The European Parliament recently approved tough new rules which will limit the way in which remuneration packages for staff within credit institutions and investment firms are structured.
The rules will apply in relation to bonuses paid at any time after the rules are implemented at a national level (implementation must take place by 1 January 2011 – less than six months from now), regardless of when the bonus was awarded or the contractual arrangements were entered into. Accordingly, employers who may be caught by the new rules will have to move quickly to review their existing remuneration packages, consider and propose new structures which are compliant with the new rules and engage in appropriate dialogue with affected employees about the changes.
Direct links to the Rules, Press Release and FAQs are included at the end of this briefing.
The rules contain similar remuneration provisions to those contained in the draft Alternative Investment Fund Managers Directive (AIFMD) (but go further in some respects) which was intended to be the subject of consultation by the FSA this autumn. However, the early inclusion of these provisions pursuant to the amendments to the Capital Requirements Directive (the CRD) and, in particular, the requirement for implementation by 1 January 2011, has caught many by surprise. The provisions in the CRD do not replace those in the draft AIFMD and entities which are not caught fully by the CRD may still need to consider the application of the AIFMD provisions in due course.
The Treasury has stressed that any new legislation “needs to be put in place in a coordinated manner in all major financial centres”. The FSA is currently studying the implications and we understand that a consultation paper will be produced shortly, possibly within the next 10 days. With the financial industry looking to the FSA for guidance on how the rules will be implemented, the clock has already started ticking.
The rules may be welcomed by those UK Banks who have already had to implement some of the proposed changes in accordance with the requirements of the FSA’s Remuneration Code, as the new rules will force their European competitors to follow suit. However, the proposed rules are much wider than the Code and could have a potentially significant impact on other institutions who may find themselves subject to them.
Which entities are within the scope of the new rules?
Those caught by the new regime include the following types of firms:
- Credit institutions – broadly, banks, building societies and electronic money institutions.
- Markets in Financial Instruments Directive (MiFID) investment firms – depending on the activities of the firm in question, and whether or not it falls within a MiFID exclusion (and subject to the concept of proportionality discussed below), this could include investment banks, portfolio/asset managers, hedge fund managers, UCITS investment firms, stockbrokers and broker dealers, corporate finance firms, many futures and options firms and some commodities firms.
- Insurers are not caught.
Flexibility and proportionality
The rules provide an element of flexibility for national authorities in the way in which they must be implemented. Therefore, the FSA could provide that hedge funds and/ or certain smaller firms may be exempt from some of the provisions (in respect of which, see below). In addition, national authorities may place restrictions on the types and designs of the instruments issued as variable remuneration, ban certain instruments as appropriate and/or limit variable remuneration, for example as a percentage of total net revenues, where such variable remuneration would otherwise be inconsistent with the maintenance of a sound capital base.
The rules also recognise that those institutions and firms covered may, themselves, apply the provisions in different ways and to the extent appropriate according to their size, internal organisation and the nature, scope and complexity of their activities (for example, in relation to the requirement to disclose remuneration practices). In particular, the rules indicate that it may not be proportionate for firms falling within Articles 20(2) and 20(3) of the Re-cast Capital Adequacy Directive (CAD) to comply with all of the principles. This means that, subject to how the amendments to the CRD are implemented in the UK, it is likely that only “full scope” BIPRU firms will feel the full force of the remuneration provisions.
Do the CRD remuneration rules apply to hedge funds?
Taken at face value, the new rules do apply to hedge funds. Indeed, the FAQs expressly state that “hedge fund managers who are investment firms as defined by the markets in financial instruments directive are covered, although the text makes it clear that these rules should be applied proportionately to investment firms. The underlying principle is that when investors’ money is put at risk, the investing firm’s incentives should be aligned with theirs”.
Unfortunately, the CRD remuneration rules do not appear fully to recognise the multitude of different ways in which financial institutions are structured and organised. It is one thing to apply the proposed rules to a publicly traded financial institution where individual portfolio mangers are employees of the financial institution, but significant difficulties arise in the case of a hedge fund manager structured as an owner-managed LLP.
For example, it would not seem to be appropriate to require a deferral or clawback where an amount has already been subject to tax (and, in any event, as the LLP partners are the owners of the business, any clawback would simply return the amount clawed back to the same people). Much will depend on how the FSA interprets the concept of “proportionality” and whether certain financial institutions such as hedge fund managers will be excluded from specific rules.
As a result, it is hoped that the FSA will rely on the proportionality principle to exempt hedge fund managers from some or all or the CRD remuneration rules (although these, and indeed any other managers within the scope of the AIFMD, still need to bear in mind that similar rules may apply in due course through the remuneration provisions of that Directive which will continue its passage through the legislative process and will not be superseded by the CRD.
Which employees will be caught?
The remuneration and bonus rules apply to certain categories of staff whose professional activities have a material impact on the risk profile of the firm, including:
- senior management;
- risk takers;
- those in control functions; and
- any employee receiving total remuneration that takes them into the same remuneration bracket as senior management and risk takers
It is unclear from the rules whether or not the above categories have been cited simply as examples of employees who are likely to have a material impact on risk or whether only those within these categories, and which the individual firm considers would have a material impact on risk, would be caught. It would appear on the face of the rules that those in Compliance, Legal and/or Human Resources may not be caught by the rules, but this could depend on the specific nature of the role.
In addition, the rules also contain separate provisions relating to those in control functions (regardless of whether or not the rules relating to bonuses apply) requiring that they are compensated in accordance with the achievement of function-related objectives, independent of the business areas they control.
When will the rules come into force?
Assuming that the FSA does not seek to implement the rules prior to the longstop date (given the extremely short period for implementation) the rules will apply to all bonuses awarded or paid on or after 1 January 2011. It is possible that the FSA could feasibly bring in provisions prior to the end of the year so, even where firms pay bonuses prior to 1 January 2011, they should remain vigilant.
What are the key provisions in respect of bonuses?
A financial institution’s remuneration policy will need to be (a) consistent with and promote sound and effective risk management and not encourage risk-taking that exceeds the level of tolerated risk of a firm and (b) in line with the business strategy, objectives, values and long-term interests of that firm and incorporate measures to avoid conflicts of interest.
The CRD remuneration rules go further than the draft AIFMD remuneration rules by specifically providing that the total variable remuneration paid to staff should not limit the ability of the credit institution to strengthen its capital base.
Deferral of at least 40% of bonus
The rules provide that at least 40% of bonuses must be deferred for a period of at least three to five years (although it is not yet clear whether this is a minimum of three years or a requirement to stagger vesting over the two year period from year three). This deferred element will increase to 60% for “large” bonuses, although no guidance has been given on what constitutes a “large” bonus and therefore it will be up to the FSA to decide on this, basing its decision on EU guidelines to be provided by the Committee of European Banking Supervisors.
50% of total bonus to be paid in contingent capital
50% of the total bonus must be paid in contingent capital which can be called upon in the case of financial difficulties. The contingent capital element is to apply equally to the deferred element of the bonus (referred to above) and the element of the bonus paid upfront. For an explanation of contingent capital, see below.
Cap on up-front cash bonuses
The result of the rules on deferral and contingent capital set out above is that the rules impose a cap on the percentage of the total bonus which can be paid up-front and in cash. For those bonuses subject to a 40% deferral, the up-front cash element will be capped at 30% of the total bonus figure (with the up-front cash element being capped at 20% in the case of “large” bonuses).
What is contingent capital?
The rules themselves do not refer to “contingent capital”, but this term is referred to in the accompanying press release and FAQs and is described as “funds to be called upon first in case of bank difficulties”.
The rules provide for the “contingent capital” element to be an appropriate balance of (a) shares/equivalent ownership interests; and (b) where appropriate, instruments which are converted in an emergency situation, or where the regulatory authority considers that a financial and solvency situation has arisen, into equity instruments ranking behind all other creditors. In each case, these assets are to be subject to a retention policy designed to align incentives with the longer-term interests of the firm.
In the case of a listed financial institution with a share-based ownership structure, structuring part of a bonus as contingent capital seems straightforward to achieve. Shares (or “equivalent ownership interests”) can be issued (albeit with a holding restriction) which could rank alongside or behind creditors generally in the event that the financial institution is in difficulty. This may, however, lead to dilution concerns for existing shareholders.
In the case of other non-listed financial institutions, a “share-linked instrument or equivalent non-cash instrument” is much more difficult to define. Is it merely an IOU?
It is unclear what the intended practical distinction is between “contingent capital” and “deferred payment” given that in both cases cash is not paid out up-front and the instruments must be subject to the appropriate retention policy.
It is likely that the main difference is that the contingent capital paid up front is treated as being fully earned by the employee but is simply held in a form of escrow by the financial institution. In other words, it is not subject to forfeiture or reduction by reference to the individual’s or firm’s future performance but if the instrument requires cash to be utilised in its settlement, then in a case of financial difficulty, it could convert to equity or be written down. If the instrument is already awarded as equity, then in circumstances of financial difficulty the individual is placed in no better position than all other equity holders.
Until the cash from bonuses has been paid out, the financial institution has access to this additional capital which is consistent with the aims of the CRD in bolstering the capital base.
The deferred element of variable remuneration, by contrast, may be reduced depending on future performance, in line with the statement that “the total variable remuneration is generally considerably contracted where subdued or negative financial performance of the firm occurs, taking into account both current compensation and reductions in payouts of amounts previously earned, including through malus or clawback arrangements”. The up-front contingent capital would arguably not be require to be reduced (save in circumstances of financial difficulties), simply being held back so as to ensure greater capital is available to the institution if things go drastically wrong.
For the employee, the main concern will be ensuring that tax is not paid on the up-front contingent capital part of the bonus if it may never be paid, or cannot be realised for a certain period. To the extent that forfeiture provisions are included requiring continued service to try to limit tax exposure, this starts to look increasingly like deferred compensation which shifts the deferred element to something more like 70-80% of the bonus and may therefore have a much more dramatic impact on overall levels of incentivisation and retention.
The illustration below shows one way in which the new rules could potentially be applied to annual bonus arrangements, subject to the FSA’s interpretation and guidance.
Click here to view the illustration.
This element could be categorised as “safe”; it is paid up-front and cannot be called upon by the firm.
Up-front contingent capital
The number of instruments awarded is fixed (and is not subject to malus or clawback arrangements), although the value of the instruments themselves may increase or decrease in accordance with market movements.
Employees own the instruments from the award date, but they are subject to sale/ redemption restrictions. As contingent capital, they would form part of the firm’s ‘Trouble Fund’ for a certain period – ie they would be subject to forfeiture, conversion or write-down if the firm ran into financial difficulty during the restricted period. It is not clear from the CRD how long the period for an “appropriate retention” is intended to be.
Unlike the up-front elements of the bonus, the deferred cash element would be subject to malus or clawback arrangements and so could decrease if either it was found that the original award level had been too high or if subsequent years’ performance justified such a reduction.
The deferred cash element would also form part of the ‘Trouble Fund’ and so would only be paid following the deferral period if doing so was justified in light of the firm’s financial stability.
Deferred contingent capital
Individuals would have a right to be awarded instruments at the end of the deferral period.
The number of instruments would be subject to malus or clawback arrangements and so could decrease in number if either the original award was later found to be too high or if subsequent years’ performance justified such a reduction. In addition, the value of the instruments could increase or decrease depending upon their market value over the deferral period.
These deferred instruments would also form part of the ‘Trouble Fund’ and so would only vest if this was justified taking into account the financial stability of the firm at that time.
What are the other main provisions?
- Salary v Bonus – firms will have to ensure that fixed salaries represent a sufficiently high proportion of employees’ total remuneration to allow the operation of a fully flexible variable remuneration policy (including catering for the possibility of not paying bonuses at all). The announcement by the European Parliament referred to the fact that bonuses will be “capped to salary”, suggesting that a maximum multiple of salary could be applied, but precise rules relating to this are to be determined at a national level, subject to forthcoming guidance from the Committee of European Banking Supervisors.
The rules envisage a far greater emphasis on fixed remuneration to reduce risk taking, which could constitute a sea-change for some firms. Employers may have to consider increasing basic salaries in order to attract and retain staff who may otherwise consider moving to competitor firms in countries where the rules do not apply. However, it would be prudent in most cases to wait to see what the FSA proposes at a national level before considering blanket increases to salaries for risk-takers.
Employers should review any terms or policies used to determine annual salary increases to make sure that the application of salary increases does not result in the “appropriate” balance between salaries and bonus elements being lost.
- Performance-based remuneration – performance-based remuneration should be based on a multi-year framework, of at least three to five years (whether this is by performance targets measured over a longer period or by the application of clawback or malus to deferred portions) taking account of the outstanding risks associated with performance. The total amount of remuneration must be based upon a combination of an assessment of the performance of the individual (based on financial as well as non-financial criteria), performance of the business unit and performance of the overall results of the institution. The structure of performancerelated criteria will also be subject to disclosure requirements (see below).
- Guaranteed bonuses – the rules indicate that guaranteed bonuses may only be paid “exceptionally” and only in the first year of hiring new staff. One key aspect is that the provisions do not explicitly provide for the payment of guaranteed sums for other business reasons, such as retention or support during periods of transition.
In addition, notwithstanding that the rules permit guaranteed payments in the first year, the terms of any such payment would, depending on the nature of the payment, still have to be in accordance with the rules relating to deferral and contingent capital. It is unclear whether or not payments which are made as a genuine ‘sign-on’ bonus, or as a compensation payment to reflect the loss of bonus or other remuneration with a previous employer, are intended to be caught by the provisions relating to ‘variable remuneration’ – therefore this will depend upon the wording of the national regulations.
- Discretionary pension benefits – for those leaving the firm before retirement, enhanced discretionary pension benefits which are granted as part of an employee’s variable remuneration package must be held by the firm for a period of five years in the form of contingent capital. For retiring employees, these benefits should also be in contingent capital, subject to a five year retention period, but can be paid over. The rules do not contain a definition of “retirement” and so the FSA will need to consider how to frame this distinction in the context of existing UK legislation relating to age discrimination. Another point to note is that the rules may impact significantly on employees’ individual retirement planning as they may be prevented from purchasing an annuity in the usual way with this element of their pension.
- Government-assisted financial institutions – there is a presumption that directors should not receive variable pay. In addition, variable pay for other staff must be strictly limited to a percentage of net revenues when it is inconsistent with the maintenance of a sound capital base and timely exit from government support.
- Disclosure of remuneration policies (including details of severances payments) – for the purpose of ensuring adequate market transparency to the market of remuneration structures and the associated risks, institutions will be required to disclose to shareholders, employees and the public, detailed information relating to remuneration policies and practices, including information on:
- the decision-making process used to determine remuneration policy (including information relating to the composition and mandate of a remuneration committee or any external consultants);
- the link between pay and performance, including the criteria used for performance measurement and risk adjustment, deferral policy and vesting criteria and the performance criteria on which the entitlement to shares, options or variable components of remuneration is based;
- the main parameters and rationale for any variable component scheme and any other non-cash benefits; and
- aggregate quantitative information on remuneration, broken down by business area and by senior management and staff whose actions have a material impact on the institution’s risk profile (and directors of large institutions only) as well as information relating to new sign-on and severance payments.
The rules require “regular updates no less frequently than annually” but are silent on the timing of disclosures, for example the proximity to the award or payment.
One significant consequence of the disclosure rules is that institutions will have to disclose information relating to new sign-on and severance payments made to senior employees and employees who have an impact on risk during the financial year, including the number of beneficiaries of such payments and disclosure of the highest award to a single person. The rules are stated to be without prejudice to applicable data protection legislation, which would at the least require information to be anonymised. However, required disclosure of this information is nonetheless likely to have a significant impact on negotiations with new-joiners and relating to the settlement of employment disputes which previously have been cloaked in confidentiality.
Institutions are likely to look to the FSA for some flexibility in the implementation of this aspect of the disclosure obligation.
With a long-stop date of 1 January 2011 for implementation, there is not much time for employers to get to grips with the consequences of the rules and even less time to fully grasp the national regulations and any additional FSA guidance when it is issued.
Therefore, firms which may be caught by some or all of the restrictions should start preparations now. Employers will be well advised to start with the review process to ascertain precisely how variable remuneration is approached in different areas of the business. They should also assess the extent to which such practices may provide contractual rights for employees which will need to be addressed through appropriate employee consultation prior to effecting any unilateral changes required by the rules. Even where existing arrangements provide flexibility to implement annual bonuses in a variety of ways at the discretion of the employer, some form of consultation with a cross-section of impacted employees would be sensible from an industrial relations perspective – focusing on the fact that the purpose of such bonus arrangements frequently looks not just at rewarding past performance but also on retention and incentivisation for future performance.
In considering what changes are required to existing remuneration structures, depending on the number of employees affected, employers may wish to discuss proposed changes with employees at an early stage, with sufficient time to meaningfully gauge employees’ views on the proposed new structure. In order to facilitate consultation, it may be appropriate to set up a specific consultation body to discuss the changes, depending upon the number of affected employees. In other cases, in particular where the affected number of employees is small, employers may consider informing and/or consulting employees about any changes on an individual basis.
In addition, where it is considered that shareholder approval is required for changes to a firm’s remuneration policy, this approval should be sought at the earliest opportunity.
Risks for non-compliance?
National authorities have the power to impose either financial or non-financial measures or penalties for breach of the requirement to have remuneration policies that are consistent with sound and effective risk management.
The final legislative step is for the EU Council to formally adopt the proposals. In the meantime, all eyes are on the FSA and other European national authority bodies to see what approach they propose to take in relation to implementation. However, as we have seen, many institutions are starting the groundwork now to enable them to react quickly when we see the national level proposals, after which there may only be two or three months to implement the requirements before 1 January 2011.
In the meantime, employers should:
- Consider the categories of employees which are likely to be affected (senior management, risk takers, those in control functions and high earners) and their potential impact (if any) on the risk profile of the firm;
- Review current bonus policies and terms, including the extent to which these are contractual and any provisions providing flexibility and/or a power to amend;
- Review performance-related bonus criteria;
- Review current arrangements and practices relating to sign-on and other guaranteed bonuses;
- Review current disclosure requirements and practice;
- Consider options for informing and/or consulting affected employees in relation to any changes, including the coverage and remit of any existing employee consultation bodies; and
- Ensure contracts for new recruits expressly refer to the possibility of future amendment in light of legislative and/ or regulatory requirements.
For the full text of the rules, please click here (to print, select pages 531 to 591).
For the press release issued by the EU Parliament on 7 July 2010, please click here
For Frequently Asked Questions issued by European Parliament, please click here
Which firms could the proportionality principle apply to?
The rules provide that it may not be proportionate for limited licence firms and limited activity firms (under Articles 20(2) and 20(3) of CAD respectively) to comply with all of the principles.
Limited licence firm: generally either a BIPRU 50k or BIPRU 125k firm which has one or more of the following permissions in relation to MiFID financial instruments:
- arranging deals in investments;
- dealing in investments as agent; or
- managing investments; and
which is not authorised to deal on its own account or provide the investment services of underwriting or placing financial instruments on a firm commitment basis.
Limited activity firm: a BIPRU 730k firm which deals on own account only for restricted purposes (to execute a client order or to gain entrance to a clearing and settlement system or investment exchange when acting as an agent or executing a client order).
Firms which fall within the CAD but which are not limited licence or limited activity firms will be “full scope” BIPRU firms and, subject to implementation in the UK, will be likely to be caught by all the provisions of the new rules.
What are clawback/malus arrangements?
The deferred element of the bonus (both cash and contingent capital) can be reduced, where subdued or negative financial performance of the firm occurs, by reference to clawback or malus arrangements.
Clawback arrangements operate whereby a deferred bonus sum can be decreased if, following a later assessment of the performance of the business unit and/ or the individual, it is found that the basis on which the individual was awarded the bonus was incorrect and it is deemed that, with hindsight, the bonus is no longer justified at that level.
Under these arrangements, sums would not be increased if it were decided that personal performance was such that the previous year’s award was too low – this could simply be reflected in the current year’s bonus award.
Malus arrangements (effectively the opposite of bonus) allow for a firm to grant a negative bonus in years of poor performance (rather than a nil bonus) which is set off against previous bonus amounts which are subject to deferral.
The Trouble Fund
The proposed rules state that variable remuneration, including the deferred portion, will only be paid or vest if this is sustainable (in accordance with the performance of the firm) and justified (in accordance with the performance of the firm, business unit and individual).
In circumstances where a firm finds itself in financial difficulty or in which payouts or awards are not otherwise sustainable and justified, a firm may look to its ‘Trouble Fund’ in bolstering its capital.
An individual’s deferred bonus (both cash and contingent capital) will form part of the Trouble Fund, as will the up-front contingent capital element.
Where it is cash which has not been paid then it is clear that this amount, retained by the firm, will help its capital base. If the individual has been awarded an instrument which could require cash to be utilised, then this could convert to equity or be written down with similar effect. If the individual has already been awarded equity or is to be awarded equity, it is not clear how this could help the firm in maintaining its capital.
The assessment would take place where sums and/ or contingent capital are deferred over a multi-year framework (eg three to five years) and the payment or vesting of the deferred amount could be subject to clawback and/or malus in each year.