The European Securities and Markets Authority (‘ESMA’) has published Guidelines on Sound Remuneration Policies under the Alternative Investment Fund Managers Directive (‘AIFMD’)1. The underlying aim is to move the financial services industry away from a culture of financially incentivised risk-taking by key staff members.
The AIFMD was approved by the Council of Ministers on 17 November 2010 and published in the Official Journal on 1 July 2011. The deadline before which the Member States are expected to have transposed the AIFMD into national law is 21 July 2013.
The AIFMD is a response to the problems arising from the economic crises that have arisen since 2008. European political leaders wanted to establish a framework to address and monitor the potential risks that might arise from the activities of alternative investment fund managers (‘AIFM’). The AIFMD also provides for a harmonised EU passport regime that will allow AIFM to provide services and market their products across the EU. It is hoped that in time the AIFMD brand will become as successful as the UCITS brand especially in a post-Madoff market where investors have become more cautious and seek to minimise risk to their investment. The AIFMD will apply to2:
- EU AIFMs that manage one or more AIFs, whether or not those AIFs are EU AIFs or non-EU AIFs;
- Non-EU AIFMs that manage one or more EU AIF; and
- Non-EU AIFMs that market one or more AIFs in the EU, whether or not those AIFs are EU or non-EU AIFs.
One of the areas addressed by the AIFMD is that of remuneration. Accordingly, as provided for under Article 13(2) of the AIFMD, ESMA published Guidelines on Sound Remuneration Policies under the AIFMD on the 28 June 2012 (the ‘Guidelines’)3. The publication of these Guidelines opens up a consultation process that will conclude on 27 September 2012. The final report is expected to be published before the end of 2012. The aim is to have these Guidelines applied in the industry before the deadline for the transposition of the AIFMD into the laws of member states on 22 July 2013.
These Guidelines are part of a number of initiatives by political leaders to move the financial services industry away from a culture of financially incentivised risk-taking by key staff members to a culture where financial reward is based on the performance and risk profile of the alternative investment fund (‘AIF’) under management and the activities of the individual concerned. This change from a quantitative to a qualitative assessment of performance and remuneration of key staff will ensure the protection of investors, increased transparency and enhanced market stability. However, it must be noted that the AIFMD does have critics who argue that it merely papers over the cracks and will actually result in funds and jobs leaving the EU to relocate elsewhere.
It remains to be seen if the AIFMD will result in a flight of funds and key staff outside Europe but it is suggested that this will not occur simply due to the scope of the AIFMD itself and, from a business perspective, the importance of the domiciliation and marketing of funds within the EU.
The Remuneration Policy
Under the Guidelines, the AIFMs will be obliged to create and maintain a remuneration policy based on the following principles4:
- measures must be taken to avoid conflicts of interest;
- The governing body must periodically review the policy and they are responsible for ensuring that it is applied in accordance with the Guidelines;
- The application of the policy must be subject to a central and independent review on at least an annual basis;
- guaranteed bonuses should only occur in exceptional situations and even then should only be offered during the first year of service for new staff;
- any payment that is made following the termination of a contract must reflect the performance of that individual. It should not be an automatic payment that may even reward failure;
- there should be an appropriate balance between fixed and variable remuneration. In addition, the governing body should retain sufficient flexibility to ensure that they can pay no variable remuneration. The practical implication of this may make it necessary to increase the standard pay of certain key staff and reduce bonus schemes;
- if variable remuneration is to be paid, at least 50% must contain non-cash remuneration, such as shares or units in the AIF. This is designed to ensure that the AIFM, the AIF it manages, the key staff and investors all have shared interests. In addition, at least 40% of the variable remuneration should be spread out over the life cycle of the AIF for a period of at least three to five years unless the life cycle of the AIF concerned is shorter. Indeed, if the variable remuneration is particularly high, at least 60% of the variable remuneration should be similarly spread out. No guidance is provided as to what would amount to particularly high variable remuneration;
- variable remuneration must only be paid if the AIFM is in a position to pay it; and
- AIFMs that are significant in terms of their size, the size of the AIFs they manage, their internal organisation, along with the nature, scope and complexity of their activities must establish a remuneration committee. The members of the remuneration committee must be non-executive members of the governing body.
Identified Key Staff
It can be noted that the Guidelines do go further that the current requirements in many Member States5 as the following is a list of the staff that such a policy would apply to on the basis that they have a material impact on the AIFM’s risk profile: members of the governing body;
- senior Management;
- persons holding control functions;
- staff responsible for portfolio management, administration, marketing and human resources;
- other risk takers whose professional activities exert material influence on the AIFM or AIFs’ risk profile. This would include persons who are capable of entering into contracts and making decisions that materially affect the risk profile of the AIF or AIFM it manages; and
- other members of staff whose remuneration takes them into the same earnings bracket as senior managers or risk takers and whose professional activities have a material impact on the risk profile of the AIF or AIFM.
This will have a major impact on AIFMs which will need to create and implement a policy that will apply to a large proportion of their staff, while also justifying to national regulators why some staff are to be identified as ‘key staff’ but others not. ESMA has responded to concerns expressed in certain quarters6 that AIFM staff who are owner-managers will be classified as key staff by stating that such structures would not fall with the scope of the Guidelines. The reason for this is due to the fact that the interest of the owner-manager in the success of the fund is aligned with the interests of the investor. In other words, if the investors incur a loss, so will the owner-manager and in this way it is felt that they are more in tune with the risks associated with any investment as they would suffer a personal loss if the investments incur a loss.
The Proportionality Requirement
The governing body of the alternative investment fund (‘AIF’) are obliged under Article 13(1) AIFMD to create and implement a sound and prudent remuneration policy that they will be required to apply in a proportionate manner and they must also ensure that the policy cannot be easily circumvented. However, the policy also needs to be flexible enough to ensure that it is appropriate in the circumstances7. In determining what is appropriate in the circumstances, the governing body will have regard to the size, internal organisation and nature of the fund, along with the scope and complexity of the activities carried out by key staff who either have or could have an impact on the risk profile8 of the fund. It is also possible for different policies to be applied to different staff.
There is no further guidance on the proportionality requirement of the policy, which is a concern for both AIFMs and national regulators alike as a large part of regulating and monitoring the remuneration policies will involve analysing them to determine if they are proportionate. As a result, there is a need for clear guidance on this matter as the current guidance provided, which essentially states that the larger the AIFM and AIF, along with the greater complexity of products it markets, then the more detailed remuneration policy must be, is perhaps overly simplistic. In particular it raises questions as to what is a large AIFM or AIF and how complex the products it markets need to be. It may the case that the final report will contain greater detail in this regard, such as a scale that would be used as a general guide to assist AIFMs or AIFs.
Emphasis on Sound Corporate Governance
Under the Guidelines, the governing body of the AIF, acting on the advice of its’ remuneration committee, will not only need to create and implement the policy but also to develop objective procedures surrounding the policy. These objective procedures should include the development of a clear paper trail.
As one of the aims of the Guidelines is to ensure greater transparency, AIFMs will be obliged to disclose their remuneration policy and procedures in their annual report to regulators in each Member State. The national regulator will not access or evaluate the policy itself but rather how that policy is implemented, the criteria used to identify which staff are “key staff” within the meaning of the guidelines and whether the policy is applied in a proportionate manner. However, it is interesting to note that even a non-EU AIFM which relies on the private placement route to the EU market will still be required to make such disclosures even though they will not be subject to any other requirements under the Guidelines until at least 2018. In addition, AIFMs that are entitled to avail of the exclusions and exemptions in Articles 2 or 3 of the AIFMD are also not subject to the Guidelines.
Following on from the framework provided in Article 22(2)(e) and (f) of AIFMD, Box 107 of ESMA’s technical advice to the European Commission on implementing the AIFMD9 sets out the content and format of the disclosure that must be contained in the annual report. The AIFM is obliged to provide the following information for each EU AIF it manages and non-EU AIF if markets in the EU:
- The total amount of remuneration for the financial year. This figure would include fixed and variable remuneration, the number of staff and any carried interest that was paid by the AIF; and
- A break-down analysis of the total remuneration figure into senior management and all other staff whose actions have a material impact on the risk profile of the AIF.
Furthermore, the remuneration policy and procedures will need to be disclosed publicly, which is intended to increase transparency and accountability.
These requirements show a clear intention to ensure a good standard of corporate governance, transparency and accountability, especially as some AIFs and AIFMs may be regulated and/or established in jurisdictions that traditionally may be viewed as not having an equivalent standard.
AIFMs that are also categorised as a MiFID investment firms are already subject to similar requirements under the EU Capital Requirements Directive since 1 January 201110, while it is also expected that ESMA will publish draft MiFID remuneration guidelines in Q3 of 2012. However, it should be noted that the structure of remuneration in AIFM compared to banks and financial institutions is different as a fund manager and investors generally share a common interest in ensuring that the performance of the fund is maximised and the risks minimised. For example, private equity funds commonly provide for carried interest to be deferred until the fund reaches a certain level of performance, while hedge funds typically only charge a performance fee once a certain level of performance is attained. Accordingly, it could be argued that in certain instances the aims of the Guidelines might already be met in such scenarios without having to incur the administrative burden of creating and implementing a remuneration policy.
These Guidelines are to be welcomed as they are one of the many initiatives aimed at protecting investors and avoiding conflicts of interest in the financial services industry.
On a wider level, these Guidelines will be one of the measures that should assist with ensuring market stability. However, while there is nothing unexpected in the Guidelines, the creation and implementation of such a policy will create challenges for the governing bodies of AIFs not just in terms of ensuring compliance with the Guidelines but also in terms of ensuring compliance with their obligations under employment law as many of their key staff will already have contracts that may objectively be said to financially incentivise risk-taking, especially if a large portion of their remuneration is variable remuneration. Indeed, it may well be the case that the beneficial effect of these Guidelines may not be seen for many years to come as their real aim would appear to be to change the culture of remuneration in the financial services industry in the future rather than remedying what many perceive to be the mistakes of the financial services industry in the past.
Finally, the Guidelines do not provide sufficient detail of exactly what is required by AIFM or AIF but perhaps this will be remedied when the consultation process is completed and the final report is published, which is expected to be before the end of 2012. In this sense, these Guidelines can be viewed as a good starting point that needs further clarification.