Important restrictions on remuneration imposed by the fourth amendment to the EU Capital Requirements Directive1, commonly known as CRD IV, which imposes, among other things, a cap on bonuses in the financial sector, have recently been implemented in Ireland (on 31 March 2014), will be of key relevance to banks and firms working in the financial services industry.
These new rules build on the rules implemented in Ireland as part of CRD III in 2011, but the most noteworthy change is the implementation of a maximum cap on bonuses payable in certain firms. This change is very likely to significantly change remuneration policies in such firms and will require such firms to carefully consider their remuneration structures in order to reward high performers, attract new hires and retain key staff, whilst ensuring that in doing so, the remuneration structure does not reward excessive risk taking.
The remuneration provisions contained in CRD IV seek to ensure that credit institutions and investment firms (“Firms”) have sound remuneration policies, which reflect effective risk management and performance, without encouraging unjustified risk taking; are in line with the Firm’s business strategy, objectives, values and long-term interests; and incorporate measures to avoid conflicts of interest. Such policies must be periodically reviewed by the Firm’s management body by reference to these principles and as to the manner of implementation of the policy.
CRD IV also provides that staff engaged in ‘control functions’ must be remunerated in a manner independent of the business unit which they oversee. The remuneration of senior management should be overseen by the Firm’s remuneration committee or, if none, by the board. Whereas fixed remuneration should primarily reflect relevant experience, qualifications and responsibility; variable remuneration should reflect a sustainable and risk adjusted performance, as well as performance in excess of that required to fulfil the employee’s job description.
In order to avoid excessive risk taking, the CRD IV rules provide that a maximum ratio between the fixed and variable component of the total remuneration should be set. The rules set the base ratio between fixed and variable remuneration at 1:1, such that an individual’s bonus could not exceed their fixed remuneration. Member states could allow this ratio to be increased to 1:2 with the approval of shareholders, and Ireland has allowed for the possibility of such an increase.
The standard for obtaining shareholder approval is very high and effectively requires a super majority (66% majority from shareholders representing a quorum of at least 50% of the voting shares and if that quorum is not reached, then a 75% majority is required). Up to 25% of variable pay can be discounted for the purposes of calculating the bonus cap if it is paid in instruments that are deferred for a period of not less than five years (to result in an effective ratio of more than 1:2). If more than 25% of the bonus is paid in this way, any excess over the 25% will not benefit from the discount. The European Banking Authority (“EBA”) has published guidelines on the type of long-term instruments that can be used and on the applicable discount rate to apply to such long-term instruments.
CRD IV requires specific steps to be taken in order to obtain shareholder approval, including providing shareholders with a detailed recommendation which sets out the reasons for and the scope of the approval sought the number of staff affected, their functions and the expected impact on the Firm’s capital base. Staff who may benefit from any increased ratio will not be allowed to exercise, directly or indirectly any voting rights they may have as shareholders in the Firm. The Firm must, without delay, inform the Central Bank of the decision by its shareholders, including any approved maximum ratio.
Which Firms will be Affected?
The CRD IV rules will apply to all credit institutions and investment firms (within the meaning of Article 4 (1) of the Markets in Financial Instruments Directive). The rules apply to EU based financial institutions at parent company and subsidiary levels, including staff of EU based institutions working outside the EEA.
Which Employees will be Affected?
The CRD IV rules apply to senior managers, risk takers, staff in control functions and any employee whose total remuneration takes them into the same bracket as senior managers and risk takers, whose professional activities have a material impact of the Firm’s risk profile.
In this regard, new EU Commission Regulations, which were been published on 4 March 2014, provide greater guidance on those employees covered by CRD IV. It has provided "qualitative criteria" (eg if the staff member is responsible for legal affairs, economic analysis or has authority regarding matters which represent 0.5% of the institution's Tier 1 capital and are at least €5m) as well as "quantitative criteria" (eg if the staff member is within the 0.3% of number of staff who have been awarded the highest total remmuneration in the preceeding financial year.)
Other Key Remuneration Provisions of CRD IV
Apart from the cap on variable pay, the other provisions of CRD IV in respect of remuneration will have less significant impact as they reflect to a significant degree the existing requirements of CRD III. Key changes include:-
Clear Distinction between Fixed and Variable Pay
The Firm’s remuneration policy must make a distinction between the criteria used for setting basic fixed remuneration and variable remuneration.
Payments on Early Termination
Payments relating to early termination of employment should reflect performance agreed over time and should not reward failure or misconduct.
Non-Cash Variable Remuneration and Deferral
At least 50% of variable remuneration should be paid in instruments that are linked to the performance of the Firm, eg share or share-linked instruments. Between 40-60% of variable remuneration should be deferred over a period of three to five years, with a deferral of at least 60% in the case of “particularly high amounts”. Such deferral must vest no faster than on a pro rata basis.
Up to 100% of variable remuneration must be subject to ‘malus’ or clawback arrangements. In particular such arrangements must apply where an individual has participated in or been responsible for conduct which resulted in significant losses to the Firm, or failed to meet appropriate standards of fitness and probity.
Guaranteed Variable Remuneration
An additional provision has been inserted that guaranteed variable remuneration must not form part of prospective remuneration plans and can only be paid where the Firm has a sound and strong capital base. This builds on the existing provision that guaranteed variable remuneration is exceptional and can only be paid when hiring new staff and when limited to the first year of employment.
Additional Disclosure Requirements
In addition to the existing disclosure requirements under CRD III, Firms will now be required to disclose to the public, on its website how the Firm has complied with CRD IV.
Additional Rules for Institutions Benefiting from Government Intervention
CRD IV imposes additional requirements for institutions benefiting from government intervention. In such cases:
- Variable remuneration must be strictly limited as a percentage of net revenue where it is inconsistent with the maintenance of a sound capital base and timely exit from government support;
- Such institutions must restructure remuneration in a manner aligned with sound risk management and long- term growth, which may involve limits on remuneration to members of the management group; and
- No variable remuneration should be paid to members of the management body unless justified.
Anti-avoidance provisions contained in CRD IV will restrict the payment of variable remuneration through vehicles or methods that facilitate non-compliance with the fixed to variable pay ratios described above. This is likely to impact the efficacy of structures that are designed to give Firms additional remuneration flexibility.
Furthermore, on an individual level, employees are required not to undertake:
- personal hedging strategies;
- remuneration- related insurance; or
- liability-related insurance to attempt to undermine the CRD IV restrictions.
The UK Government recently launched a legal challenge in the Court of Justice of the European Union claiming that the remuneration provisions in CRD IV (in particular, the bonus cap) are not compatible with EU law. The challenge suggests that these provisions do not have a basis in the EU treaties, are disproportionate and have been brought into effect in a manner which infringes the principle of legal certainty.
The UK Government’s challenge also highlights other issues including the UK Government’s concern over the level of power that has been delegated to the EBA 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 cap, will potentially lead to a significant increase in the number of identified staff. It is likely to be some time before the outcome of the UK Government’s challenge is known.
Next Steps for Firms in the Financial Sector
Institutions and firms which are within the scope of CRD IV should carefully consider their remuneration policies, having regard to the new CRD IV rules. Institutions and firms should also identify potential employment law risks, for example the extent to which existing contractual rights of employees may fall foul of the bonus cap provisions and which will need to be addressed through appropriate employee consultation prior to effecting any unilateral changes. In particular, the cap on bonuses may require affected institutions to consider their responses to the new rules, whether this is through raising base pay or through considering a more detailed remuneration policy, which provides for the required deferral and non- cash remuneration elements, together with the underpinning principles of CRD IV, whilst appropriately incentivising excellent performance. At the very least, some institutions may need to take steps to allow for the increased bonus cap, by referring the matter to their shareholders.