker dealers¹.
- Potential extension of scope to all regulated firms
- Rewriting contracts and timing issues
- Incentive arrangements
- EEA and cross-border issues
Potential extension of scope to all regulated firms
The FSA is also considering whether the Code should be extended to all authorised firms and if so, whether it should apply on the same basis as for the larger banks, building societies and broker dealers. The FSA's preliminary view is that the rule is "self-evidently a high level requirement which should be followed by all firms", and that both the rule and the ten principles should apply to the wider regulated community.
The FSA suggests that compliance with the Code by this wider group would however be assessed in a proportionate and risk-based way, with greater flexibility in some areas (e.g. smaller firms would probably not need to establish remuneration committees). The proposed guidance explains that what will be necessary to achieve compliance with the Code will vary according to the nature, scale and complexity of the firm and its business activities.
Firms that are not within the group of larger banks, building societies and broker dealers directly affected by the first stage of the consultation should therefore carefully consider whether they wish to comment on the rule and the principles set out in the Code (by 18 May). The principles are to be incorporated as evidential provisions - this means that compliance with the principles will tend to establish compliance with the rule.
The FSA is clearly open to the notion that there should be a degree of flexibility for firms whose size and business are significantly different from that of the larger banks, building societies and broker dealers. Firms will need to consider whether the guidance (other than having remuneration committees) might pose issues for them and highlight these in their (or their trade association's) responses to the discussion (by 18 June).
Rewriting contracts and timing issues
The FSA's proposals envisage that by 6 November 2010, in respect of firms to which the Code applies, all employment contracts or other arrangements with employees that provide remuneration benefits should be Code compliant. This means that employers will have to amend (renegotiate or terminate) remuneration terms in employment contracts and incentive arrangements which are not compliant with the Code.
The FSA's timetable will give firms 5 months from July 2009 (publication of the policy statement) to amend remuneration terms which are noncompliant but are in contracts that enable the firm to amend the terms to make them Code compliant. For those contracts which do not provide flexibility for the employer to amend the remuneration terms, firms will have longer (until November 2010) to ensure that these terms are either amended, renegotiated or terminated.
What is clear is that in both cases employers will have to exercise extreme caution in seeking unilaterally to amend or terminate employees' contracts or other arrangements, or face potential employment claims including breach of contract and unfair dismissal. Part of the process will be to give due consideration to engaging with impacted employees and taking care to ensure that appropriate consultation is undertaken, even where arrangements are expressed to be merely "discretionary".
The FSA understands (from the 22 firms - banks, investment banks and building societies - subject to the initial remuneration review carried out late last year) that the number of guaranteed bonus contracts with a duration of more than one year is low. In so far as this is not true in other parts of the financial services sector, firms or their trade associations may wish to raise this with the FSA, since the timing of the transitional provisions is predicated on this assumption.
That said, it is not clear whether the transitional provisions (and the timetable for bringing contracts into compliance with the Code) will apply to the wider authorised community if the FSA does decide in July that the Code should apply across the board. The way in which the FSA has approached the timing of the transitional provisions suggests they could equally apply to the totality of regulated firms. On the other hand, the larger banks, building societies and broker dealers are expressly on notice that the transitional arrangements will not apply to any contracts they enter into now, or have entered into since 18 March 2009.
Between now and late July, firms in the wider authorised community should give this careful consideration before entering into any employment contract or other binding arrangement which would confer a guaranteed bonus with a duration in excess of one year.
Although the content of the Code is yet to be finalised, firms should now be considering how their current incentive arrangements would need to be revised in order to ensure that they are in compliance with the principles underpinning the Code.
Any revised arrangement should take account of the principles that the majority of any significant bonus should be deferred (Principle 9) and that such deferred bonus should be linked to future performance (Principle 10). If a bonus is earned and/or paid but future performance is unsatisfactory, or if the bonus was based on incorrect financial or other data, then the employer may need to claw back the bonus. Firms should ensure that any claw-back or forfeiture provisions are properly drafted and legally enforceable. Consideration will need to be given to the circumstances in which payments might be clawed back or forfeited, to what time limit will apply for payments to be at risk, and to what mechanics can be implemented to ensure that the claw-back is effective and how it will be communicated to employees.
Currently, many bonus arrangements are operated on an informal or "discretionary" basis. As market practice develops to take account of the Code, carefully drafted formal bonus scheme rules will be needed to replace these existing informal arrangements.
EEA and cross-border issues
UK branches of EEA firms will not fall within the scope of the proposed new framework. This is because responsibility for systems and controls is the province of home competent authorities. The Code is to form part of the FSA's Senior Management Arrangements, Systems and Controls sourcebook (SYSC) as a new Chapter 19.
The Code will, however, apply to the overseas branches of UK firms in both EEA and non-EEA jurisdictions.
The FSA has been involved in policy work on remuneration issues which is being taken forward within the Financial Stability Forum (FSF) and within the Committee of European Banking Supervisors (CEBS), both of which have produced sets of principles - the FSF is to publish its document shortly; CEBS published draft high-level principles on remuneration for consultation earlier this month. Although the FSA says these initiatives are broadly consistent with its own, the FSA notes that its Code goes further than either in:
- explicitly requiring remuneration committees to be ready to prepare an annual remuneration policy statement for the FSA on request;
- requiring the major part of significant bonuses to be deferred, and the deferred element to be linked to the future performance of the firm; and
- calling for risk adjustment to be applied to performance metrics for long term incentive share plans as well as yearly bonuses.
The FSA considers that by making these concrete proposals ahead of other jurisdictions, the UK is signalling how the general principles might be put into practice. However, the FSA acknowledges that there is a risk that there may well not be complete international alignment in this regard, and that the European Commission has announced that it is proposing to launch a new recommendation on remuneration in the financial services sector next month.
There is, therefore, a real risk that these proposals could have adverse implications for the UK's competitiveness. Indeed, in Annex 5, paragraph 11 of the consultation paper, the FSA acknowledges that the impact could be significant. In finalising its policy in July, the FSA has promised to consider whether the implementation plans of authorities in the major financial centres have been satisfactorily aligned. It seems, however, that firms are not to be given an opportunity to make representations about the degree of alignment that may have been achieved