On 21 December 2015, the European Banking Authority (EBA) published the final form of ‘Guidelines on Sound Remuneration Policies’ (the Guidelines) together with an opinion on the application of proportionality (the Opinion).
On 21 December 2015, the European Banking Authority (EBA) published the final form of ‘Guidelines on Sound Remuneration Policies’ (the Guidelines) together with an opinion on the application of proportionality (the Opinion).
Although much of the Guidelines will be familiar from the draft guidelines published in March 2015, there are a number of changes which reflect lobbying by certain groups during the three month consultation on those draft guidelines. These principally relate to:
- LTIPs (to be valued for the purposes of the cap at grant subject to certain conditions);
- the exchange rates for thresholds not in Euro; and
- the application of CRD’s remuneration rules to subsidiaries that are also subject to AIFMD or UCITS (irrespective of whether additional sectoral regulation also applies).
There is little meaningful change on the position for proportionality in the Guidelines themselves – reflecting the EBA’s view that the existing “neutralisation” approach endorsed by the CEBS guidelines has no foundation in the directive. The EBA has, however, published the Opinion urging an amendment to CRD4 to allow for a uniform approach to proportionality by Member States. If adopted, this would provide an exclusion for smaller and non-complex institutions from the requirements relating to deferral and payment in instruments; it would also allow individuals with low variable pay to be exempted (including in large institutions). However, it would not extend to the bonus cap itself.
The EBA is standing firm on the idea that the maximum ratio of fixed to variable pay should apply to all institutions and individuals in scope – this will mean that all firms who are subject to CRD4, regardless of size or licence, will be required to apply the bonus cap for their material risk takers. The EBA considers this to be an integral part of a sound remuneration policy that does not impose undue cost or administrative burden on institutions and should therefore be observed by all institutions subject to CRD4.
- 21 December 2015: EBA issues final Guidelines and publishes opinion on amending CRD4 to introduce certain proportionality exemptions.
- Around March 2016: within two months of the publication of the Guidelines in the official European languages, local regulators must state whether and to what extent they intend to comply with the Guidelines and to the extent that they indicate that they do not intend to comply, they must explain the reasons for this (under the ‘comply or explain’ principle).
- 22 March 2016: EBA consultation on remuneration of sales staff closes.
- By end of March 2016: ESMA due to publish the UCITS guidelines on remuneration.
- By end June 2016: European Commission to submit a report on its review of the remuneration provisions of CRD4 to the European Parliament and the Council, following a public consultation closing on January 14th. The report is likely to answer the issues raised in the EBA's Opinion.
- 31 December 2016: existing 2010 CEBS guidelines are repealed.
- 1 January 2017: date of application of the new EBA guidelines.
While there has been some clarification around the proportionality principles, the Guidelines largely reflect the approach set out in the draft guidelines.
- The EBA has repeated its view (supported by the European Commission) that the ‘neutralisation’ approach to certain of CRD4’s remuneration provisions in small and less complex institutions, is not in line with the provisions of CRD4. Its view is that there is no scope under CRD4 for any institution to waive (partially or fully) any of CRD4’s remuneration provisions (which is what the neutralisation approach entails).
- Accordingly, the Guidelines confirm that each of CRD4’s remuneration provisions must be applied by all institutions - including smaller banks and investment firms. The express reference in the draft guidelines to the ability to apply minimum thresholds (in relation to the deferral of a portion of variable remuneration or pay out in instruments) has been deleted and instead institutions are required to apply the requirements in a proportionate manner having regard to a combination of “their size, the internal organisation and the nature, scope and complexity” of their activities.
- The EBA has simultaneously published an Opinion addressed to the European Commission, European Parliament and Council in an attempt to bring about an amendment to CRD4 itself and so establish a more harmonised approach to proportionality across Member States. This Opinion recommends the following:
- An exemption for smaller and non-complex institutions from the requirement to apply remuneration principles regarding deferral and payment in instruments; and
- A limit on the scope of the remuneration principles regarding deferral and payment in instruments for staff who receive low amounts of variable remuneration (including in large institutions).
- The EBA is also recommending that the directive allow the use of share-linked instruments by listed institutions (which CRD4 does not currently permit) provided that those instruments reflect exactly the value of shares.
- The EBA is firmly of the opinion that there should be no waiver in the application of the bonus cap. It considers that this is easy to apply, does not create additional administrative costs and ensures that no inappropriate incentives for risk-taking can be provided.
- As a result of these changes, banks and IFPRU investment firms which currently take advantage of the UK regulators (FCA and PRA) proportionality exclusions will need to actively start planning during 2016 for implementation of the bonus cap from 1 January 2017. The same is true for institutions benefiting from exclusions offered by local regulators in other jurisdictions.
Identification of staff
The final Guidelines have largely confirmed the draft version circulated in March.
- The Guidelines confirm that institutions are to go through an annual process of assessing which staff are identified staff (ie those whose professional activities have a material impact on the institution's risk profile) before applying the remuneration provisions in a proportionate way.
- Institutions are to apply the qualitative and quantitative criteria set out in the EBA’s Regulatory Technical Standards (RTS) as well as any additional internal criteria on identified staff when going through this assessment process. Identified staff are to reflect the risk levels in different activities within the institution.
- The Guidelines confirm the requirements set out in the draft guidelines in relation to governance, the involvement of internal control functions, details of the records required to be kept by the institution and the process for notifying and obtaining prior approval for excluding staff from the list of identified staff.
- The Guidelines further clarify the approach for identifying staff that should be taken by non-CRD subsidiaries within a CRD consolidated group. The Guidelines call for the "consolidating institution" to apply CRD4 requirements to all identified staff across the group and also require all CRD 4 entities within a consolidating institution to conduct an additional identification process on a solo basis.
- The final Guidelines also include a number of additional technical confirmations on the process for identifying staff including those whose professional activities have or are likely to have a material impact on the institution's risk profile for a period of at least three months in a financial year and those who have been in a role for less than three months.
Categories of remuneration
- The EBA has confirmed its view that all remuneration must either be categorised as fixed or variable.
- Remuneration should only be treated as fixed where the conditions for its award and its amount meet a series of criteria. These are that the relevant conditions are pre-determined; that they are non-discretionary, reflecting an individual’s professional experience and seniority; that they are transparent to staff with respect to the individual amount awarded; that they are permanent (i.e. are maintained over a period tied to the specific role and organisational responsibilities); that they are non-revocable; that they cannot be reduced, suspended or cancelled by the institution; that they do not provide an incentive for risk assumption; and that they do not depend on performance.
- Any remuneration component will automatically be treated as variable remuneration if it cannot be characterised as fixed remuneration by reference to these criteria.
- The Guidelines consider specific types of remuneration, including role-based allowances, LTIPs, carried interest payments, retention bonuses and severance pay.
- Allowances: Any institution that seeks to categorise a role-based allowance as fixed remuneration is required to document how that conclusion has been reached by reference to the criteria for fixed remuneration in circumstances where allowances are paid to identified staff only, or are limited to cases where the bonus cap would otherwise be exceeded, or are linked to indicators that could otherwise be understood as proxies for performance. Additionally, any allowance that is based on an individual’s role, functions or organisational responsibilities must satisfy the fixed remuneration criteria, taking into account that the allowance needs to be tied to a role or organisational responsibility and should be maintained unless there are material changes to an individual’s responsibilities and authorities; that the amount of the allowance does not depend on other factors; and that other staff members fulfilling the same role or having the same organisational responsibility and who are in a comparable situation should receive a comparable allowance.
- LTIPs: The drafting of the Guidelines in relation to LTIPs is not as clear as it might be. The Guidelines draw a distinction between an LTIP (or other element of variable remuneration) that is subject to a combination of past performance and future performance conditions measured over a period of at least one year, and an LTIP subject to future performance alone. An example falling into the first category would be a deferred bonus arrangement where the amount delivered is based on a mixture of past and future performance.
- Where the first category applies, the LTIP award will count towards the ratio of fixed to variable pay for remuneration cap purposes (the variable remuneration cap ratio) in the year for which the award was granted. In other words, if a deferred bonus is granted by reference to performance in 2017, with vesting determined by reference to performance in the period from 2018 through to 2021, the award is taken into account in 2017. This approach also applies where past performance has been measured over a multi-year basis as opposed to a single year.
- In contrast, where LTIP awards are based on future performance only, the Guidelines suggest that the award should only be treated as having been made once performance conditions have been satisfied (in other words, on vesting of the award). The LTIP award is taken into account in determining the variable remuneration cap ratio in the financial year prior to vesting. In other words, if a five year performance award ends on 31 December 2017, with the award vesting in 2018, the award is taken into account for remuneration cap ratio purposes in 2017. Provided the award is over a fixed number of instruments, the value that is taken into account is the market price or fair value of the award at the date of grant.
- The Guidelines also contain other provisions relevant to LTIP awards, including the application of malus and clarification that the deferral period for an award only starts to run on vesting.
- Carried interest: The Guidelines also provide for carried interest arrangements. Payments made to individuals which do not represent a pro-rata return on an individual’s investment constitute variable remuneration and should be valued at the date of the award for purposes of determining the variable remuneration cap ratio. Conversely, payments that do represent a pro-rata return on investments made by individuals through a carried interest vehicle do not need to be included in determination of the ratio.
- Retention Awards: The Guidelines also confirm that retention awards should only be made where the institution has a legitimate interest in making the award. Examples given include where there is a restructuring, in a wind-down situation or following a change of control. The Guidelines confirm that retention bonuses are variable compensation and should be taken into account in determining the variable remuneration cap ratio. The Guidelines stipulate that the value of the award can either be pro-rated on a linear basis over the retention period, or alternatively the full amount can be taken into account when the retention condition is satisfied. The second alternative was not provided for in the draft guidelines.
- Guaranteed variable remuneration: Unlike retention awards, guaranteed variable remuneration does not have to be taken into account in determining the variable remuneration cap ratio if the guarantee is given when the employee is hired. The Guidelines also confirm that guarantees do not have to be subject to malus and clawback requirements and can be paid in full in non-deferred cash. However the scope for awarding guaranteed variable remuneration is limited to exceptional circumstances and can only occur where the institution has a sound and strong capital base, and should only be awarded in the first year of employment.
- Buyout Awards: In contrast to guaranteed variable remuneration, buyout payments for deferred remuneration forfeited on leaving a prior employer are subject to all the requirements that apply to variable remuneration generally, including deferral, payment in instruments and clawback. Although this is not made explicit, the requirements relevant to LTIPs summarised above presumably apply to buyout payments for purposes of determining the variable remuneration cap ratio.
- Severance Payments: Save for regular remuneration payments related to the duration of the individual’s contractual notice period, any severance payment is to be regarded as variable remuneration. However, severance pay is not taken into account in determining the ratio between fixed and variable remuneration in certain limited circumstances, including where the payment is mandatory under local law or the payment is made in a redundancy situation or to settle an employee claim and the institution can demonstrate to the regulator the reasons for the payment and that it is appropriate. Garden leave payments are also not taken into account for these purposes.
- The Guidelines also provide that institutions which award remuneration in a currency other than the Euro should convert the thresholds set out in Article 4 of Commission Delegated Regulation 604/2014 as set out in Article 5 of that Regulation using either the internal exchange rate used for the consolidation of the accounts or the exchange rate used by the Commission for financial programming and the budget for the month where the remuneration was awarded.
Remuneration policy, award and pay out of variable remuneration
Most of the proposals have been adopted in the final Guidelines, with a few minor amendments and clarifications.
- The final Guidelines now set out more clearly the requirements on institutions to have a remuneration policy for all staff as well as a policy applicable to identified staff. In order to assist with the practical implementation of this requirement, the Guidelines indicate how institutions should approach the setting of fixed and variable pay.
- The remuneration policy should set out in advance the appropriate ratio between fixed/variable pay for identified staff. Different ratios may be set for different locations, business units, functions and categories of staff. The Guidelines detail how such ratios should be calculated and state that the effective ratio of fixed to variable remuneration should be calculated as the sum of all variable components of remuneration awarded for the last performance year, including amounts for multi-year accrual periods, divided by the sum of fixed elements of remuneration awarded for the same performance year.
- The requirement to make awards subject to a retention period and to defer a portion of variable remuneration should ensure that the award of variable remuneration is aligned with an institution’s long-term risks and performance and that ex-post risk adjustments (such as malus and clawback) can be applied as appropriate (see below).
- The instruments used for the award of variable remuneration should contribute to this alignment of variable remuneration with performance and risk. Priority should be given to instruments which are subject to bail-in and shares rather than the use of value-based items like share-linked instruments. While the Guidelines effectively preclude listed financial institutions from using phantom share arrangements or other similar instruments, the EBA has, in its Opinion, proposed to amend the text of CRD4 to remove the requirement for listed companies to use only actual shares (and not share-linked instruments), which would enable listed companies to make use of simple phantom share arrangements. Local regulators will need to decide how to take a practical but compliant approach to this issue while they await the outcome of any change to CRD4.
- The final Guidelines confirm how institutions should calculate the ratio of variable remuneration that is paid out in instruments. It is stated that all amounts should be valued at the point of award unless otherwise stated in the Guidelines – there is clearly no intention here to override the EBA guidelines on the applicable notional discount rate for variable remuneration under Article 94(1)(g)(iii) of CRD4.
- The final Guidelines increase the period over which instruments used to deliver variable remuneration should be retained for some categories of identified staff. The final Guidelines confirm that the appropriate minimum retention period for the deferred part of variable remuneration for identified staff who are members of an institution’s management body and senior management is one year (where the deferral period is at least five years). This is six months longer than that required for identified staff who do not perform such management roles.
- The increase in retention period will add to the overall impact on variable remuneration awarded to UK PRA Senior Managers in Level 1 and 2 banks – they will have to wait for up eight years before all their deferred variable pay is delivered in full (seven years deferral under for PRA Senior Managers Regime plus a further one year of retention on amounts delivered in instruments).
- Subject to contract or labour law, malus and clawback arrangements should be applied up to 100% of variable remuneration and should apply at least over both deferral and retention periods (which could extend for six years under the Guidelines) and should always be performance or risk related. The Guidelines also expand the criteria under which malus and clawback operate to include the conduct of staff where they contributed to regulatory sanction. While the Guidelines set out provisions for aligning the practice of clawback in Member States to that in the UK, they do not appear to recognise that clawback is prevented or discouraged by national labour laws in a number of Member States.
- Where it is difficult or not possible to enforce clawback under national laws, institutions should reflect this in their remuneration policies and ensure that malus or implicit risk alignments (such as the use of increased deferral periods) are applied to the extent possible. The wording in the draft guidelines has been revised to note that where the application of clawback would be subject to “legal impediment”, avoiding the use of pro-rata vesting may be appropriate. This is a change from the formulation in the draft guidelines on vesting periods endorsed by the EBA where clawback “cannot be applied”.
Governance process for implementing sound remuneration policies
Reflecting the approach in the draft guidelines, the final Guidelines set out clear principles on the governance and structure of remuneration policies including the scope of responsibility of each function within the institution.
- Significant institutions are required to establish remuneration committees at individual, parent company and group level. The consolidating institution should ensure that a remuneration committee is established when legally required. The Guidelines also indicate that a remuneration committee is required at subsidiary level for institutions that are significant on a standalone basis, even if they are part of a significant group of institutions.
- The Guidelines further explain the role of shareholders in the approval of the remuneration policy and in certain decisions relating to remuneration, in particular regarding any vote to approve a ratio between variable and fixed pay of higher than 100%.
Remuneration policies and group context
Most of the proposals have been adopted in the final Guidelines, with some points being clarified in response to the views expressed during the consultation.
- The final Guidelines clarify that consolidation is assessed on a prudential, rather than accounting, basis.
- Consolidating institutions and local regulators should ensure that a group-wide remuneration policy is implemented and complied with for all staff in all institutions and other entities within the scope of prudential consolidation. This could include asset managers, private wealth firms and insurers owned by banks – even if these entities are not themselves subject to CRD4, they (and their staff) will be subject to the relevant provisions and must have remuneration policies which are consistent with the group-wide remuneration policy.
- This approach means that the bonus cap will be applicable to UCITS or AIFMD regulated subsidiaries of CRD4 regulated institutions when neither the UCITS or AIFMD directives provide for such a cap. The legality of the EBA seeking to impose a bonus cap on these subsidiaries ‘through the back-door’ has been questioned. The Guidelines also give rise to a significant disparity between the position of 'stand alone' funds that are solely regulated by UCITS or AIFMD and those that are controlled by a CRD4 regulated firm, which could itself found claims. In response, the EBA has commented that, aside from the bonus cap, the requirements of the UCITS and AIFMD directives are comparable with the CRD4 requirements. Where there is a direct conflict between the requirements of CRD4 and the UCITS or AIFMD directives, the latter will prevail.
- The group-wide remuneration policy of institutions and entities within a group located in more than one Member State will need to specify how it will deal with differences between national implementations of CRD4, in particular with respect to variations in the maximum ratio between fixed and variable pay.
- Some respondents to the consultation on the draft guidelines had questioned the requirement for shareholders of a subsidiary in a third country (but within the scope of prudential consolidation and therefore subject to the CRD4 requirements) to approve an increase in the bonus cap to 200%. The final Guidelines state that shareholder approval at the group, rather than local, level should be obtained.
Sound capital base
The final Guidelines have been slightly revised from the draft version circulated in March by expanding the granular requirements to demonstrate compliance.
- Institutions and local regulators should ensure that the award, pay out and vesting of variable remuneration, including the application of malus and clawback arrangements, under the remuneration policy is not detrimental to maintaining a sound capital base.
- Institutions should include the impact of variable remuneration - both upfront and deferred amounts - in their capital and liquidity planning and their internal capital adequacy assessment process.
- Local regulators should intervene where the awarding of variable remuneration is detrimental to the maintenance of a sound capital base by: (i) requiring the institution to reduce or apply a cap to the overall pool of variable remuneration determined until the capital adequacy situation improves; (ii) requiring institutions to use net profits to strengthen the capital base; and (iii) if necessary, applying performance adjustment measures, in particular malus (the final Guidelines have deleted a previous reference to applying clawback, but this would not prevent a local regulator from requiring clawback to be applied).
Record keeping and disclosures
The final Guidelines are broadly unchanged from the draft version published in March.
- The Guidelines include detailed provisions in relation to record-keeping requirements (particularly in relation to decision making) and the disclosure of remuneration, which are more onerous than those in the CEBS 2010 guidelines.
- There has been a significant increase in the disclosure obligations for most firms.
Entry into force
The effective date of the Guidelines has been moved from 1 January 2016 to 1 January 2017. The Guidelines do not specify if this refers to any awards made after this date, or awards made in respect of performance after this date. Precedent would suggest that the latter (performance from 1 January 2017) is more likely. However, firms should be aware that some local regulators may take a different position or voluntarily choose to comply earlier.
The EBA's proposed changes to proportionality require a change to the directive itself. This means that the timing remains uncertain – changes will need to go through the full legislative process in Europe with agreement from the Commission, Council and Parliament. It is clear that the EBA intend to provide support to ensure this change is made as soon as possible. However, it is distinctly possible that the legislative process to amend the Directive could take longer and may not be complete by the end of 2016.
Although the final EBA Guidelines are non-binding on institutions, they are based on the ‘comply or explain’ principle. This principle enables a local regulator to ‘explain’ how it considers it can implement the requirements of CRD4 in a different manner. Local regulators to whom Guidelines apply are expected to comply by integrating the Guidelines into local rules and to impose and enforce those rules on the institutions they regulate.
Where a Member State chooses not to follow the Guidelines either partially or entirely, it must inform the EBA and state its reasons for non-compliance. The EBA website will publish this information on its website (in an attempt to put pressure on the relevant regulators).
As a technical matter, the EU Commission may initiate infringement proceedings against a Member State for not having complied with CRD4 if it considers the ‘explanation’ inadequate. Such proceedings could ultimately end up in the ECJ where the relevant Member State would have the opportunity to justify its position. The EBA has no direct claim against institutions based on these Guidelines.
Table: Implementation of national discretions (1)
Click here to view table.