The UK Financial Services Authority (the FSA) is due to publish an updated version of its Remuneration Code which is anticipated to apply to a wide range of FSA-regulated businesses with effect from 1 January 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 Client Alert considers the scope of the revised code and is essential reading for any companies carrying out FSA regulated activities in the UK.
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.
The FSA have been reviewing the 2009 Code since its implementation and published a consultation paper setting out its proposed revisions in July 2010. A revised version of the code (the Revised Code) is due to be published in mid-November 2010 and will be implemented with effect from 1 January 2011.
When Will the Revised Code Apply?
The Revised Code will apply with effect from 1 January 2011 and firms which are already governed by the 2009 Code are expected to take part in meetings and discussions in Q4 of 2010 to discuss governance, controls, performance measurement and risk adjustment to prepare for its implementation. In addition, the FSA will review its remuneration plans for the 2010 bonus round, which will come into effect on 1 January 2011. 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 1 July 2011.
Why Is the 2009 Code Being Revised Within the First Year of Its Implementation?
Even before the 2009 Code was implemented, the FSA committed to reviewing the code during the course of 2010, both to monitor its effectiveness and to implement certain recommendations of the Walker Review — the independent review of corporate governance in UK banks and other financial institutions commissioned by the HM Treasury and carried out by Sir David Walker in 2009. In addition, the Financial Services Act 2010, which came into effect in April, requires the FSA to introduce rules governing the remuneration practices of financial sector firms. The Revised Code implements these new powers.
Another key driver behind the Revised Code is the implementation of the European amending directive, CRD3, which will amend the EU Banking Consolidation and Capital Adequacy Directives with effect from 1 January 2011. CRD3 institutes extensive reforms to the rules regarding remuneration and the Revised Code will implement these reforms in the UK. On 8 October 2010 the Committee of European Banking Supervisors (CEBS) published its draft guidelines as to how the requirements of CRD3 relating to remuneration should be implemented. The final draft of the Revised Code, due to be published at some point this month, should reflect many of the recommendations from the CEBS guidelines and we have therefore referred to these guidelines below.
Who Will the Revised Code Apply To?
Perhaps the most reported proposed change is the expansion of the application of the Code:
More firms will be caught
The 2009 Code only applies to the 26 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 which 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 consultation paper explains that this will include a large number of asset managers including hedge fund managers and all UCITS1 investment firms plus some firms which engage in corporate finance, venture capital, the provision of financial advice, brokers, several multilateral trading facilities and others. Given the lack of clarity in this statement, compliance officers should consult the Perimeter Guidance Manual (PERG) of the FSA handbook to determine whether they are caught by BIPRU and the Capital Adequacy Directive. This in turn will clarify whether the Revised Code will apply or not.
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 organisation 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. This will include those entitled outside the EEA e.g. in the Middle East or Africa. The scope of the Revised Code is therefore potentially wider than it may first appear.
Note that UK 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.
More Employees Will Be Caught — "Remuneration Code Staff"
The number of affected employees within a regulated firm will also be expanded significantly under the Revised Code. Whereas the 2009 Code requirements apply to those employees who either hold significant influence functions (as defined in the FSA Handbook) or have, or could have, a material impact on the firm’s risk profile, the Revised Code expands the affected group with a new definition of "Remuneration Code Staff". 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
- 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.
The FSA will expect firms to identify all Remuneration Code Staff and ensure that their remuneration complies with the Revised Code requirements. Firms are also required to notify their Remuneration Code Staff of the Revised Code and ensure they are aware of its impact on their remuneration.
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 per cent of their total remuneration and their total remuneration is no more than £500,000 per annum. It appears that these employees can be exempt from the Revised Code restrictions regarding guaranteed bonus, retention periods for variable remuneration in the form of shares, deferral requirements, performance adjustments and the voiding and recovery rules. This should be a useful exemption provided that firms are able to organise their remuneration policies to apply different rules to different categories of employees. Some employers may find it easier to take a one-size-fits-all approach.
What Are the Proposed Changes to the Revised Code?
The general purpose of the Revised Code remains broadly the same — to ensure that the relevant entities adopt remuneration policies which promote effective risk management. As ever, the devil is in the detail. Whereas the 2009 Code contained eight key principles, the Revised Code will incorporate 12 updated principles and will apply to a wider range of FSA-regulated organisations.
The 12 Principles of the Revised Code
Principle 1 — Risk Management and Risk Tolerance
A firm’s remuneration policy should not encourage risk taking that exceeds the regulated firm’s tolerated risk level. This is consistent with the 2009 Code but brings the Revised Code in line with CRD3.
Principle 2 — Supporting Business Strategy, Objectives, Values and the Long Term Interests of the Firm
A firm’s remuneration policy must be aligned to its business strategy and long term corporate values. This is consistent with the 2009 Code in substance but the new wording is aligned with the CRD3.
Principle 3 — Avoiding Conflicts of Interest
This was previously part of the guidance to the 2009 Code but is now a principle in itself in line with CRD3. The FSA will expect to see evidence of procedures in a firm’s remuneration policy that are designed to avoid conflicts of interest, including those related to customers’ interests.
Principle 4 — Governance
This is an expansion of the first principle under the 2009 Code. In particular, firms of a "significant" size will be required to establish remuneration committees and the chair and members of the committee must be Non-Executive Directors. The remuneration committee should be responsible for the preparation of decisions regarding remuneration, including those with implications for risk management. The implementation of a firm’s overall remuneration policy and framework should be subject to annual independent internal review, for example by the remuneration committee.
Principle 5 — Risk and Compliance Function
This is another expansion of an existing principle in the 2009 Code — that remuneration for employees in risk and compliance functions should be determined independently (i.e., by a remuneration committee) and should be based on achieving the objectives of those functions. In the Revised Code, HR and Legal functions will be included in this category of "compliance" workers which will expand the reach of this requirement.
Principle 6 — Remuneration and Capital
This new principle has been introduced to the Revised Code in light of CRD3 which requires firms to ensure that the total variable compensation paid by the firm to all staff does not limit their ability to strengthen their capital base. In addition, total variable compensation should be adjusted if the firm suffers subdued or negative financial performance. This will require remuneration committees to review annually the whole impact of its remuneration policies — across the organisation.
Principle 7 — Exceptional Government Intervention
The Revised Code will introduce rules relating specifically to organisations which are in receipt of state aid which will reflect the requirements of CRD3. In broad terms, those entities will be expected to justify any variable remuneration available to their directors.
Principle 8 — Profit-based Measurement and Risk Adjustment
The Revised Code will require firms to take account of current and future risks when determining any variable remuneration. This will be relevant when setting performance targets for any bonus or long term incentive plans, including options or share incentive plans.
Principle 9 — Enhanced Discretionary Pension Benefits
The Revised Code requires that pension policies are in line with the company’s business objectives, values and long-term interests. This is in response to a CRD requirement that discretionary pension benefits should be held for five years in the form of shares or share-like instruments. Note that this does not apply to standard pension plans and contributions but rather one-off, discretionary payments into individual pension plans. The Revised Code will implement this rule although the extent to which this will be implemented for all Remuneration Code Staff, or only the most senior managers, remains to be seen.
Principle 10 — Personal Investment strategies
In accordance with CRD3, the Revised Code will introduce a requirement that firms should not allow employees to use personal hedging strategies or insurance policies that undermine the alignment of their remuneration to the firm’s risk. Regulated firms will be required to maintain arrangements to ensure compliance with this rule. These restrictions will not apply to personal insurance polices to protect regular income for health care benefits or mortgage payments.
Principle 11- Avoidance of the Code
The Revised Code will contain a new rule prohibiting firms from awarding remuneration through alternative vehicles or other methods which are designed to avoid compliance with the Code. In particular the FSA will scrutinise the use of "non-recourse loans" to staff.
Principle 12 — Remuneration Structures
This last principle contains most of the fundamental reforms which regulated employers will have to become familiar with. Under this principle, the Revised Code will implement rules which will directly affect the way that remuneration is structured in order to ensure that effective risk management is being promoted. In particular, new rules will apply regarding performance measurement, the proportion of fixed to variable remuneration, deferral of payments, payment of a proportion of bonuses in shares and performance adjustment. These proposals are reviewed in more detail below.
Principle 12 in Detail — New Rules Regarding the Structuring of Remuneration
The Revised Code will require remuneration policies to comply with the following rules:
Performance measurement. Appropriate performance conditions must be implemented for performance related remuneration. In line with the 2009 Code, the Revised Code states that non-financial performance metrics should form a significant part of the performance assessment process and performance assessment on a moving average of results can be a good way of measuring long term performance.
Fixed to variable proportion of remuneration. This is a new requirement for firms to specify an appropriate balance between fixed and variable compensation in their remuneration policies. The proportion of fixed to variable remuneration should reflect the current and future risks to the business and the capital and liquidity costs of the business activities that the employees are engaged in. The CEBS guidance has confirmed that the relevant ratio is something for each firm to determine carefully and to be checked by the national regulator. We expect further clarity on this when the FSA publish the final version of the Revised Code.
Proportion in shares and retention. At least 50 per cent 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. Note that this retention element is in addition to the deferral obligation discussed below — in other words, remuneration policies should specify that any shares transferred to an employee should be retained for a particular period, even if receipt of those shares was already deferred under the deferral rules above. The CEBS guidance recognises that it may be appropriate for retention periods to be shorter for deferred equity bonuses than for non-deferred bonuses. There is currently no guidance as to what an appropriate retention period will be. The FSA has acknowledged that this requirement to pay 50 per cent of variable remuneration in shares will be difficult to implement for unlisted companies before 1 July 2011.
Deferral. At least 40 per cent of a bonus must be made over a period of at least three years. For staff earning more than £500,000, at least 60 per cent of a bonus must be deferred over the same period. The FSA have proposed that Long Term Incentive Plan (LTIP) awards will also be included in the calculation of the deferred proportion and LTIPs should be structured so that half of the award should vest after three years or more, and the other half should only vest after five years or more. The CEBS guidance has clarified that the 50 per cent minimum non-cash requirement must be applied to both deferred and non-deferred variable remuneration.
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. This implements the broad principle of adjusting bonuses for "malus" which has been under discussion since the outset of the banking crisis. The Revised Code will require firms to consider a malus adjustment where there is evidence of employee misbehaviour or material error, material down turn in the firm or business unit’s performance, or if the firm or business unit suffers a material failure of risk management. The FSA consultation paper specifically notes that this adjustment of deferred remuneration is not a requirement to "clawback" vested remuneration which is views as a limited performance adjustment approach.
Guaranteed bonuses. Guaranteed bonuses were clearly frowned upon under the 2009 Code. Under the Revised Code, affected firms must not offer guaranteed bonuses other than in exceptional circumstances where new hires are in the first year of their employment. Even then, the guaranteed bonus must not exceed the bonus payable by the previous employer (which the guaranteed bonus is designed to replace) and the bonus must be subject to performance adjustment and deferral. In effect this undermines the concept of the "guaranteed" bonus as even those which are deemed acceptable under the Revised Code will become subject to performance related adjustment.
Severance Pay. Payments made on early termination of an employment relationship must reflect the employee’s performance over time and must not reward failure. Firms should set up a framework in which severance pay is determined and approved in line with their general governance structures for employment and must be able to explain to the FSA the criteria they use to determine severance pay.
Voiding Provisions. This is a new rule which sets out that any contractual provisions which breach the Revised Code rules regarding guaranteed bonuses, deferral will be void. Any contractual provisions which seek to get round the voiding rule will also be void. The firm will be required to recover payments made to employees in breach of those rules.
The FSA has indicated that it will apply a proportional approach to the implementation of the Revised Code so that, in line with CDP3, firms are required to comply in a way and to the extent that is appropriate to their size, internal organisation and the nature, scope and complexity of their activities. This aspect of the Revised Code is perhaps the most unclear and yet will be extremely relevant for firms trying to understand their compliance obligations. Both the FSA consultation paper and the CEBS guidance have stated that the proportional approach will not allow firms to escape compliance with at least some aspects of the Revised Code. However, several industry spokesmen have responded by pointing out that this statement in itself lacks "proportionality" as in certain industries any application of the Revised Code will be disproportionate.
One approach the FSA have suggested is a tiered system comprising (i) rules all affected firms must comply with, (ii) rules which would be applied in proportion to the size, scale, scope and complexity of the firm and (iii) rules which are applied on a "comply or explain" basis. The CEBS guidance is not much clearer. Rather than setting out simple guidelines on what would be proportional implementation of the Revised Code for various types of firms, the CEBS guidance indicates the factors that a firm may take into account in deciding on the appropriate application of remuneration rules for the firm and for various sub-categories of Remuneration Code Staff. We expect further announcement from the FSA on this aspect of the Revised Code 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% of remuneration to be in shares or share-like instruments could create dilution concerns for existing shareholders. For organisations which are not companies, this rule will require "equivalent non-cash instruments" to be developed such as stock appreciation rights and phantom options.
There is also a concern that increasing the proportion of shares in remuneration could leave to employees pursuing short-term strategies to inflate share value which are not consistent with long-term risk management. In response, Arlene McCarthy MEP, a Vice Chair of the Economic and Monetary Affairs Committee of the European Parliament has indicated in a letter to the Financial Times that some firms will be required to include "tier 1 hybrid securities" (i.e., bonds which are convertible into equity) in their instruments to deliver this balanced remuneration. We are expecting further clarification on this point in the final version of the Revised Code.
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 1 January 2011. In addition the Revised Code will apply to all remuneration paid on or after 1 January 2011 and therefore includes bonuses in respect of work done in 2010. Although the FSA does not expect firms which only come into scope on 1 January 2011 to apply the full range of the Revised Code’s provisions until July 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.
At present, therefore, the only option is for FSA regulated firms that will be caught by the Revised Code, to prepare remuneration policies now that are compliant with the draft code and the CEBS guidance in the hope that such policies will only require minor amendments when the final Revised Code is published.
What To Do Next?
- Determine whether the Revised Code will apply to your organisation
- 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 also those Remuneration Code Staff who could be exempt from certain rules
- Notify any Remuneration Code Staff of the Revised Code 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 regarding performance measures, a split between cash/non-cash payments, deferral of payments, severance payments, discretionary pension payments or guaranteed bonuses
- 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