The FSA’s letter to CEOs

Unsurprisingly, given the current financial crisis, the issue of pay and bonuses at banks and other financial institutions is under scrutiny. Criticism of the City bonus culture has been mounting, and on Monday 13 October, as the Government was bailing out three of the UK’s largest banks, the Financial Services Authority (FSA) wrote to the UK’s top banks and building societies. The “Dear CEO” letter (a link to which is attached: http://www.fsa.gov.uk/pubs/ceo/ceo_letter_13oct08.pdf), deals with “inappropriate” remuneration schemes that the FSA, along with many others, believe may have contributed to current financial conditions.

The FSA believes that some investment banking and trading remuneration structures may have given “incentives to staff to pursue risky policies, undermining the impact of systems designed to control risk, to the detriment of shareholders and other stakeholders”. It urges its recipients to review their pay policies and, where necessary, change them.

Currently, the FSA is avoiding being prescriptive; instead, it is seeking to provide high-level criteria against which firms’ policies can be assessed. It already has a “firm view” of what constitutes “bad practices”, which it sets out in an annex to the letter. This is accompanied by its “initial view” of “good practices”.

The FSA letter makes clear that it is not formal Guidance but is an update on its work, already in progress, on remuneration policies. The letter sets out the FSA’s next steps. It has already had high-level discussions with London-based firms, and, before the end of the year, it will make further visits. Early next year it will publish its findings about remuneration structures in the London market, together with firmed up good practice guidance.

Steps to be taken

The FSA’s letter clearly cannot be ignored. Its recipients will need to comprehensively review their remuneration schemes. They will also need to set out to the FSA their findings and proposed actions. Whilst the letter seems to recognise that firms cannot change their approach to remuneration overnight, it does expect them to be moving towards good practice. Further, there are some strong statements about risk management. For example, “If the [remuneration] policies are not aligned with sound risk management, that is unacceptable. Immediate action will be required to change the policies”.

The importance of the FSA’s letter may well extend beyond its recipients at the large banks and building societies. Other firms regulated by the FSA and managing investment risk will read it with interest, particularly as such a letter will tend to set regulatory expectations.

Whilst the FSA’s guidance is still to some extent a work in progress, recipients of the letter, and other firms, should review their current pay policies against the list of good and bad practices provided. Practices to eliminate include:

  • bonuses calculated on the basis of revenues, without any counterbalancing risk controls and without taking risk or capital cost into account; 
  • bonuses calculated solely on the basis of financial performance and for the current financial year only; 
  • remuneration that has little or no fixed component and is paid wholly in cash; 
  • remuneration that does not include performance adjusted deferred compensation; 
  • deferred compensation which is not linked to the future performance of business undertaken in previous years.

The annex to the letter also deals with governance issues, and warns against remuneration processes which are not transparent and which are not independently overseen.

Employment law issues?

In recent years many firms have in any event been moving away from the “bad practices” identified by the FSA. This has mainly been for commercial reasons. Few employers want to pay the whole of a bonus in cash, and deferred compensation is popular to retain talent and to align the interests of the individual with those of the business. Nevertheless, certain firms will, as a result of the FSA letter, identify the need for a change in remuneration policies. In these circumstances employment law issues may come into play.

Changing a contractual bonus scheme to the employee’s detriment, without his/her consent, could result in a claim for breach of contract. The employee could also claim the breach is so fundamental that it entitles him/her to resign and claim constructive dismissal. It would of course assist the employer’s defence if it could show that changes to the scheme are in response to FSA guidance. However, in order to avoid unfair dismissal liability, the firm would have to follow a fair procedure and consult fully with employees about the changes.

It would however be unusual for the type of bonuses targeted by the FSA to be contractual. If bonuses, or the terms under which they are made, are genuinely “discretionary”, breach of contract issues should not arise. It would still be possible for an employee to argue that the employer had exercised the discretion capriciously or in bad faith. However, such a claim would be unlikely to succeed where the employer had taken into account FSA guidance.

Where, to comply with FSA guidance, discretion under a bonus scheme is to be exercised in a different way, it would be sensible for the firm to be explicit about this and set out the new criteria. This would be in line with the recent trend, now set to continue, moving away from purely discretionary bonuses and towards well-designed transparent schemes. Not only do these kinds of schemes make it easier to justify bonuses, but also they may be more attractive to employees (who will know better where they stand). In addition, they should reduce the risk of costly employment claims, particularly in the arena of equal pay and discrimination, which tend to arise where there is secrecy surrounding pay schemes.

Conclusion

Given the current political climate and the poor performance of many institutions, we are, with or without FSA intervention, going to see City bonuses seriously reduced. Job losses mean there is also going to be a wider pool of talent from which to recruit and less competition on pay generally. The “Dear CEO” letter, and the further action expected from the FSA, may ultimately prove helpful to employers, including in terms of managing employees’ expectations. The letter does not signal the end of the City bonus culture; rather it provides guidance as to how it may survive, albeit in a different (and certainly less excessive) form.