On 27 June 2013, the legislative package known as the Capital Requirements Directive IV (CRD IV) was published in the Official Journal of the European Union, following the approval of its text by the European Parliament in April. CRD IV was supplemented by the Capital Requirements Regulation (CRR) published on the same day.
CRD IV includes various provisions in relation to the financial services sector, most notably new rules requiring affected institutions to limit the ratio of fixed to variable remuneration of certain staff. Colloquially, this has become known as the "bonus cap" because the measures are largely a response to perceived excessive bonuses in the banking industry.
This Alert summarises the impact of the bonus cap provisions on European and global financial institutions. It also briefly notes other possibly significant provisions in CRD IV, which merit attention.
Which institutions are impacted?
European Union (EU) entities impacted by CRD IV are, broadly speaking, credit institutions and investment firms within the Markets in Financial Instruments Directive (MiFID)—this includes all retail and investment banks, but also other forms of investment firm such as hedge funds. In an international context, EU subsidiaries of non-EU financial institutions will be within its scope if they meet the requirements.
The bonus cap provisions will apply in respect of work done from January 2014 onwards. Bonus packages are typically determined by prior-year performance, so for most, it is anticipated that measures need only be complied with on a practical basis when bonus determination takes place in 2015. However, there will not be complete clarity on this commencement point until implementation details are known. Equally, the timing of the required website information on compliance with the bonus cap and certain local provisions (discussed below) will be known only when there are more details available on actual implementation.
The bonus cap does not apply to all staff. Those affected are described as "senior management, risk takers, staff engaged in control functions" and certain, similarly compensated senior personnel. "Senior management" is a defined term, which means those responsible for the day-to-day management of an institution.
Although the scope of executives impacted seems vague, from a UK perspective, application will be to "Code Staff" already identified under the UK Remuneration Code. However, it should be noted that the European Banking Authority (EBA) will, by March 2014, draft more specific criteria required to identify affected personnel. This is anticipated to widen the scope of the bonus cap provisions since the proposed criteria are a response to the perception that some countries (the UK included) have taken a minimalist view on the application of EU remuneration rules in the financial services industry. The EBA published a draft note on this in May 2013 and are currently consulting on the issue, but full details remain outstanding. Employees affected do not have to work in the EU, although this point is controversial and will be subject to review in 2016.
Bonus cap provisions
The 1:1 ratio
The starting point of the bonus cap is that an affected individual's variable remuneration must be no greater than 100 percent of his or her fixed remuneration. In other words, the ratio of fixed to variable remuneration must be 1:1 or higher. However, there are provisions to increase the variable element.
Consent to changing the ratio
The variable remuneration element can be increased to 200 percent of the fixed pay, namely a ratio of 1:2, if the firm's shareholders agree. This requires a 66-percent majority of shareholders representing a quorum of at least 50 percent of the voting shares. If that quorum is not achieved, then a 75-percent majority is required. If shareholders are asked to approve a change to the ratio, they must be provided with a detailed recommendation containing certain specifics such as the number of employees affected. Any such affected employees who are also shareholders are not allowed to vote.
Additionally, the institution's regulator must be kept informed of the process relating to the change in ratio—e.g., must be advised that a vote is being sought, provided with information to confirm that the higher ratio does not conflict with the firm's capital adequacy requirements, etc. Member states may implement their own procedures in this area.
From an international point of view, EU subsidiaries of overseas entities should be able to alter the ratio as described above with relative ease, although they need to be sure that the correct procedures are followed to do this.
Variable elements of remuneration
Up to 25 percent of the variable remuneration may be awarded in the form of discounted long-term instruments. These are instruments which are deferred for at least five years and which may be valued for the purposes of the ratio on a discounted basis. This provision will allow, to an extent, an increase in the variable remuneration element of the ratio. Currently, we do not have any information as to how valuation will operate for these purposes. The EBA will be required to issue guidelines by March 2014.
At least 50 percent of the variable remuneration must consist of shares or equivalent instruments or other instruments that can be readily converted to equity in adverse circumstances. They should reflect the credit quality of the institution concerned.
At least 40 percent of the variable remuneration must be deferred. In the case of high amounts of deferred remuneration (£500,000 or more in the UK), at least 60 percent must be deferred.
Apart from in relation to new hires in their first year, variable remuneration should not be guaranteed.
The principle of proportionality will apply to the implementation of the rules. This means that small institutions will not necessarily be obliged to comply with every detail of the bonus cap provisions.
The implementation of the bonus cap may include anti-avoidance provisions, the details of which will be at the discretion of member states.
Subject to local contract and employment law, the variable remuneration needs to be subject to malus or clawback arrangements—the rules on this to be implemented by member states.
Firms impacted by the bonus cap must maintain a website with details of their compliance (this extends to other elements of CRD IV).
The FCA issued a statement on its website on 27 June 2013 in immediate response to the publication of CRD IV. There will, according to this statement, be consultation on UK implementation later in the summer.
Action points in relation to the bonus cap
At this point, with the details of implementation unknown at this time and EBA guidelines due next March, there is a limited amount to consider. There is the option of waiting until some areas are clarified. However, certain measures can be taken in advance of this.
One issue, which is likely to merit early review, is the status of a financial institution's current variable consideration arrangements in terms of being contractual or discretionary. If contractual arrangements breaching bonus cap requirements are entered into before January 2014, it is unknown whether or not they would result in a breach of CRD IV. It has been suggested by the EBA that contractual entitlements in place prior to the publication of the draft bonus cap rules in June 2012 would fall outside the provisions, but this point has not been confirmed. Accordingly, the general recommendation now is that, to the extent that any contractual arrangements with affected staff exceed the bonus cap, they should be altered. Most bonus schemes are described as being "discretionary," but in many EU countries, this statement is not legally conclusive. Other factors are taken into consideration in determining whether a scheme is contractual or discretionary, including oral discussions and previous practice.
If new contractual arrangements with affected staff are entered into which provide for variable remuneration to be paid after 1 January 2014, the arrangements should be, at the very least, stated to be subject to change to comply with remuneration regulation. Guaranteed bonuses are still acceptable for new staff in their first year, but they should be considered carefully and, as stated, be specifically subject to remuneration regulation.
Institutions may want to start reviewing their current arrangements with affected staff to ascertain the likely impact of a 1:2 fixed to variable ratio. This should include reviewing the proportion and nature of historic variable remuneration.
Financial institutions should consider the most appropriate ways to fulfil the known requirements of the variable remuneration. The equity (or equivalent) instruments, deferred remuneration and clawback arrangements can all be considered. Particular care may be needed with clawback provisions.
Other elements of CRD IV
Beyond the bonus cap, which has received the most attention, there are additional requirements in relation to remuneration in CRD IV and the CRR. Most of them reflect the requirements introduced by CRD III in relation to remuneration policy and certain disclosures. However, there are certain new disclosure requirements, which means that firms will have to disclose the number of staff being remunerated by €1 million or more broken down in increments of €500,000.
CRD IV contains five new capital "buffers"—the capital conservation buffer, the countercyclical buffer, the global systemic institution buffer and the other systemic institution buffer. These buffers will be gradually introduced from 2016.
The CRR also introduces two new liquidity buffers. Again, they will be in force from 2016.
It is important to note that there are also new corporate governance requirements designed to strengthen the CRD's requirements on institutions' management bodies. There are specific provisions in relation to risk management. They came into force in January 2013.
As stated above, compliance with certain elements of CRD IV needs to be evidenced on an organisation's website. The timing and nature of compliance with this will only be apparent at implementation, but institutions should be mindful of this and be aware of the need to comply.