Summary and Implications
The new FSA remuneration code (the Code) came into effect on 1 January 2011. Final rules on the Code were published in a policy statement by the FSA released on 17 December 2010.
Pay in the European Union is now the most severely restricted in the world and the UK leads the pack. The application of the Code to the worldwide operations of banks could make the recruitment and retention of top talent problematic for UK banks. UK banks which operate in Asia, South America and the USA will be at a competitive disadvantage, particularly in view of the absence of restrictions on pay in the USA.
The publication of the Code was delayed by the FSA from November to December to ensure that the final rules were consistent with relevant European Union legislation (the Capital Requirements Directive (CRD3) and the guidance on remuneration published by the Committee of European Banking Supervisors on 10 December 2010).
The Code replaces the FSA’s previous remuneration code which only applied to the 26 largest UK banks, building societies and broker-dealers. The Code applies to all banks and building societies, firms subject to the Capital Adequacy Directive (CAD) and UK branches of firms headquartered outside the EEA. Firms which are in the scope of the Code for the first time must comply with the Code by 1 July 2011, although they must take reasonable steps to comply as soon as reasonably practicable.
The recent focus on remuneration stems from the view prompted by the financial crisis that staff in financial firms were incentivised to take excessive risk by widespread discretionary bonus arrangements. The Code aims to redress perceived imbalances so that the senior management of a firm and staff which have a material impact on its risk profile, such as proprietary traders, cannot simply be awarded large cash bonuses at each year end.
This briefing summarises the key parts of the Code, in particular:
- Scope of Code: which firms are caught by the Code;
- Code Staff: which staff are caught by the Code;
- Remuneration arrangements: what needs to be done by a firm in relation to the remuneration of Code Staff; and
- Proportionality: application of the Code depending on the type and size of a firm.
Certain EU directives which are in the pipeline, such as the Alternative Investment Fund Managers Directive, Solvency II and UCITS V include restrictions on remuneration and firms will need to be mindful that that legislation will come into force over the next few years.
Scope of the Code
The Code applies to all banks and building societies, CAD firms and UK branches of equivalent firms headquartered outside the EEA. CAD firms include investment banks, UCITS investment firms, most asset managers, some brokers and some corporate finance and VC firms. Over 2,500 firms will be subject to the Code. Many asset managers will escape the Code because they are “exempt CAD” or “MiFID exempt” firms. The Code also applies to all branches of a firm in any jurisdiction in the world and all members of a “UK consolidation group” and its “non-EEA sub-group.”
The Code applies to all code staff (Code Staff) who work for a firm caught by the Code. Code Staff are defined as all staff who have a material impact on the firm’s risk profile, including:
- Risk takers;
- Staff who perform a “significant influence function”;
- Senior managers;
- Staff whose total pay takes them into the “same bracket” as senior management and risk takers;
- Heads of support and control functions, including compliance, legal and investment research; and
- Could include risk takers and SIFs in overseas parents
Firms must identify and list all staff who are Code Staff. All contracts between firms and Code Staff must comply with the Code.
Code Staff whose total pay is up to £500,000 and no more than 33 per cent of that total pay is bonus will not be subject to the rules on bonuses (including deferral, payment in kind and guaranteed bonuses). For example, this would disapply the Code to an employee who earns £100,000 (including pension and benefits) and a bonus of £25,000. For Code Staff who are caught by the Code, the following principles must be reflected in their remuneration packages:
- Individual, business unit and firm wide performance must be taken into account;
- At least 40 per cent of any bonus must be deferred over at least three years;
- For Code Staff whose total remuneration exceeds £500,000 the deferral rate rises to 60 per cent;
- At least 50 per cent of any bonus must be paid in shares, share-linked instruments or other equivalent non-cash instruments. This should be applied equally to the deferred and undeferred portions of any bonus; and
- Guaranteed bonuses must be exceptional and limited to new hires for the first year of service.
- Unvested deferred bonuses must be reduced where the firm or the business unit suffers a material downturn in its financial performance or a failure of risk management, and in the case of misbehaviour or material error on the part of an employee.
- Any early-termination payments will have to reflect long term performance and must not reward failure. The FSA is expected to publish further guidance on this point.
- A firm must ensure that its total bonus payments do not limit its ability to strengthen its capital base.
- The Code requires firms to apply provisions on guaranteed bonuses on a firm-wide basis and not just to Code Staff.
Application to firms - proportionality
CRD3 gives the FSA flexibility to apply a proportionate approach to applying the remuneration principles. The Code therefore identifies four “tiers” of firm (from Tier 1 – the highest – to Tier 4 - the lowest), and some of those tiers are entitled to disapply parts of the Code. For firms in Tiers 1 and 2, broadly all rules in the Code apply and Tier 1 firms are subject to an annual review by the FSA. For firms in Tiers 3 and 4, most of the rules in the Code on pay can be disapplied.
Tier four firms include “Limited Licence Firms”, that is to say those firms that do not deal on their own account, and “Limited Activity Firms” which will include firms that only act on behalf of clients. This means that a large number of independent fund managers will be treated as tier four firms.
Small investment firms will, however, still need to comply with a large part of the Code, including ensuring that the firm remuneration policy is in line with the business strategy of the firm and that the governing body of the firm periodically reviews the firm’s remuneration policy and its implementation.
The table below sets out how the principles of the Code apply to each tier of firm.
Naturally, many existing employment contracts with Code Staff will not be Code-compliant. The Code requires firms to put in place Code-compliant employment contracts by the end of 2011. The FSA is entitled to treat as void bonus arrangements which are entered into after 1 January 2011 and are not Code-compliant.
This issue could lead to significant disputes between firms and staff.
Unfortunately, the FSA has provided little detail on whether the Code will apply to carried interest, and how certain vehicles, such as LLPs and unlisted companies, can meaningfully pay Code Staff in membership interests and unlisted shares (which are illiquid and present valuation difficulties). A further concern in relation to LLPs is that they are transparent for UK tax purposes so that members of LLPs will be obliged to pay tax on profits as they arise even if those profits are not distributed to them. The FSA proposes to consult with industry bodies about these issues in early 2011.
In terms of timing, the FSA has helpfully provided transitional provisions for those firms that were not previously subject to the Code. Such firms have until 1 July 2011 to comply with the Code although they must take reasonable steps to comply with the Code as soon as reasonably practicable.
Firms caught by the Code should consider the following action points to as a starting point on how the Code affects the firm.
- Does the Code apply to your firm and does the Code apply to more than one entity in your group?
- Which of your staff are Code staff?
- Which tier are you in (for the purposes of proportionality)?
- Review your employment contracts/LLP agreements.
- Take care with severance packages.
- Prepare a remuneration policy.
Click here to see table.