The UK Financial Services Authority (the FSA) has now published the revised version of its Remuneration Code which applies to a wide range of FSA-regulated businesses with effect from 1 January 2011. The revised code implements key reforms to remuneration practices within a wide range of FSA-regulated entities. This Client Alert 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.
In response to the recent banking crisis, in January 2010 the FSA introduced a Remuneration Code which applied only to the 26 largest banks, broker-dealers and building societies in the UK. A revised version of this code (the Revised Code) was finally published by the FSA on 17 December 2010 and took effect from 1 January 2011. The Revised Code applies to a far wider range of FSA-regulated entities — estimated to be around 2500 firms — and implements some far reaching reforms which will change the way that certain financial services firms can pay their employees.
In our November 2010 Client Alert, we outlined the proposals in the draft Revised Code which, at that time, was still under review. This Client Alert outlines the key aspects of the now-finalised Revised Code and focuses on practical steps that affected employers should be taking now to ensure compliance.
Which Firms Does the Revised Code Apply To?
The Revised Code applies 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 captures a large number of asset managers, investment firms and firms involved in corporate finance, venture capital, the provision of financial advice, brokers and others.
However, the “proportionate” approach to implementation means that there are different levels of compliance required by different “tiers” of firm and certain rules are “neutralised” for certain firms — see below.
In addition, “Exempt CAD” firms (i.e., those FSA-r egulated firms which are authorised to provide investment advice and/or execute or transmit orders without holding any client money or assets) are not subject to the Code.
How Does the “Proportionate” Approach Work?
After much speculation, the FSA have now clarified how the “proportionate” approach to implementation of the Revised Code will work. In-scope firms will be categorised into four tiers with Tier 1 firms having the highest compliance obligations (being largely those large firms to which the 2010 Code applied) and Tier 4 firms having the lowest obligations (being those “limited licence” or “limited activity” firms whose activities present the least risk). The Tiers are defined broadly as follows:- Tier 1 — Largest banks and building societies (capital resources exceeding £1bn); full scope BIPRU £730K firms (capital resources exceeding £750m) and third country BIPRU firms with total assets (for the branch) exceeding £25bn
- Tier 2 — Medium-sized banks and building societies (capital resources between £50m and £1bn); full scope BIPRU £730K firms (capital resources between £100m–£750m); and third country BIPRU firms with total assets (for the branch) between £2bn and £25bn
- Tier 3 — All other banks, building societies and full scope BIPRU firms (including branches) which do not fall into Tiers 1 and 2
- Tier 4 — All BIPRU limited licence and limited activity firms and third country branches with similar permissions
Tiers 1 and 2 are intended to capture the larger banks, building societies and broker dealers who are engaged in significant proprietary and investment banking activities. Tier 3 intends to capture those smaller operations which might occasionally take overnight or short-term risk on their balance sheet whilst Tier 4 is intended to capture those firms that generate income from agency business without putting their balance sheets at risk.
Note that the “neutralisation” of the rules for firms in certain tiers is not necessarily automatic and firms are encouraged to talk to the FSA about their approach. In addition, a group of regulated entities is required to apply the highest Tier standards to all entities within its group unless the FSA agrees otherwise.
Which Employees Will the Revised Code Apply To?
Most of the provisions in the Revised Code apply only to the “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 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. Compliance officers should seek to identify these staff as a matter of priority.
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 as, in respect of exempted staff, firms can then disapply certain rules (including the rules relating to guaranteed bonuses, the requirement for variable remuneration to be paid 50 percent in shares or share like instruments, deferral of variable remuneration and the performance adjustment rule).
Affected firms are required to identify their Remuneration Code Staff and make those individuals aware of their status. For cautious compliance officers, there is clearly a temptation to over estimate who will be included as Remuneration Code Staff and simply treat all employees the same. This approach could seem particularly attractive in a small organisation which, by virtue of being a Tier 4 firm, does not have too may Revised Code rules to apply to its Remuneration Code Staff. However, this approach carries its own risks. As a firm grows and/or takes on new regulated activities it could move up the tiers and be required to apply more of the Revised Code rules to its Remuneration Code Staff. In addition, it is anticipated that future remuneration regulations will define affected employees in the same way (including the AIFM Directive due to come into force later this year — see below). In either situation it will be difficult for firms to justify why someone previously categorised as Remuneration Code Staff when minimal compliance was required, no longer falls into that category when the applicable rules are extended.
The 12 Principles of the Revised Code
The general purpose of the Revised Code is to encourage firms to adopt remuneration policies which promote effective risk management. All in-scope firms must adopt and implement a remuneration policy which complies with the Revised Code. The Revised Code comprises 12 principles which in-scope firms must adhere to through the content and the implementation of their remuneration policies.
The 12 Principles of the Revised Code
Principle 1 — Risk Management & Risk Tolerance
A firm’s remuneration policy should not encourage risk taking that exceeds the regulated firm’s tolerated risk level.
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.
Principle 3 — Avoiding Conflicts of Interest
A firm’s remuneration policy must include measures that are designed to avoid conflicts of interest, including those related to customers’ interests.
Principle 4 — Governance
Firms must ensure that their governing body adopts and periodically reviews its remuneration policy, and firms of a“significant” size should establish remuneration committees. The chair and members of the committee must be independent and not carry out executive functions within the firm. Note that under the FSA’s “proportionate” approach all firms, including those in Tier 1, have some flexibility as to whether a remuneration committee is actually required.
Principle 5 — Risk and Compliance Function
Firms must ensure that remuneration for employees in the risk and compliance functions is adequate, is determined independently (e.g. by a remuneration committee) and is based on achieving the objectives of those control functions. This includes employees in the HR and Legal functions.
Principle 6 — Remuneration and Capital
Firms must ensure that the total variable compensation paid to staff does not limit the firm’s ability to strengthen its capital base. This will require firms to regularly review the whole impact of its remuneration policies — across the organisation — and to ensure that its variable remuneration structures are flexible enough to allow funds to be diverted to build its capital resources.
Principle 7 — Exceptional Government Intervention
Firms which are in receipt of state aid must ensure that any variable remuneration is limited by reference to the firm’s net revenue, aligned with risk management and long-term growth and only paid to senior personnel where justified.
Principle 8 — Profit Based Measurement and Risk Adjustment
Firms must 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. This rule may be disapplied by Tier 4 firms.
Principle 9 — Enhanced Discretionary Pension Benefits
Pension policies must be in line with the company’s business objectives, values and long-term interests. 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.
Principle 10 — Personal Investment Strategies
Firms must put in place arrangements to ensure that their employees do not use personal hedging strategies or insurance policies that undermine the alignment of their remuneration to the firm’s risk.
Principle 11 — Avoidance of the Code
Firms must ensure that variable remuneration is not paid through vehicles or methods that facilitate the avoidance of the Remuneration Code.
Principle 12 — Remuneration Structures
This last principle contains most of the fundamental reforms which regulated employers will have to become familiar with. These proposals are reviewed in more detail below
Principle 12 in Detail — New Rules Regarding the Structuring of Remuneration
Principle 12 of the Revised Code sets out more detailed rules on how remuneration should be structured. The extent to which in-scope firms are required to comply with these rules depends on which “Tier” the firm is categorised in and we have explained in this section which Tier of firm each rule applies to.
- General requirement — remuneration must be consistent with and promote effective risk management. This applies to all in-scope firms.
- Performance measurement — performance based remuneration must be linked to the performance of the individual, business unit and the firm’s results and take account of non-financial criteria. This applies to all firms. In addition, firms in Tiers 1-3 must assess performance on a multi-year framework (i.e. performance targets must take into account performance over a number of years), Tier 4 firms may be able to disapply this multi-year requirement.
- Fixed to variable proportion of remuneration — Firms must specify an appropriate balance between fixed and variable compensation in their remuneration policies. The ratio 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. This rule applies to all firms in Tiers 1-3 but not to firms in Tier 4.
- Proportion paid 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” 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 arrangements 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 below. The FSA has not specified what the retention period should be but has indicated in discussions that six months should usually be sufficient. This rule only applies to firms in Tiers 1 and 2 and those firms have until 1 July 2011 to implement it.
- Deferral — At least 40 percent of a bonus must be deferred 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. Where a bonus is paid in cash and shares, the deferral rules apply to both the cash and the share elements of the bonus. This rule only applies to firms in Tiers 1 and 2 and does not apply to “exempt” Remuneration Code Staff). However, the FSA have indicated that they believe all firms should consider introducing a deferral mechanism to their remuneration practices for all employees.
- 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 or if there is reasonable evidence of employee misbehaviour or material error. Again this rule only applies to firms in Tiers 1 and 2 and does not apply to “exempt” Remuneration Code Staff.
- Guaranteed bonuses — 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. This rule applies to all Firms but can be disapplied in respect of “exempt” Remuneration Code Staff.
- Severance Pay — payments made on early termination of an employment relationship must reflect the employee’s performance over time and must not reward failure. This applies to in-scope firms in all tiers.
- Voiding Provisions — Any contractual provisions which breach the Revised Code will be void. Firms are required to recover payments made to employees in breach of those rules. This applies to in-scope firms in all tiers.
When is Compliance With the Revised Code Required?
The Revised Code has now been implemented, effective 1 January 2011, however certain transitional provisions are in place. Firms which are newly coming into scope (i.e. firms other than the original 26 firms that the 2010 Code applied to) will have until 1 July 2011 to comply with the relevant remuneration structure rules set out in Principle 12 of the Code. In the meantime, newly in-scope firms should take all reasonable steps to comply with the Code including preparing a remuneration policy.
Firms which were covered by the 2010 Code are required to comply with all rules from 1 January 2011 except for the rule requiring Remuneration Code Staff to receive a percentage of their variable pay in shares or share like instruments. This rule must be complied with by 1 July 2011.
Clearly compliance with the Revised Code will generate a number of practical issues for employers. Drafting a remuneration policy which conforms to the Revised Code’s 12 Principles is relatively straightforward but the FSA will expect the policy to be implemented and understood by those affected. The requirement for 50 percent 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. Such plans will need to be carefully drafted to ensure compliance with the deferral and retention rules and also to manage the risk that an income tax liability could arise before the employee is able to benefit from a payment to fund the tax charge.
In addition to designing new remuneration structures that meet the various Revised Code requirements, in-scope firms will have to reconsider their existing remuneration arrangements. Employers who have always enjoyed the freedom to remunerate their employees as they see fit and have entered into contractual arrangements with their employees on that basis, will have to review their existing remuneration commitments, and if necessary, renegotiate them with employees to avoid breaching the Revised Code. Even firms in Tier 4 will have to review any discretionary pension arrangements, guaranteed bonuses or “golden parachutes” and although firms can use the Revised Code as leverage in their negotiations with employees, most employees will expect something in return for giving up such lucrative benefits. There is also a concern that the guaranteed bonus restriction could create a “poacher’s paradise” in which employees are incentivised to leave their existing employment to take up employment with a rival firm that can guarantee the employee’s first year bonus. We have set out on the following page some practical steps to take now.
Coming Soon — More Regulation on the Horizon
Finally, employers that escape the application of some or all of the FSA Revised Code should be aware that further regulation is on the horizon. The Alternative Fund Managers Directive (AIFMD) was adopted by the European Parliament in November 2010 and will come into force in March 2011. European member states will have until 2013 to implement it through local, secondary legislation. The AIFMD will apply to a number of hedge funds, private equity funds and other alternative investment funds (such as investment trusts, venture capital funds, real estate funds and commodity funds). The AIFMD imposes restrictions on the amount and form of remuneration that an alternative investment fund manager can pay senior staff and takes a similar approach to the FSA rules discussed above.
The directive contains an overarching requirement for alternative investment fund managers to have a remuneration policy in place that is consistent with, and promotes sound and effective risk management. The AIFMD also contains similar rules relating to the ratio of fixed/variable remuneration, deferral, performance adjustment, payments being in shares/share like instruments, restrictions on guaranteed bonuses and performance related pay. One issue that is already causing considerable confusion is that under the AIFMD is that “remuneration” will include carried interest and it is not clear how the remuneration principles will apply to carried interest in practice. The European Securities and Markets Authority is required to issue guidelines on the application of the remuneration provisions which should provide further clarity on the extent and application of these new rules.
Practical Steps — What To Do Now?
- Identify whether the Revised Code applies to your organisation? If so, which Tier does your organisation fall into? This will determine which rules will apply.
- Determine whether your remuneration committee or other governing body responsible for remuneration meets the governance standards required by the Revised Code and if not take measures to ensure that it does.
- Prepare a remuneration policy which demonstrates how the firm’s practices adhere to the principles and rules of the Revised Code.
- Identify those employees who could be classified as “Remuneration Code Staff” and also those who could be exempt. Be careful not to list anyone as Remuneration Code Staff unnecessarily.
- 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.
- For Remuneration Code Staff exercising a “Control Function” (e.g. compliance, HR, legal) ensure that there is no potential conflict of interest in the way that their variable remuneration is paid. For example any bonuses dependent on profits from high risk business groups may create a conflict of interest.
- Consider what steps are required to enable bonuses to be paid in shares or other non-cash instruments. Take advice on the drafting and implementation of an appropriate share incentive plans or plans which provide for “share-like” instruments.
- Consider what processes are available to enable the firm to claw back any payments made under the voiding and recovery provisions.