The European Banking Authority (EBA) published its final guidelines on sound remuneration policies under Articles 74(3) and 75(2) of the CRD IV Directive (2013/36/EU) (‘the Directive’) on 21 December 2015. A key aim behind the Directive was to address concerns about bankers’ remuneration, which was believed to be a major cause of the collapse of the financial markets in 2008. The EBA is mandated under the Directive to develop guidelines on sound remuneration policies with respect to the remuneration provisions in Articles 92-95 of the Directive. These guidelines aim to ensure a level playing field among institutions within Member States.
The final guidelines will now be translated into official EU languages and published on the EBA website. The deadline for competent authorities (in the UK this will be the FCA and the PRA) to report whether and to what extent they will comply with the guidelines will be two months after publication of the translations. The guidelines will now take effect from 1 January 2017 rather than 2016 as originally stated to take into account the revisions. The FCA and the PRA have stated that application will be for the 2017 performance year so firms should now be considering whether their practices and procedures are aligned with the guidelines in readiness for January 2017. In particular, if the regulators comply with the guidelines, the bonus cap (see below) will apply without proportionality for the 2017 performance year.
The European Commission (EC) together with the EBA will submit a report on the review of the remuneration provisions on the application of proportionality (detailed below) by the end of June 2016 to the European Parliament. To this end the EBA submitted to the EC an opinion on proportionality together with the final guidelines. The regulators must comply with any consequent changes to the Directive.
The Directive provides that a remuneration policy must be consistent with and promote sound and effective risk management and must not encourage risk-taking that exceeds the level of tolerated risk of the institution. To this end, there must be a clear distinction between the criteria for setting fixed and variable pay. Fixed remuneration must be permanent, pre-determined, non-discretionary and non-revocable. Variable pay must be based on performance or, exceptionally, other conditions and firms must be able to justify the use of any variable remuneration element.
If the institution maintains a website, this must explain how it complies with the Directive’s requirements on remuneration.
Article 94 deals with the variable aspects of remuneration:
- Fixed pay and variable pay should be set at a ratio 1:1. The variable component can increase to 1:2 only with shareholder approval (known as the ‘bonus cap’. A majority of at least 66% of shareholder votes in favour must be in favour provided there is a quorum of at least 50% of shareholders. If that quorum is not reached, 75% of shareholders must vote in favour.
- Guaranteed variable remuneration should not form a part of prospective remuneration plans. It should be:
- occur only when hiring new staff
- occur where the institution has a sound and strong capital base and
- be limited to the first year of employment.
In the final guidelines, where shareholders are requested to approve a higher maximum ratio of variable to fixed pay up to 200% the shareholders who can vote are those of the institution where the material risk taker (MRT) operates. For subsidiaries, the subsidiary’s general assembly may decide. Staff who are affected by the proposal cannot vote.
The Proportionality Principle
Article 92(2) provides that when establishing and applying total remuneration policies for categories of staff including
- senior management
- risk takers
- staff engaged in control functions and
- any employee receiving total remuneration that takes them into the same remuneration bracket as senior management and risk takers, whose professional activities have a material impact on the firm’s risk profile (‘identified staff’ or MRTs)3, firms should comply with the remuneration principles that it sets out in a manner and to the extent that is appropriate to their size, internal organisation and the nature, scope and complexity of their activities. This proportionality principle has led, however, to confusion as to the extent of its application.
By letter dated 23 February 2015 the EC clarified that the remuneration provisions in the Directive apply to all institutions, without distinction. In particular, there was no room for exceptions or exemptions from the provisions with regard to the deferral of variable remuneration, pay-out in instruments and the application of malus. The EBA then consulted on the guidelines.
EBA Opinion on Proportionality
On 21 December 2015, alongside publication of its final guidelines, the EBA published an opinion addressed to the EC, European Parliament and Council on the application of the proportionality principle to the Directive’s remuneration provisions. On the basis of the consultation responses, the EBA recommended a more harmonised approach and legal clarification to ensure consistent application of the remuneration requirements across the EU.
It recommends therefore that the Directive be amended to:
- exclude certain small, non-complex firms from the requirements to apply the remuneration principles regarding deferral and payment in instruments for variable remuneration
- limit the scope of the remuneration principles as regards staff who receive low amounts of variable remuneration, including in large institutions
- allow listed institutions to be able to use share-linked instruments for variable remuneration as they have the same effect as shares when they reflect exactly the value of shares. Firms will not be able to pay dividends or interest on shares during deferral periods.
The EBA has stated that it will provide the EC with guidance by June 2016 on how the Directive should be amended so for the time being, the position remains uncertain.
Deferral/ malus and clawback
Article 94 provides that at least 40% of variable remuneration must be deferred over a period which is not less than three to five years and is currently aligned with the business cycle, the nature of the business, its risks and the activities of the employee. At least 50% should be paid in specified non-cash instruments. The deferral of variable remuneration allows institutions to apply explicit ex post adjustments, in particular by the application of malus. The payout in instruments leads to implicit ex post adjustments due to changes in the value of instruments awarded.
The key points on deferred remuneration are:
- Remuneration payable under deferral arrangements must vest no longer than on a pro rata basis
- Where variable remuneration is particularly high, at least 60% should be deferred over a period determined in accordance with the business cycle, nature of the business, its risks and activities of the employee
- Variable remuneration, including the deferred portion, should be paid or vest only if it is sustainable according to the financial institution as a whole and justified on the basis of
- the performance of the institution,
- the business unit and
- the individual concerned.
- Remuneration packages that relate to compensation or buy-out from contracts in previous employment must align with the long-term interests of the institution including retention, deferral, performance and clawback arrangements4.
- The final guidelines provide that when setting the deferral period and proportion to be deferred, institutions should consider:
- The responsibilities and authorities by MRTs and their tasks
- The business cycle and nature of the institution’s activities
- Expected fluctuations in the economic activity and performance and risks of the institution and business unit and the impact of MRTs on these fluctuations
- The approved ratio between the variable and fixed components of the total remuneration and the absolute amount of variable remuneration.
The final guidelines provide that for senior management there should be a deferral period of at least five years and firms should defer a significant higher portion of the variable remuneration paid in instruments. Associated additional retention periods have been removed from the final guidelines although the UK requires a 7 year deferral for senior managers5.
The final guidelines also provide that the first deferred portion should not vest sooner than 12 months after the start of the deferral period. Vesting should not take place more frequently than annually.
In the final guidelines, the EBA have clarified that retention bonuses should be treated as variable remuneration and must comply with the requirements for variable remuneration but where properly paid they are exempt from ex ante risk adjustments and so can be awarded after the retention period ends or conditions are met.
Long Term Incentive Plans (LTIPS)
The final guidelines provide that when an award of variable remuneration, including LTIPs, is based on past performance of at least one year but also depends on future performance conditions, certain criteria should apply, including:
- The additional performance conditions should be clearly set out
- Firms should assess whether the conditions have been met before vesting
- The additional conditions should be set for a predefined performance period of at least one year
- When the conditions have not been met, up to 100% of the award should be subject to malus
- The deferral period can be measured from date of grant but should end at the earliest one year after the last performance condition has been assessed
Provided that an LTIP award is based on past performance of at least one year, the award should be taken into account in calculating the bonus cap for the financial year in which it was awarded.
The final guidelines state that where a prospective remuneration plan for variable remuneration, including LTIPs, is exclusively based on future performance conditions the amount should be considered as awarded after the performance conditions have been met. In these circumstances, an LTIP award counts towards the bonus cap for the financial year in which it vests.
Application of malus and clawback
Unless otherwise provided, up to 100% of variable pay should be subject to malus or clawback arrangements particularly where the employee:
- participated in or was responsible for conduct resulting in significant losses
- failed to meet appropriate standards of fitness and propriety.
The final guidelines state that in addition to these criteria, institutions should also use specific criteria including:
- evidence of misconduct or serious error by the staff member (e.g. breach of code of conduct)
- whether the institution and/or business unit subsequently suffers a significant downturn in its financial performance
- whether the institution and/or business unit in which the identified staff member works suffers a significant failure of risk management
- significant increases in the institution’s or business unit’s economic or regulatory capital base
- any regulatory sanctions where the conduct of the identified staff member contributed to the sanction.
The final guidelines state that under no circumstances should an explicit ex post risk adjustment lead to an increase.
Role Based Allowances
On 15 October 2014 the EBA published an opinion on the use of ‘role-based allowances’ (RBAs) which some firms had been treating as part of fixed remuneration. RBAs are not explicitly related to performance although they do not form part of basic salary, are not pensionable, are initially granted for a limited period of time and can be adjusted on a fully discretionary basis.
The EBA’s opinion was that to comply with the Directive, the conditions for granting RBAs and their amount should be predetermined, transparent to staff, permanent (they should be tied to the specific role and organisational responsibilities and be non-revocable). If RBAs do not comply with these criteria, they should be classified as variable remuneration. The final guidelines incorporate the content of the opinion and clarify the criteria for determining when remuneration is fixed. Additionally the final guidelines state that allowances are only permissible when paid to any other staff fulfilling the same role and in a comparable situation. The final guidelines also suggest that fixed pay can be paid in instruments but in such a case payment must be contractually determined in advance by the value of the awarded instruments and the rationale for such a payment should be justified.