Yesterday afternoon it was announced that the UK Government has launched a legal challenge in the Court of Justice of the European Union against the cap on variable remuneration introduced by the new capital requirements directive ("CRD IV").

Although this may ultimately result in the cap being overturned, the UK may nonetheless have to implement the provisions in the interim, and in which case, those affected will be hoping that the decision of the Court of Justice is reached before the 2015 bonus round when the bonus cap is likely to bite.

The announcement makes clear that the Government believes that real improvements in the alignment of bankers’ pay with risk and performance have already been made, and that the proposed bonus cap would undo this good work by forcing banks to increase salaries and therefore fixed costs.  These views have been widely expressed across the UK financial services sector, and it will be welcome news that the Government has now acted on these concerns.

The challenge focuses on the legal basis for the bonus cap, but also highlights other issues including a challenge to the extra-territorial effect of the cap, the lack of a proper consultation and impact assessment, and that the powers delegated to the European Banking Authority go beyond developing technical standards to formulating policy.

What does this mean for firms subject to the cap?

The Government's announcement states that "Given our obligations under European law, Britain will still be implementing the remuneration provisions in CRD4."

It is likely to take at least a year before the outcome of the UK's challenge is known. The Prudential Regulatory Authority will therefore need to act in the interim, given that the cap is required to be implemented from 1 January 2014 and is expected to first affect bonuses in 2015. Earlier this week there were indications that the PRA will likely consult on the implementation of the cap in the coming weeks.

If a decision in favour of the UK were to be reached before the 2015 bonus round, affected banks, building societies and in-scope investment firms might avoid the cap entirely, although if the decision takes longer they may be caught in respect of at least one performance round.

Given the possibility of the bonus cap still coming into effect (either temporarily or permanently) those affected need to continue to plan their responses. However, the approach taken will now need to build in flexibility to deal with the different possible scenarios.

The UK's challenge: some more detail

Full details of the UK's submission to the Court of Justice are not yet available. The next step is that the Court would be expected to release the name and case number, possibly along with some limited information. Further information may then become available when details of the challenge are published in the Official Journal in a few months' time. The Court documents would, however, normally not be made publically available.

We understand that the Government's application questions the legal basis for the bonus cap. The CRD IV directive was introduced on the basis of Article 53(1) of the Treaty on the Functioning of the European Union ("TFEU"), aimed at securing freedom of establishment, but there are arguments that the bonus cap goes far beyond this aim and is instead aimed at imposing and harmonising limitations on pay. This outcome has been subject to questions ever since the bonus cap was proposed, given that Article 153 of the TFEU sets out the areas in which minimum requirements across member states can be adopted, but expressly states that this power does not apply in respect of pay.

The announcement also highlights the Government's concern over the level of power that has been delegated to the European Banking Authority to develop binding standards. Critically, the EBA's proposed standards on which staff will be deemed to be risk takers, and so subject to the bonus cap, will potentially lead to a dramatic increase in number of affected staff: the British Bankers' Association response to the EBA consultation suggested that the increase may be more than twenty-fold from the current numbers of Code Staff. Firms and representative bodies have already been questioning the EBA's proposal, given that whilst the CRD IV text applies the bonus cap to individuals who have a material impact on risk, the EBA's standards would impose mandatory tests that would catch staff irrespective of their actual impact on risk.