The UK government and the Financial Services Authority (FSA) have recently announced plans to tackle the “big bonus” culture in the City, which has been perceived as one of the causes of risky behaviour that has led to the current financial crisis. As a condition of its bail-out package to ailing banks, the UK government has stated that it expects that no cash bonuses will be paid to board members (i.e., officers and directors) of banks that are “bailed out” by it, although bonuses that take the form of shares are permitted. In the same week, the FSA produced a statement encouraging all FSA-regulated firms to review their remuneration policies. It has been clear for some months that the FSA intended to place a greater weight on regulated firms’ remuneration policies when assessing each firm’s overall risk, and the published statement is a reflection of this intention.

The Financial Services Authority

The FSA is concerned that employees of FSA-regulated firms are being encouraged to engage in short-term risk-taking through the use of “inappropriate” remuneration arrangements which are not consistent with sound risk management. While the FSA has said that it does not wish to be “involved in setting remuneration levels”, it will expect regulated firms to be moving towards good practice in this area. While the FSA’s recommendations are not yet official guidance, such is the relationship between authorised firms and the FSA that it would be usual for firms to comply with the FSA’s suggestions prior to any formal guidance being issued.

What is good practice?

The FSA has produced some criteria for good and bad remuneration policies. For example: 

  • bonuses should be calculated by reference to performance measures including riskmanagement skills and not just on the basis of financial performance;
  • remuneration should not be paid wholly in cash and employers should consider using shares to encourage corporate citizenship; and
  •  the whole or part of bonuses could be deferred so that the impact of the employee’s performance on the firm’s long term profits can be established.

The FSA says that it “expects firms to comply with its published criteria”. The FSA's covering letter is at http://www.fsa.gov.uk/pubs/ceo/ceo_letter_13oct08.pdf.

Compliance

At this stage, firms should be reviewing remuneration policies to ensure that they do not encourage high-risk behaviour and that a more prudent approach is favoured.

The FSA, in the course of supervising the activities of a regulated firm, can seek disclosure of relevant practices and policies (including remuneration policies and practices) and can suggest that changes are made.

If the firm does not comply with FSA requirements, ultimately the FSA has powers to impose fines and/or issue a public statement of censure. In addition, where it has concerns it may increase the capital requirement for that firm (to reflect the increased risk associated with that firm), and increase its ongoing scrutiny.

Impact

To the extent that regulated firms operate annualised bonus arrangements, they will now have to think about possible alternatives. Depending on the type of firm, it may or may not be possible to award shares or options in place of cash. To the extent that any firm puts in place share option or share incentive arrangements or simply defers payment of cash bonuses, it will need to consider a number of structural issues to create a design that is palatable to both the FSA and to employees.

Issues that regulated firms will need to consider when implementing deferred compensation arrangements (including share option or incentive arrangements) include: 

  1. the tax implications of doing so; 
  2. how employees are to be treated if they leave in different circumstances. How will a “good leaver” be defined for the purposes of plan rules? 
  3. where shares are to be granted instead of cash bonuses, firms will need to consider whether shares will need to be retained, for how long, and the mechanism for retention. For senior employees this may severely limit their opportunities to sell shares (as they may also be restricted from doing so during any closed period); and 
  4. where all or part of bonus payments are to be deferred to allow the firm to assess the impact of the employee’s performance on the firm’s long term profits, the firm will need to consider how it will (objectively) measure that impact. This change in particular will need careful thought as employees may be unhappy with being judged with hindsight on work that seemed appropriate and of a high standard (and was within their firm’s existing riskmanagement policies) at the time it took place.

Of course, many regulated firms may take the view that their existing arrangements already comply with sound risk management principles and that little or no change is needed. Nevertheless all firms ought to be thinking about the robustness of their arrangements and should be prepared to defend the policies and plans if they were to come under the scrutiny of the FSA.

ANNEX: Criteria for good and bad remuneration policies