The UK Financial Services Authority (the FSA) is due to publish an updated version of its Remuneration Code which will apply to a wide range of FSA-regulated businesses with effect from January 1, 2011. The revised code will implement key reforms to remuneration practices within FSA-regulated entities in response to developments in the UK and at a European level. This article considers the key facts in relation to the revised code and is essential reading for any companies carrying out FSA-regulated activities in the UK.

Background

In response to the recent banking crisis the FSA introduced a remuneration code that requires the UK’s largest banks, building societies and broker dealers to put in place remuneration policies that are consistent with effective risk management. This code was introduced in 2009 (the 2009 Code) and has applied to approximately 26 large regulated entities operating in the UK since January 2010. A revised version of the code (the Revised Code) was due to be published in mid-November 2010 and scheduled to take effect on January 1, 2011 — although at the time of writing it still had not been finalized.

When Will the Revised Code Apply?

The Revised Code will apply from January 1, 2011 in relation to the firms which are already governed by the 2009 Code. The FSA will not expect firms which only come into the scope of the Revised Code to comply with the full range of the Revised Code provisions until July 1, 2011.

Who Will the Revised Code Apply To?

More Firms Will Be Caught

The 2009 Code only applies to approximately 26 of the largest FSA-regulated firms whereas the FSA estimates that the Revised Code will apply to 2,500 FSA-regulated firms. This is because the Revised Code will apply to all FSA-regulated firms that are subject to the Prudential Sourcebook for Banks, Building Societies and Investment Firms (BIPRU) which covers all banks, building societies and Capital Adequacy Directive investment firms. The FSA has indicated that this will capture a large number of asset managers, investment firms and firms involved in corporate finance, venture capital, the provision of financial advice, brokers and others.

Not Only UK-based Entities Will Be Caught

The FSA will expect UK-regulated groups to apply the Revised Code globally, including in their non-regulated businesses. Also where the head office of a non-EEA organization is based outside the UK but has a UK subsidiary at the head of a sub-group, the Revised Code should be applied to all entities within that sub-group.

Note that UK-based branches of firms headquartered outside the EEA will be caught by the Revised Code. However, UK branches of EEA-regulated firms are not required to comply with the Revised Code but they will be required to comply with corresponding rules in their home member state which will also be implementing the CRD3 rules on remuneration.1

The scope of the Revised Code is therefore potentially wider than it may first appear.

More Employees Will Be Caught — "Remuneration Code Staff"

The Revised Code introduces a new definition of "Remuneration Code Staff" whose remuneration must comply with the Code requirements. This encompasses all employees whose professional activities have a material impact on the firm’s risk profile, including senior management and other staff exercising control functions, risk takers and any staff whose pay puts them in the same remuneration bracket as senior management and risk takers. This will include any individuals who are seconded to the firm or otherwise working there in one of these capacities other than as an employee.

Any Exemptions?

Affected firms can apply to the FSA for some Remuneration Code Staff to be exempt from certain strands of the Revised Code requirements on the basis that the variable portion of their remuneration comprises no more than 33 percent of their total remuneration and their total remuneration is no more than £500,000 per annum. This should be a useful exemption provided that firms are able to organize their remuneration policies to apply different rules to different categories of employees.

Key Requirements

We have summarized below the key requirements of the Revised Code. Note however that these requirements are set out in more detail in our Client Alert in addition to other requirements relating to governance, discretionary pension arrangements, personal investment strategies and risk management.

What Are the Proposed Changes to the Revised Code?

The Revised Code will require affected firms’ remuneration policies to comply with the rules relating to:

  • Performance Measurement: Appropriate performance conditions must be implemented for performance related remuneration.
  • Fixed to Variable Proportion of Remuneration: Firms must specify an appropriate balance between fixed and variable compensation in their remuneration policies which reflects the current and future risks to the business.
  • Proportion in Shares and Retention: At least 50 percent of any variable remuneration should be made in "shares, share-linked instruments or other equivalent non-cash instruments of the firm" and these share components must be subject to retention.2
  • Deferral: At least 40 percent of a bonus must be made over a period of at least three years. For staff earning more than £500,000, at least 60 percent of a bonus must be deferred over the same period. Long Term Incentive Plan (LTIP) awards should be structured so that half of the award should vest after three years or more, and the other half after five years or more.
  • Performance Adjustments: Performance related adjustment of deferred, variable remuneration must be made if during the deferral period the firm or business unit’s performance is poor.
  • Guaranteed Bonuses: Affected firms must not offer guaranteed bonuses other than in exceptional circumstances where new hires are in the first year of their employment.
  • Severance Pay: Payments made on early termination of an employment relationship must reflect the employee’s performance over time and must not reward failure.
  • Voiding Provisions: Any contractual provisions which breach or attempt to avoid the Revised Code rules regarding guaranteed bonuses or deferral will be void. The firm will be required to recover payments made to employees in breach of those rules.

Proportional Approach

The FSA has indicated that it will apply a proportional approach to the implementation of the Revised Code so that, in line with CRD3, firms are required to comply in a way and to the extent that is appropriate to their size, internal organization and the nature, scope and complexity of their activities. This aspect of the Revised Code is perhaps the most unclear and we expect further announcement from the FSA on it in the next few weeks.

Practical Considerations for Employers

There are a number of practical issues buried in the detail of the Revised Code rules relating to the structuring of remuneration. For example, the requirement for 50 percent of remuneration to be in shares or share-like instruments could create dilution concerns for existing shareholders. For organizations which are not companies, this rule will require "equivalent non-cash instruments" to be developed such as stock appreciation rights and phantom options.

Perhaps the biggest difficulty faced by employers is that the Revised Code has still not been published in its final form and yet is due to apply with effect from January 1, 2011. Although the FSA does not expect firms which only come into scope on January 2011 to apply the full range of the Revised Code’s provisions until July 1, 2011, clearly this creates a major headache for employers who will have to look for ways to renegotiate bonus arrangements with their employees which would otherwise breach the Revised Code rules.

What to Do Next?

  • Determine whether the Revised Code will apply to your organization
  • Determine whether your remuneration committee meets the standards required by the Revised Code and if not take measures to ensure that it does
  • Identify those employees who could be classified as "Remuneration Code Staff" and notify and prepare them for any upcoming changes to their remuneration
  • Review existing remuneration arrangements applicable to Remuneration Code Staff and consider whether changes are required to introduce any of the Revised Code requirements
  • Consider what steps are required to enable bonuses to be paid in shares or other non-cash instruments
  • Consider what processes are available to enable the firm to claw back any payments made under the voiding and recovery provisions

Coming Soon: Remuneration Reforms Under the EU Alternative Investment Fund Managers (AIFM) Directive

Although a number of firms will escape the application of the FSA Revised Code, further regulation is on the horizon. On November 11, 2010 the European Parliament adopted a draft text of the AIFM Directive which includes provisions regulating the governance, structure and disclosure of remuneration of AIFM senior managers, risk takers and staff exercising control functions. These rules are largely similar to those implemented under the Revised Code (with some exceptions) and will expressly apply to amounts paid directly to staff by the relevant alternative investment funds, including carried interests and transfers of fund shares or units which benefit staff. These reforms are anticipated to affect fund managers located in the EU or located outside the EU but managing EU funds or marketing funds into the EU. There are exemptions, for example for holding companies, central banks, pension funds investing their own money only and managers who only manage funds on behalf of parent or subsidiary undertakings. There are also lighter controls applying to smaller fund managers. The AIFM Directive is expected to be adopted in early 2011 and member states will be required to implement legislation complying with it by 2013.