This article is an extract from The Executive Remuneration Review, 11th Edition. Click here for the full guide.
Over the past year, there have been various European Union legislative and regulatory changes impacting executive remuneration, with a particular focus on developing the regulatory framework that supports the regulatory regimes impacting remuneration within EU-regulated credit institutions and investment firms.
These changes build on the existing extensive legislative framework that regulates executive remuneration, including the financial services rules that regulate remuneration within credit institutions, investment firms, asset managers, insurers and reinsurers; rules on share dealing and market abuse, corporate governance pay disclosure and voting requirements; laws regulating the offer of securities; and data protection rules. EU-wide regulation on each of these topics is intended to ensure a consistent approach throughout all EU Member States, creating a 'level playing field' across businesses and EU Member States.
This chapter is not intended to be comprehensive but will alert readers to relevant issues and developments that they should be aware of.
II Wider areas of EU regulation impacting executive pay
i Share dealing and market abuse
The Market Abuse Regulation (MAR)2 came into effect on 3 July 2016 and reformed the EU market abuse regime. Much of MAR focuses on general market abuse issues, such as insider dealing and market manipulation. However, the rules also impact executive remuneration. MAR includes notification and disclosure requirements for persons discharging managerial responsibilities (PDMRs) working within issuers linked to EU traded securities and for persons closely associated with a PDMR (PCAs).
The rules include requirements for PDMRs and PCAs to notify the issuer and the relevant competent authority within three business days of every transaction conducted on their own account relating to EU traded shares or debt instruments, or linked derivatives, of that issuer. The issuer must notify the market within two business days of being notified by the PDMR or PCA. The rules also provide for 'closed periods' during which PDMRs cannot deal in securities of the issuer, as well as prohibitions on dealing in securities when holding inside information, both subject to limited exemptions.
ii Corporate governance
In 2007, the EU published the Shareholder Rights Directive (SRD).3 The SRD aims to improve corporate governance in EU companies traded on regulated markets by enabling shareholders to better exercise voting rights across borders. The rules cover a wide range of formalities for general meetings, including minimum notice periods, information requirements and voting rules.
The SRD was amended in June 2017.4 The amendments established a range of corporate governance rules, including an obligation for companies to publish a directors' remuneration policy subject to a shareholders' vote. EU Member States may determine whether this vote is binding or advisory, but a vote must be held whenever the policy is amended and at least every four years. Companies must also publish a clear and understandable directors' remuneration report annually, which is subject to an advisory shareholders' vote.
iii Securities laws
The offer of securities to the public within the EU is governed by the EU Prospectus Regulation (EUPR),5 which replaced the EU Prospectus Directive on 21 July 2019. Under the EUPR, a prospectus is required for an offer of securities unless an exemption applies.
An offer of securities by a company to existing or former employees or directors within its group will be exempt from prospectus requirements under an employee exemption, provided that a document is made available to individuals containing information on at least the number and nature of the securities and the reasons for, and details of, the offer or allotment.
iv Data protection
The General Data Protection Regulation (GDPR)6 entered into effect on 25 May 2018. The GDPR gives individuals greater rights in relation to the processing of their personal data and has widespread application wherever personal data processing takes place. Executive remuneration structures will be caught by the GDPR. Businesses based in the EU or with employees in the EU will need to ensure that their remuneration structures are compliant with the GDPR.
III Rules for credit institutions
The EU adopted the Capital Requirements Directive (CRD) III in 2010,7 establishing the majority of the rules that regulate remuneration within EU-regulated credit institutions and certain investment firms. The scope of the CRD remuneration rules was expanded with the publication of CRD IV and the Capital Requirements Regulation (CRR) in 2013.8
The CRD regime underwent further amendment as a result of the publication of CRD V and CRR II.9 CRD V had to be implemented by EU Member States by 28 December 2020, and CRR II applied directly from 28 June 2021. At a high level, CRD V and CRR II continue to regulate remuneration within EU-regulated credit institutions but now apply only to the largest and most systemically important investment firms.
The CRD and CRR rules must be read in conjunction with the remuneration guidelines published by the European Banking Authority (EBA) that clarify regulatory expectations on the application of the remuneration rules. These guidelines were originally published in 2016 but have been updated to reflect the recent legislative changes, with the revised guidelines applying from 31 December 2021.10
Although some of the rules apply on a firm-wide basis, a number of rules apply only to staff members whose professional activities have a material impact on the firm's risk profile (known as identified staff or material risktakers), which would include, for example, the firm's management body and senior management. The EU published updated regulatory technical standards in June 2021 to clarify which staff members should and must be caught by these rules.11
The CRD remuneration rules are extensive and, for example, require that:
- performance-related remuneration must be assessed over a multi-year framework and be based on a combination of the assessment of individual performance (both financial and non-financial criteria), business unit performance and the firm's overall results;
- guaranteed bonuses must be exceptional, occur only when hiring new staff and where a firm has a sound and strong capital base, and be limited to the first year of employment;
- variable remuneration cannot exceed 100 per cent of a material risktaker's fixed remuneration, or 200 per cent where qualified shareholder approval is given, although a discount rate of up to 25 per cent can be applied in limited circumstances;
- termination payments must reflect performance achieved over time and not reward failure or misconduct;
- remuneration relating to compensation or buyout from contracts in previous employment must align with the firm's long-term interests;
- at least 50 per cent of variable remuneration must be delivered in shares or certain other permitted instruments;
- between 40 and 60 per cent of variable remuneration must be deferred for at least four to five years and must be aligned with the nature of the business, its risks and the activities of the staff member, vesting no faster than on a pro rata basis;
- variable remuneration must be paid or vested only if it is sustainable according to the firm's financial situation and is justified based on performance. Firms must set adjustment mechanisms, including malus (to reduce or forfeit unvested variable remuneration) and clawback (to recover paid or vested variable remuneration);
- any instruments awarded must be subject to an appropriate retention policy designed to align incentives with the firm's longer-term interests; and
- staff must not use personal hedging or insurance that undermines the risk alignment effects of the rules.
The CRD rules also contain a number of requirements that relate to pay governance and policy, including, for example, that the remuneration policy and practices must be gender-neutral, that control functions must be remunerated independently of the performance of the business areas that they control and that certain significant firms must establish a remuneration committee.
A key concept of the CRD is the proportionality principle that enables certain firms and individuals to be excluded from the application of the requirements to pay a portion of variable remuneration in instruments and to defer a portion of variable remuneration where the firm or individual complies with certain requirements, such as asset and remuneration thresholds, as relevant.
The CRR sets out substantive disclosure rules, requiring the public disclosure of qualitative and quantitative remuneration information. The qualitative disclosures include information about the decision-making process for determining the remuneration policy, information about the link between pay and performance, and the most important remuneration design characteristics. The quantitative disclosures are broken down by business area and material risktaker category and include: (1) amounts of fixed and variable remuneration, (2) amounts and forms of variable remuneration, (3) amounts of deferred remuneration awarded during the financial year, and (4) amounts of sign-on and severance payments awarded. Firms are also required to disclose certain information relating to the application of the proportionality principle.
IV Rules for investment firms
Investment firms were previously regulated under the CRD and CRR regime (see above). This was criticised as being inappropriate and disproportionate for the business models and risks associated with investment firms. As a consequence of this, the EU introduced a prudential regime for investment firms, comprising the Investment Firms Directive (IFD) and Investment Firms Regulation (IFR).12 The IFD had to be implemented by EU Member States by 26 June 2021 and the IFR applied directly from that date.
The EBA recently published guidelines on the application of the requirements on remuneration policies for investment firms. These guidelines applied from 30 April 2022.13
Similar to the CRD, although certain remuneration rules apply firm-wide, some requirements apply only to those categories of staff whose professional activities have a material impact on the risk profile of the investment firm or of the portfolios managed, which, for example, includes the firm's management body and senior management. In January 2021, the EU published a final draft of the regulatory technical standards that would be used to clarify which staff members should and must be caught by these rules. It is not known when the regulatory technical standards will come into effect.14
Each investment firm will fall into one of three categories. The first category, the largest and most systemically important investment firms, will be subject to the CRD and CRR remuneration rules. The second category, consisting of 'small and non-interconnected' investment firms, as determined by reference to set criteria, will be subject to only a few general remuneration requirements. The third category, which consists of firms that are not caught by either of the other categories, will be subject to the full remuneration rules under the IFD and IFR.
The IFD remuneration rules are broadly similar to those under the CRD, with a few notable differences, such as (1) there is no prescribed ratio between fixed and variable remuneration (instead, firms must set their own appropriate ratio between fixed and variable remuneration, and EU Member States are given the discretion to set their own local prescribed ratios, if they choose to do so), (2) the requirement to award at least 50 per cent of variable remuneration in prescribed instruments includes the ability to award non-cash instruments that reflect the instruments of the portfolios managed, and (3) variable remuneration must be deferred over a period of three to five years, instead of four to five years.
Investment firms are also subject to rules regulating remuneration governance and policy. These requirements are broadly similar to those under the CRD. A notable difference is that firms with a remuneration committee must ensure that the remuneration committee is gender-balanced.
Similar to the CRD rules, the IFD rules contain a proportionality principle that enables certain firms and individuals to be excluded from the application of the requirements to pay a portion of variable remuneration in instruments and to defer a portion of variable remuneration where the firm or individual complies with certain requirements, such as asset and remuneration thresholds, as relevant.
Investment firms are also subject to public remuneration disclosure requirements. The quantitative, qualitative and proportionality principle disclosure obligations under the IFR are broadly comparable with those under the CRR II, although certain requirements are not replicated in the IFR, meaning that the disclosure burden is lower for investment firms.
V Rules for asset managers
i Alternative Investment Fund Managers Directive
Firms authorised under the Alternative Investment Fund Managers Directive (AIFMD)15 will be subject to remuneration rules implemented in 2013, as supplemented by remuneration guidance published by the European Securities and Markets Authority (ESMA) in 2013, as amended in 2016.16
The remuneration rules apply to all EU-regulated alternative investment fund managers (AIFMs), including managers of hedge, private equity, venture capital, commodity, infrastructure and real estate funds. Similar to the CRD and IFD, although some rules apply on a firm-wide basis, a number of requirements apply only to the remuneration of those categories of staff whose professional activities have a material impact on the risk profile of the AIFM or of the funds that they manage, including, for example, senior management.
The AIFMD remuneration rules broadly align with the CRD rules, with certain key differences, including, for example: (1) there is no prescribed ratio between fixed and variable remuneration, (2) the minimum non-cash instrument requirement must be satisfied using units or shares of the fund concerned or certain other permitted instruments, and (3) the minimum deferral period is three to five years and must be appropriate in view of the life cycle and redemption policy of the fund concerned.
As with the CRD, certain AIFMs must establish a remuneration committee. In terms of disclosure, any AIFM seeking to obtain authorisation under the AIFMD must disclose details of its remuneration policies and practices to its regulator and must also, annually, disclose specific remuneration information for the funds it manages and markets.
ii Undertakings for the Collective Investment in Transferable Securities Directive
Firms authorised under the Undertakings for the Collective Investment in Transferable Securities Directive V (UCITS V)17 will be subject to remuneration rules implemented in 2016 that broadly align with the corresponding rules under the AIFMD (see above). The remuneration rules are supplemented by remuneration guidance published by ESMA in 2016.18
UCITS V applies to undertakings for collective investment in transferable securities (UCITS) and their management companies. Similar to the CRD, IFD and AIFMD, although some remuneration rules apply firm-wide, some rules apply only to the remuneration of those categories of staff whose professional activities have a material impact on the risk profile of the UCITS management company or of the UCITS that they manage, including, for example, senior management.
Similar to AIFMD, the UCITS V rules broadly align with the CRD rules, with certain key differences, including, for example: (1) there is no prescribed ratio between fixed and variable remuneration, (2) the minimum non-cash instrument requirement must be satisfied using units or shares of the UCITS concerned or certain other permitted instruments, and (3) the minimum deferral period is three years.
As with the CRD, IFD and AIFMD, certain UCITS management companies must establish a remuneration committee. UCITS V also requires certain disclosures to be made, including, for example, a requirement for the UCITS prospectus to detail the remuneration policy, methods of remuneration calculation and information about those responsible for remuneration.
VI Rules for insurers and reinsurers
Insurance and reinsurance businesses are subject to the remuneration rules set out in the Solvency II Regulation,19 supplementing the Solvency II Directive,20 as supplemented by the European Insurance and Occupational Pensions Authority's corporate governance guidance.21
Under the remuneration rules, an insurance or reinsurance undertaking must adopt a written remuneration policy. The policy must promote sound and effective risk management and must not encourage risk-taking that exceeds the risk tolerance limits of the undertaking. The policy must apply to the undertaking as a whole and contain specific arrangements that take into account the tasks and performance of the administrative, management and supervisory body, persons who effectively run the undertaking or have other key functions, and other categories of staff whose professional activities have a material impact on the undertaking's risk profile.
The remuneration provisions are not as stringent as under other sets of rules. There are, however, wide-ranging requirements, including the requirement to establish an independent remuneration committee; the requirement for an appropriate balance of fixed and variable remuneration; the requirement for the measurement of performance-related variable remuneration to be based on the performance of individuals, the relevant business unit and the overall results of the undertaking; and the requirement for a minimum deferral period of three years.
VII Rules for sales incentives
In December 2016, the EBA published guidelines on remuneration relating to the sale and provision of retail banking products and services. In 2017, the EU published a regulation22 that supplemented the Markets in Financial Instruments Directive II (MiFID II)23 and set out remuneration rules for all persons who could impact service provision or firm corporate behaviour within firms providing investment services, including front office, sales or other staff indirectly involved in providing investment or ancillary services. The MiFID II provisions and EBA guidance cover similar points.
When providing sales incentives, firms should generally ensure that they:
- do not remunerate or assess performance in a way that conflicts with duties to act in clients' best interests;
- do not use remuneration structures or sales targets that could provide incentives to recommend a particular financial instrument to a retail client when the firm could offer a different financial instrument that would better meet the client's needs;
- design and implement remuneration policies that have appropriate criteria to be used to assess performance, including qualitative criteria encouraging acting in clients' best interests;
- define and implement remuneration policies and practices under internal procedures that take account of the interests of all clients of the firm, ensuring that clients are treated fairly and their interests are not impaired by remuneration practices adopted in the short, medium or long term;
- do not create remuneration policies that create a conflict of interest or incentives that may lead relevant persons to favour their own interests or their firm's interests to the potential detriment of any client; and
- ensure that remuneration and similar incentives are not solely or predominantly based on quantitative commercial criteria, and instead take into account appropriate qualitative criteria reflecting compliance with the applicable regulations, the fair treatment of clients and the quality of services provided to clients.
The MiFID II rules also require that the management body approves the firm's remuneration policy and that senior management takes responsibility for day-to-day policy implementation and for monitoring compliance risks.
A more recent set of rules impacting sales incentives is the Insurance Distribution Directive (IDD),24 which took effect from 1 October 2018. Under the IDD, insurance distributors must not be remunerated, or remunerate or assess the performance of their employees, in a way that conflicts with their customers' best interests. In particular, remuneration arrangements or sales targets must not provide an incentive to recommend a particular insurance contract where a different insurance contract is available that could better meet a customer's needs.
VIII ESG and executive remuneration
Environmental, social and governance (ESG) topics and risks relating to ESG topics continue to be subject to significant regulatory and investor focus around the world. The EU has been particularly active in this space, implementing a range of sustainability-related measures, including, of particular importance to remuneration, the Sustainable Finance Disclosure Regulation (SFDR), which took effect on 10 March 2021. Among other requirements, the SFDR requires a broad range of financial services firms to set out in their remuneration policies information on how those policies are consistent with the integration of sustainability risks, and requires that information to be published on a firm's website.25
In 2021, the EBA also published a report setting out proposals to further align remuneration within credit institutions and investment firms to ESG risks.26 The EBA will use the report as a basis for the development of guidelines on the management of ESG risks by firms and the supervision of ESG risks by regulators.
IX Conclusion and outlook
The regulation of executive remuneration continues to attract scrutiny from EU regulators and legislators across all sectors. We expect to see the regulatory and legislative landscape surrounding executive remuneration to continue to develop over the coming years, with a particular focus on how businesses align executive remuneration to ESG topics and risks, particularly in relation to ESG topics such as climate change and diversity.
The financial services sector has remained the key focus for EU regulators and legislators, with substantive changes to the regulatory regimes for credit institutions and investment firms in recent years, and with a broad range of financial services firms being required to comply with ESG-related disclosure requirements. This primary focus on financial services will partly stem from the political appetite to carefully manage risk within the financial services sector, also recognising that financial services have a significant role to play in mitigating certain ESG risks, particularly in relation to climate change.
It is yet to be seen whether the current challenging economic environment will result in more wide-ranging regulation of pay at an EU level, particularly from a corporate governance perspective. We have seen increased scrutiny of executive pay by shareholders across a broad range of sectors, including as a result of the covid-19 pandemic, and it is possible that this will translate into regulatory or legislative activity to deal with any perceived deficiencies in the current EU corporate governance framework.