UK and European Remuneration Reform: Year in Review

In the past three years, international regulatory focus on remuneration has gripped the globe. The heart of the debate which arose in the context of remuneration structures in investment banking and their contribution to global financial crisis has extended past this into remuneration across a broad range of industries. This past year has seen a number of developments which have intensified in both the UK and Europe as we draw close to the year end. We look back at the year and consider where regulation and industry guidelines have emerged in the context of pay structures and recent developments in the area of transparency and taxation. We also provide a comprehensive review of the hugely anticipated new remuneration code [1] the final version of which was published by the Financial Services Authority last Friday.

Changes to Remuneration Structures

Capital Requirements Directive (2006/48/EC and 2006/49/EC) (CRD3)

The Capital Requirements Directive (2006/48/EC) (CRD) was adopted in 2006 and set out the capital requirements for credit institutions and investment firms to ensure consistent application within the European Union (EU) of the international prudential framework for capital requirements, known as Basel II. Since adoption, there have been a series of proposals to amend the CRD including more recently changes to protect the interests of creditors and improve financial stability. On 7 July 2010, the European Parliament approved the text of the new EU Directive to amend CRD (CRD3) and this revised directive included the introduction of a new requirement for certain firms [2], to adopt remuneration policies and practices which take account of several principles covering the structure, amount and timing of bonus payments. The CRD3 measures which the European Parliament announced at the time of publication contains “some of the strictest rules in the world on bankers’ bonuses” and are required to be implemented by firms by 1 January 2011. The Council of the European Union adopted CRD3 on 11 October 2010 and the final text was published and came into force only days ago, on 14 December 2010. [3] The Committee of European Banking Supervisors (CEBS) is tasked under CRD3 to issue guidelines to assist firms in complying with and implementing the remuneration principles. Draft guidelines were published in October 2010 and the final and revised version was released on 10 December 2010 (CEBS Guidelines). [4]

Revised Remuneration Code

The UK Financial Services Authority (FSA) published on 17 December 2010 its Policy Statement [5] (PS10/20) setting out feedback to its July 2010 consultation paper [6] (CP 10/19) adopting a new Remuneration Code (Code) which comes into force on 1 January 2011. The timing of publication of the Code and its effective date leave very little time for firms impacted by the changes to comply but the delay was unavoidable due to the delay in the publication of the final versions of CRD3 and the CEBS guidelines.

A quick reminder: The first version of the FSA’s Remuneration Code was published in February 2009 as a direct response to the global financial crisis and the desire to discourage excessive risk-taking. At that time, the application of the code was directed at just under 50 FSA regulated banks, broker-dealers and building societies although the FSA did indicate that extension of the scope of the code to a broader range of market participants was under consideration. In fact, the final version of the code (which came into force almost one year ago, on 1 January 2010) applied only to half that number of FSA regulated firms. In July 2010 however following publication of CRD3, the FSA published CP 10/19 to consult on a revised version of the Code which would extend the application of the Code to almost 2,500 firms and introduce twelve new remuneration principles. [7] This extension was confirmed in PS10/20 and the FSA calculates that now almost 2,700 firms will fall within the scope of the Code.

Who is Impacted:

(i) Firms – CRD3 significantly increased the scope of the firms to which the Code applies to extend to all banks and building societies covered by the definition of credit institution in Article 4(1) Banking Consolidation Directive [8], all investment firms to which the Market in Financial Instruments Directive (MiFID) applies [9] and to all UK branches of firms whose home state is outside the EEA (collectively, Code Firms). The extension to MiFID investment firms will mean certain hedge fund managers and Undertakings for Collective Investments in Transferable Securities (UCITS) investment firms, as well as some firms that engage in corporate finance, venture capital and the provision of financial advice, and stockbrokers, will now be covered by the Code. UK branches of firms whose home state is within the EEA are not required to apply the Code as their home state will be required to apply equivalent provisions under CRD3. Where the revised Code applies to a UK firm, it will also apply to the remuneration of employees and directors of all of the UK firm’s group entities worldwide. A UK firm’s overseas operations will therefore fall within the scope of the revised Code. UK subsidiaries of non-EEA country groups will be obliged to apply the revised Code in relation to all the entities within the sub-group which undertake investment activities that are regulated by the MiFID, including entities based outside the UK.

(ii) Code Staff – The Code is based upon twelve Remuneration Principles which apply primarily to Code Staff. This comprises “categories of staff, including senior management, risk takers, control functions and any employee receiving total remuneration that takes them into the same remuneration bracket as senior management and risk takers, whose professional activities have a material impact on the firm’s risk profile” (subject to a de minimis threshold – see further below). It is incumbent upon firms to compile a list of Code Staff ahead of bonus allocation period and to notify staff who will be potentially subject to the Code’s rules, including the voiding provisions (see below). To ensure a more consistent approach between firms as to who falls within the pool of Code Staff, the FSA have provided a set of non-exhaustive examples of the key positions they would expect to be classified as Code Staff. [10] In line with CEBS Guidelines, the Code requires provisions on guaranteed bonuses (see (vi) below) to be applied on a firm-wide basis and not just to Code Staff.

Key Features of the Code:

(i) General Rule & Approach – Code Firms must “establish, implement and maintain remuneration policies, procedures and practices that are consistent with and promote sound and effective risk management”. In applying the Code, the FSA also encourages firms to have regard to applicable good practice on remuneration and corporate governance such as guidelines produced by the National Association of Pension Funds (see Annex 2, Section D, available here). In support of one of the central pillars in CRD3, the FSA has recognized that the policies put in place by firms should be proportionate to the nature, scale and complexity of its activities (the Proportionality Principle) and the Proportionality Principle should also be applied in assessing the pool of Code Staff. In respect of firms, the FSA has devised a high-level, four tier [11] proportionality framework and has provided guidance on which of the principles and rules in the Code should be applied by firms depending on which tier they fall within.

(ii) Governance – The Code was revised to introduce additional governance requirements including for large firms to have Remuneration Committees, the members of whom must be non-executive directors only and mandating within the scope of responsibility of these committees, preparation of decisions on remuneration including those with implications on risk management.

(iii) Remuneration Structure – Firms will need to ensure that there is an appropriate balance between the fixed pay (such as salary) and variable compensation (such as bonus or discretionary equity awards) of each affected employee and will be expected to set maximum ratios of variable to fixed pay for different categories of staff. For those Code Staff whose remuneration exceeds the de minimis threshold [12], firms will need to take steps to ensure that:

• a. at least 40% of variable remuneration being paid to Code Staff is deferred over at least three to five years, with awards vesting no faster than on a pro-rata basis (and the first vesting no earlier than one year after the award);
• b. at least 60% of variable remuneration should be deferred (where the amount of the variable remuneration is particularly high, generally over £500,000); and
• c. at least 50% of the total of any variable remuneration (including both deferred and undeferred elements) must be paid in a non-cash form, specifically in an appropriate balance of shares, share-linked instruments or equivalent non-cash instruments; and (for some firms) bonds. Firms will need to apply appropriate minimum retention periods [13] during which time employees will not be able to dispose of the non-cash instruments.

The deferred components of both cash and share based remuneration will be subject to performance adjustment and run the risk of forfeiture (see further below).

This means that Code Staff can expect to receive just 20-30% of variable remuneration by way of an “up front” cash payment.

(iv) Pensions – The revised Code imposes a new rule that a firm’s pension policy should be in line with the business strategy, objectives, values and long-term interests of the firm. It also introduces a new requirement in relation to non-standard enhanced discretionary pension payments – these should be held for five years in the form of shares or share-like instruments.

(v) Severance Payments – The revised Code includes a new rule and guidance to ensure that payments relating to early termination of a contract (i.e. severance pay) reflect performance over time and do not reward failure. Hence, pure financial safety nets in the event of early termination are not acceptable unless overlaid with effective performance measures

(vi) Guaranteed and Retention Bonuses – The revised Code restricts guaranteed bonuses to one year. Even then, guaranteed bonuses should not be routine but may be given only to new hires in exceptional circumstances and only for the first year of service. In cases where “sign-on” bonuses are justified in order to “buy out” the arrangements offered by the employee’s previous employer the replacement bonus should not be more generous in amount and terms than the previous arrangement. The Code includes guidance that guaranteed bonuses should be subject to the same deferral criteria as other types of variable remuneration. Finally, retention bonuses should not be awarded save in exceptional circumstances, for example, the need to keep key staff following a merger process or when a firm is winding down.

(vii) Caps, Performance Measurement & Downward Adjustment Mechanisms – Whilst the Code does not include an overall cap on remuneration packages, Principle 6 requires that the firm’s total variable remuneration should not limit its ability to strengthen its capital base. All Code Firms must ensure that any measurement of performance used to calculate variable remuneration components include adjustments for all type of risks (current and potential) and takes into account, inter alia, the cost and quantity of capital. Long-term incentive plans (LTIPs) will be treated as pools of variable remuneration and therefore firms will be required to ensure that: (a) the vesting of awards granted under an LTIP is subject to appropriate performance conditions, which are adjusted for all types of current and potential future risk factors; and (b) half of the award vests after no less than three years and the remainder after no less than five years. The current assessment of the FSA is that many firms will have to adjust their existing performance measures to comply with these new rules. Under the Code, firms will be need to ensure that they have the contractual ability to reduce the amount of an employee’s deferred remuneration to ensure that the amount that the employee receives on vesting properly reflects the performance of the employee, the firm and the business in which the employee works. A downward adjustment mechanism will also need to be in place where there is evidence of employee misbehaviour or material error, or the firm (or business unit) suffers a material financial downturn or there is a material failure in risk management. Firms will need to review their existing performance measurement criteria and consider the implementation mechanisms in place and the employment law implications of making the required changes.

(viii) Hedging & Anti-Avoidance – The revised Code prohibits all forms of personal investment strategies being taken by employees to hedge or insure against the impact of these new remuneration structures and Code Firms are to maintain effective arrangements to ensure employees comply with this requirement. In addition to the specific ban on personal investment strategies being taken out by Code Staff impacted by the new rules, the FSA have also included a new rule prohibiting firms from awarding remuneration through anti-avoidance vehicles and methods. In particular, the FSA will scrutinise non-recourse loans and unusual stock pledge instruments afforded to Code Staff.

Implementation Timetable: Firms already subject to the current Code will be expected to comply with the new provisions from 1 January 2011. [14] However, the FSA recognizes that for some firms, in particular unlisted firms, it may be find particularly challenging to satisfy the new requirement that at least 50% of variable remuneration should be paid in an appropriate non-cash form. Therefore, on the basis of the proportionality provisions in CRD 3, the FSA is prepared to accept that firms may be able to justify not being in full compliance with this specific requirement by 1 January 2011. The FSA expects, however, that the firm will be taking steps to comply with this requirement as soon as is reasonably possible, and in any event by 1 July 2011.

Monitoring & Enforcement: The FSA are proposing to include within their existing supervisory processes, an annual review of firms remuneration policies. Firms will be required to submit a minimum level of data via an electronic return which include self-certification that their policies are compliant with the Code and in certain cases the FSA may permit a “comply or explain” approach. The new Code gives the FSA express powers to prohibit Code Firms from remunerating its staff in a specified way and critically introduces new “voiding powers” which allow the FSA to render void provisions of agreements that contravene certain of the FSA prohibitions (see further below). Finally, the FSA will also have the power to require firms to recover payments made or property transferred pursuant to a void provision. We are clearly in a very different era to one of three years ago.

Employment Law Challenges of Implementing the Code: The requirements imposed by the Code will have a substantial impact upon the employment relationships of large number of employees in the financial services industry and are a radical departure from the principle of freedom of contract. The employment law issues faced by Code Firms will depend upon how they have structured pay and incentives historically but the main implications include:

(i) Grandfathering – The Code makes an exception for contractual obligations entered into before 19 July 2010 although requires firms to take reasonable steps to amend or terminate such arrangements at the earliest opportunity. Whilst this is relatively straightforward in the case term of fixed term agreements that expire and can be renegotiated in the short term, it is not clear what steps an employer is required to take if an employee refuses to amend ongoing or multi-year bonus entitlements.

(ii) Voiding – The Code is backed up a statutory power which renders certain contractual provisions void to the extent that they breach Code provisions regarding: (a) guaranteed bonuses; and (b) deferral. Payments made in breach of other Code provisions or to non-Code staff are not subject to this provision. Nevertheless a voiding provision of this nature is without precedent and gives the Code real teeth.

(iii) Application to Non-UK Employees – Where the Code applies to employees based outside the UK then their contractual obligations may not be governed by English law and it is questionable whether the voiding provisions will be effective. Local courts and especially those in non-EU jurisdictions may also be less inclined to give effect to the policy intention behind the Code when construing contractual obligations.

(iv) Application to Non-Code Employees – Whilst the Code only applies to Code Staff many financial institutions may wish to adopt similar structures for a wider pool of employees. Indeed, in the final version of the Code, firms have been encouraged to apply the provisions regarding guaranteed bonuses, risk adjustment, personal investment strategies, severance and deferral on a firm wide basis to all staff. In the absence of an express regulatory requirement these arrangements may be more vulnerable to challenge by employees.

(v) Mutual Trust and Confidence – Over recent years the courts have developed an implied term of “mutual trust and confidence” in order to police the exercise of contractual discretions by employers. It is unclear if the requirements of the Code will “trump” the implied term or if the Courts will use the implied term to limit the operation of the Code in situations where they consider that it operates unfairly.

(vi) Restraint of Trade – Whilst the Code requires at least 40% of variable remuneration for Code Staff to be subject to deferred vesting over 3-5 years (with a risk of forfeiture) it does not mandate that vesting should be subject to a requirement that the employee be “in employment” at the relevant vesting date. We will wait to see whether it becomes industry practice for employers to impose “in employment” conditions in an attempt to “lock” Code Staff into their business for extended period – and the extent which employees attempt to attack these provisions as unlawful restraints of trade.

(vii) Adjustment for Clawback and Malus – It is uncontroversial that awards should be subject to adjustment for a broad range of risk factors prior to the date that they are awarded/paid (so called ex ante adjustment). However, the Code goes further and also applies to require adjustment after the award date (so called ex post adjustment). The Code only mandates ex post adjustment prior to the award vesting (so called “malus” adjustment) and does not expressly mandate ex post adjustment after the award vests (so called “clawback” arrangements). Whilst employers may wish to consider whether to impose clawback provisions they are more vulnerable to challenge.

AIFM

On 11 November 2010, the Alternative Investment Fund Managers Directive (AIFM) was adopted by the European Parliament. The AIFM is expected to come into force in March 2011 with implementation by member states by March 2013.

Who is Impacted: We have previously reported [15] on the types of firms impacted by the AIFM. The categories of persons covered are based on similar principles as embodied in CRD3, including at least “senior management, risk takers, control functions, and any employee receiving total remuneration that takes them into the same remuneration bracket as senior management and risk takers” .

General Rule & Approach: The AIFM requires alternative investment fund managers (Managers) to establish remuneration policies and practices for senior staff which are consistent with and promote sound and effective risk management. As with CRD3 and the Code, the AIFM embodies a proportionality principle and permits some flexibility for AIFMs in complying with the rules by reference to their sixe, internal organization and the nature, scope and complexity of their activities. The new European Securities and Markets Authority (ESMA) is required to issues guidelines on the remuneration provisions and it is likely that they will be based on the guidance to be finalised by CEBS as referred to above.

Governance: AIFMs which are significant in size or if any funds managed by the alternative investment fund manage (AIF) are significant, will also be required to have a remuneration committee, the members of which must be non-executive. This mirrors the CRD3 requirements.

Scope of ‘Remuneration’ & Key Requirements: The AIFM imposes restrictions on the amount and form of remuneration that an alternative investment fund manager can pay senior staff. There is no specific definition of remuneration for these purposes but the AIFM does apply to remuneration of any type paid by the AIF, any amount paid directly by the funds managed, including carried interest [16] and any transfer of shares or units in the fund. The precise scope of what is in fact covered by the AIFMD in particular transfer of units/ shares is unclear and we await further guidance from ESMA on the impact on carried interest and co-investment arrangements in particular. The key requirements echo many of the principles in CRD3, being: (i) the need for fixed and variable remuneration to be appropriately balanced; (ii) variable compensation that can be paid without deferral must be no more than 40% of total remuneration and 60% of the variable remuneration should be deferred over at least three years; (iii) provisions for payment and vesting of deferred components should be performance related (by reference to the performance of the relevant individual, business unit and fund); (iv) at least 50% of the variable remuneration should be paid in units or shares of the AIF which should also be subject to a suitable retention policy; and (v) restrictions on guaranteed variable remuneration such as guaranteed bonuses.

USA

For developments in the context of changes to remuneration structures in firms operating in the US financial services sectors in particular under Dodd-Frank Wall Street Reform and Consumer Protection Act, please refer to our client updates published in June and July 2010. [17]

“Take Aways” for 2011

2010 has been another busy year for regulators in the UK, Europe and globally. The implementation of policies to comply with the new rules on remuneration structures and disclosure are a huge challenge for firms – particularly in the context of the UK, the 2,000 + firms which will be for the first time subject to various new provisions in this area.

In a recent study published by Mercer LLC it was reported that 94% of European financial services respondents said they had cut bonuses, while 56% had increased the weight of long term incentives. About 53% say they have linked bonuses to subsequent corporate performance and about 70% of the respondents had raised basic salaries. Whilst the details of the new Code and disclosure regulations kick in, the changes to remuneration packages will continue. From a practical perspective, Code Firms need to identify Code Staff and other impacted employees, notify these employees that they may be subject to the relevant CRD3 rules; undertake an audit of the contracts, policies, pro forma contracts, Employee Handbooks and similar to ensure all relevant provisions regarding variable remuneration, bonuses and other incentive awards are consistent with the new requirements. Remuneration Committees of Code Firms may need to be reconstituted and their scope of responsibility examined to ensure they are fulfilling the duties expected of them and where appropriate seeking external aid. Reporting requirements of firms will also need to be examined to ensure adequate disclosure (whether in Annual Reports or other standalone reports) are met.

The debate on banker pay and bumper bonuses will rage on – in the mean time firms need to be rapidly deploying all resources to ensure they are in full compliance.

Endnotes

[1] See Annex 2, available here.
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[2] See “Who is Impacted” below for scope of CRD3
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[3] http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2010:329:0003:0035:EN:PDF
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[4] www.c-ebs.org/cebs/media/Publications/Standards%20and%20Guidelines/2010/Remuneration/Guidelines.pdf
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[5] http://www.fsa.gov.uk/pubs/policy/ps10_20.pdf
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[6] http://www.fsa.gov.uk/pages/Library/Policy/CP/2010/10_19.shtml
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[7] See Annex 1 (available here) for a list of the key 12 Remuneration Principles as finally set out in CP10/20. This list does not include the Guidance and Evidential Provisions supporting the Remuneration Principles nor does it include the detailed rules on the effect of breaches of the principles.
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[8] Credit institutions as defined under Article 4(1)(a) Directive 2006/48/EC (http://eur-lex.europa.eu/LexUriServ/site/en/oj/2006/l_177/l_17720060630en00010200.pdf ) and investment firms as defined under Article 3(1)(b) Directive 2006/49/EC (http://eur-lex.europa.eu/LexUriServ/site/en/oj/2006/l_177/l_17720060630en02010255.pdf)
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[9] But excluding firms which are exempt from CRD
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[10] (A) Heads of significant business lines (e.g. Fixed income/ Foreign exchange /Commodities/ Securitisation/ Sales areas/ Investment banking (including M&A advisory)/ Commercial banking/ Equities/ Structured finance/ Lending quality/ Trading areas/ Research) including regional heads, and any individuals or groups within their control who have a material impact on the firm’s risk profile. AND (B) Heads of support and control functions (e.g. Credit, market, or operational risk Legal /Treasury controls /Investment research/ Human resources (HR) / Compliance/ Internal audit/ Information technology ) and other individuals within their control who have a material impact on the firm’s risk profile
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[11] For details of the four tiers, refer to paragraph 3.23 of PS10/20. In summary, tiers one and two cover large banks and building societies (eg exceeding £1bn in capital resources) and broker dealers that engage in significant proprietary trading or investment banking activitites; tier three consists primarily of small banks and building societies and firms that may occasionally take over-night short terms risks with their balance sheet and tier four will contain firms that generate income from agency business without putting their balance sheets at risk.
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[12] Staff whose variable remuneration is greater than 33% of their total remuneration and whose total remuneration exceeds £500,000. In addition, the Code provides for adjustment of application of the provisions in the case of persons who have been Code Staff for only part of the year (at least 3 months but less than 12 months)
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[13] Note: This retention period should be imposed in addition to the vesting periods for deferred awards
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[14] This covers remuneration awarded on or after 1/1/11; remuneration due on the basis of contracts entered into prior to 1/1/11 but paid on or after 1/1/11 and that yet to be paid out but relating to services provided in 2010
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[15] See our article (http://www.gibsondunn.com/publications/pages/EUAIFMDirective-Update.aspx) for a summary of the scope of the AIFM and its key provisions
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[16] Carried interest is defined in the AIFM as “a share in the profits of the AIF accrued to the AIFM as compensation for the management of the AIF and excluding any share in the profits of the AI accrued to the AIFM as a return on any investment by the AIFM into the AIF”
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[17] http://www.gibsondunn.com/Publications/Pages/ExecutiveComp-CorpGovernanceProvisionsofDoddFrankBill.aspx and http://www.gibsondunn.com/Publications/Pages/Dodd-Frank-ExecutiveCompensationCorporateGovernanceProvisions.aspx
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