Countdown to July 2013
The Alternative Investment Fund Managers Directive (the Directive) is due to be transposed into UK law on 22 July 2013. With only 2 months to go, there are many unanswered questions, particularly in relation to the remuneration aspects.
Broadly, the Directive will be relevant to:
- EU alternative investment fund managers (Managers) that manage one or more so-called Alternative Investment Fund (Fund);
- non-EU Managers that manage one or more EU Funds; and
- non-EU Managers that market any Funds in the EU.
For some, the remuneration provisions in the Directive will be entirely new. Others will have been subject to a similar set of requirements under the FSA Remuneration Code since 2011, albeit that certain of the remuneration provisions may have been disapplied on proportionality grounds.
The FCA’s latest consultation paper (CP3) is due to be published in the coming weeks and should provide further clarity on how the provisions of the Directive will be implemented in the UK. In respect of remuneration, this is likely to be in the form of a new UK AIFMD Remuneration Code.
In the meantime, set out below is a summary of the relevant provisions of CP1, CP2, the Treasury consultations and the ESMA Guidance, which set out the story so far. Whilst the UK can depart from ESMA’s Guidance, if it considers this goes beyond the requirements of the Directive, material departures are unlikely.
A Year’s Grace: the Transitional Provisions
It had been expected that firms would have to be fully compliant with the Directive by 22 July 2013. However, the government’s proposals set out transitional provisions for UK and EU Managers who, immediately before 22 July, are managing a Fund, and for third country Managers who, at that time, are marketing a Fund in the EU. Such Managers have a one-year transitional period in order to lodge all authorisation applications, providing a more realistic timetable for affected firms. Managers must comply with the provisions of the Directive from the point at which their application is approved, or by 21 July 2014, whichever is the earlier.
ESMA has clarified that the remuneration requirements will be subject to the same transitional provisions. It appears that Managers will need to demonstrate their compliance with the remuneration requirements as part of the approval process. However, it may be necessary to demonstrate that a compliant remuneration policy has been in place from the start of the relevant bonus year in which approval is requested. Therefore, Managers should ascertain any necessary amendments as soon as possible following the publication of the UK rules.
Remuneration: The Basics
- Who is covered? Specific remuneration provisions will apply to Identified Staff, namely those members of staff whose activities are likely to have a material impact on the risk profile of the Manager. Identified Staff should include: the governing body (executives and non-executives), senior management, control functions, staff responsible for portfolio management, administration, marketing and human resources, and other risk takers (which could include individual traders or desks). Also included should be those whose remuneration is within a similar bracket to the above categories, provided that their activities have a material impact on risk. In addition, ESMA has indicated that certain of the remuneration provisions should apply on a Manager-wide basis, for example the restrictions in respect of guarantees.
- How is remuneration defined? This includes remuneration of any type paid by the Manager or the Fund (by way of payment or benefit) and any transfer of shares or units in the Fund in exchange for professional services by the Identified Staff. Carried interest is expressly included, and is defined as a share in profits of the Fund accruing to the Manager as compensation for management of the Fund. Co-investment arrangements are excluded. However, it remains unclear exactly how the provisions regarding carried interest and coinvestment arrangements will be applied in practice.
ESMA recognises that employee shareholders or partners in the Manager may receive dividends or similar distributions as owners. Such payments are excluded from the scope of ESMA’s Guidelines, but only to the extent they do not circumvent them (whether intentionally or not).
The ESMA Guidance also extends the remuneration guidelines to delegates, even where such delegate is not itself a Manager. The Guidance requires that the Manager should ensure that the delegate is subject to remuneration requirements that are “equally as effective”, or that appropriate contractual arrangements are put in place with the delegate to ensure there is no circumvention of the remuneration requirements. The FCA has been urged by certain UK industry bodies not to adopt this Guideline, as it appears to go beyond the requirements of the Directive.
- Remuneration Policy - there is an overarching requirement for Managers to have a remuneration policy that is consistent with and promotes sound and effective risk management. The Remuneration Policy must be in line with business strategy, objectives, values and interest of the Manager and its Fund, or the Fund investors, and may require to be disclosed to investors and regulators. It must also be reviewed annually.
- Conflicts Policy - each Manager is required to have a written conflicts of interest policy appropriate to its size and organisation, and the nature, scale and complexity of its business.
- Remuneration Committee* - there is a general requirement for Managers to put in place a remuneration committee (although certain Managers will be exempt on proportionality grounds, in respect of which see below).
- Deferrals* - at least 40% (and in some cases 60%) of variable remuneration must be deferred over at least 3 years. Vesting of the first tranche must not take place within the first 12 months.
- Awards in instruments / units* - at least 50% of variable remuneration (including both the upfront and deferred elements) must be paid in units or shares, and subject to an appropriate retention policy (under the FSA Remuneration Code, a minimum 6 month retention period applied).
- Risk Alignment (Malus / Clawback)* - ex ante and ex post risk alignment measures must be taken into account (i.e. at the stage of setting bonus pools, when individual bonus awards are decided, and after the award has been made). These measures include the potential reduction of unvested deferred sums / awards (malus adjustments), if there is an adverse financial situation or poor performance of individual, Manager or Fund. In such circumstances, this could also extend to clawback of amounts already paid (which goes further than the FSA Remuneration Code).
* These requirements may be disapplied entirely, on proportionality grounds.
Thresholds and Proportionality: A lifeline?
The Directive contains a partial exemption for Managers that have total assets under management of €100m or less, or which manage unleveraged Funds that have total assets under management of €500m or less. The government had initially proposed that the full requirements of the Directive should nonetheless apply to these sub-threshold Managers, but it has since clarified its commitment to avoid gold plating unless there is strong justification. Accordingly, sub-threshold entities will be exempt from the full requirements of the Directive, including the remuneration and related disclosure aspects.
ESMA has confirmed that Managers with less than €1.25bn assets under management and less than 50 employees should be exempt from the requirement to establish a Remuneration Committee. Other Managers can taken into account certain proportionality factors to determine whether or not it is appropriate to have a Remuneration Committee.
ESMA has also confirmed that certain Managers will be able to disapply entirely the requirements to pay remuneration in units and to operate deferrals on proportionality grounds (together with the related provisions on retention periods and malus/clawback). Disapplication cannot happen automatically and Managers should be able to provide national regulators with a detailed explanation why such requirements have been disapplied. However, there is still little guidance as to how the proportionality test will be applied in practice in the UK, in particular in cases of groups containing multiple Managers.
Performance: Assessment Criteria and Risk Alignment
Under the Directive, performance-related remuneration for Identified Staff must take into account nonfinancial as well as financial criteria. The assessment period must be based on a multi-year framework and take into account a combination of the performance of the individual, the relevant business unit, and the Manager entity as a whole.
Possible risk adjustments must be taken into account in the setting of performance criteria, the allocation of bonus pools, and decision making in respect of individual awards. The ESMA Guidance makes clear that Managers should have the power to reduce variable remuneration to zero. Accordingly, it is not possible to have a guaranteed floor in bonus arrangements.
For those in control functions, as set out above, performance assessment must be by reference to objectives which are linked to those functions and are independent of the performance of the business unit or area they control.
Compliance: Independence in Structure and Remuneration
The Directive requires the “functional and hierarchical” separation of risk management from operational units, where proportionate. In general this means that those performing risk management functions must not be supervised by those responsible for the performance of operating units (i.e. portfolio managers). However, the FCA has confirmed that structure will be taken into account, in particular in respect of private equity funds where this separation may be unworkable.
A permanent, independent compliance function should be in place, with an appointed compliance officer who reports to senior management at least annually. Compliance staff must not have any involvement in the activities they monitor and, as set out above, their remuneration must be independent of those activities. However, the ESMA Guidance confirms that variable remuneration may also be determined by Manager-wide performance, provided it is not based exclusively on this. Ultimately, the governing body, senior management and any supervisory function will be responsible for enduring compliance with the Directive and that a permanent and effective compliance function is in place, even if this is outsourced.
Guarantees: Sign Ons and Buy Outs
The Directive places a restriction on the award of guaranteed bonuses. Guaranteed variable remuneration should be “exceptional”, occur only in the context of hiring new staff and must be limited to the first year. As set out above, this restriction applies to all staff, not only Identified Staff.
It is hoped that additional guidance will be provided by the FCA (as was the case in respect of the FSA Remuneration Code) to clarify that guaranteed bonuses can be used to buy out the existing bonus commitments relating to new hires, provided that reasonable steps are taken to mirror its terms (e.g. to replicate the split between cash and instruments, and to continue any ongoing deferral provisions).
Severance Pay: No Reward for Failure
The ESMA Guidance confirms that severance payments should be related to the individual’s performance over time and should not amount to a reward for failure. Accordingly, golden parachutes will need to be carefully drafted to ensure compliance.
Disclosure and Reporting Obligations: The Annual Report
Managers are required to submit an annual report in respect of each EU Fund it manages and each Fund it markets in the EU. In most cases, the report must be completed no later than 6 months following the end of the financial year. As well as setting out information in respect of the Manager’s balance sheet and income, a report on activities, and details of any material changes during the financial year, the annual report should also contain the following information:
- the total remuneration for the financial year split into fixed and variable remuneration paid by the Manager, the number of beneficiaries and the details of carried interest paid; and
- the aggregate amount of remuneration broken down by senior management and members of staff whose actions have a material impact on the risk profile of the Fund.
Next Steps for Managers
Existing arrangements should be reviewed and consideration given to who is likely to be on the list of Identified Staff. In particular, Managers should examine the performance assessment and risk alignment mechanisms already incorporated in their bonus plans.
Managers may wish to include wording in employment contracts for new hires and bonus plans to seek to reserve the right to amend the remuneration provisions, as appropriate, in order to ensure compliance with the new remuneration rules, once finalised.