On December 17, 2010, the UK’s Financial Services Authority (“the FSA”), published the final version of its revised ‘Remuneration Code’ (“the Code”) governing pay in the UK financial services industry. The Code represents a radical reform of remuneration structures for banks and other financial institutions. Whilst the Code takes effect from January 1, 2011, some of the more restrictive provisions will not immediately bite, giving firms six months until July 1, 2011 to comply. The initial proposals had provoked major concern within the investment management industry, with investment fund managers brought within scope for the first time. After industry representations to the FSA, however, the final version of the Code effectively exempts investment managers from having to comply with the most onerous provisions including the requirements to ensure fixed and variable remuneration are “appropriately balanced,” to pay 50 percent of variable remuneration in shares or share-like instruments, and to defer bonuses (with the possibility of claw-back).
The UK had previously introduced the Code unilaterally on January 1, 2010, in response to political pressure stemming from the financial crisis. The Code was principally confined to banks, as its application was determined by minimum levels of regulatory capital. The FSA subsequently consulted on proposed amendments to the Code in order to implement remuneration rules of wider application prescribed by the third Capital Requirements Directive (“CRD III”).
The FSA has rushed the new remuneration regime through in order to meet the tight EU implementation deadline of January 1, 2011. The FSA is leading the way on timing, ahead of certain other Member States which are still digesting CEBS’ recently published ‘Guidance to national regulators on how to implement the CRD III’s remuneration policies and practices’ (December 10, 2010). As stated above, banks and firms will be able to benefit from a six-month transitional period in respect of certain of the more restrictive provisions. Further, the FSA has indicated that it will not ask firms to supply a data return and Remuneration Policy Statement (recording firms’ self-assessment of compliance with the Code) until the latter half of the year.
Whilst banks and other financial institutions will need to adhere to the Code in full, due to the FSA’s willingness to utilise the flexibility CRD III affords regulators to implement the new rules in a proportionate manner, the negative impact of the new proposals has been significantly reduced for many investment firms (as discussed further below).
Expanded Scope of the Proposals
The expanded scope of the Code represents one of the most significant changes to the existing regime. This is because remuneration restrictions will apply not only to all banks and building societies, but also to all Capital Adequacy Directive investment firms, and UK branches of firms whose home state is outside the European Economic Area. In practice, therefore, nearly all asset managers, as well as many corporate finance, venture capital and advisory firms, brokers and private equity firms, will be subject to the new restrictions. The FSA has estimated that more than 2,500 FSA authorised firms fall within the Code’s scope.
The types of individuals affected by the Code (“Code Staff”) are potentially numerous, as the definition of Code Staff is broad. Code Staff now includes all staff who have “a material impact” on the firm’s risk profile, including any person who performs a significant influence function for a firm, senior managers, risk takers, staff engaged in control functions, and any employee receiving total remuneration that takes them into the same remuneration bracket as senior management and risk takers, and whose professional activities have a material impact on the firm’s risk profile.
The people constituting Code Staff will vary from firm to firm, requiring individual analysis on a case-by-case basis. According to the FSA’s guidance, ‘risk takers’ will include heads of significant business lines (such as research, trading and regional heads), as well as heads of support and control functions (such as legal, compliance and HR). Meanwhile ‘Senior Manager’ is defined as an individual employed by the firm with responsibility for management and supervision, and who reports directly to the governing body, a member of the governing body, the chief executive or the head of a significant business group. There is, however, a de minimis provision, which excludes from scope anyone whose bonus does not exceed 33 percent of their total remuneration and whose total pay is equal to, or less than, £500,000.
The new rules will have particular ramifications for UK-headquartered groups. UK groups will be obliged to apply the Code globally to all their regulated and unregulated entities, while UK subsidiaries of non-EEA groups will be obliged to apply the Code in respect of all entities within their subgroup (whether such entities are based in the UK or not). This will put UK (and other EU) firms competing in overseas markets at a disadvantage.
CRD III has enabled national regulators to apply the Code to investment fund managers less prescriptively, taking into account a particular firm’s “size, internal organisation and the nature, scope and complexity of its activities.” The FSA has fully embraced this proportionate approach and in so doing has created a four-tiered supervisory architecture, with full Code application to “Tier One” institutions with the “litest” application for “Tier Four” firms, as follows:
- Tier One: Banks and building societies with capital resources exceeding £1 billion;
BIPRU €730,000 firms that are full-scope BIPRU investment firms with capital resources exceeding £750 million; all third-country firms with total assets (for the branch) exceeding £25 billion. In practice this includes all the major investment banks.
- Tier Two: Banks and building societies with capital resources between £50 million and £1 billion; BIPRU €730,000 firms that are full-scope BIPRU investment firms with capital resources between £100 million and £750 million; and all third-country BIPRU firms with total assets (for the branch) between £2 billion and £25 billion. This category covers any other investment banks and building societies.
- Tier Three: Any bank, building society and full-scope BIPRU investment firm that does not fall within Tiers One or Two; and all third-country BIPRU firms that are not in Tiers One, Two or Four.
- Tier Four: All limited licence and limited activity firms (including third-country BIPRU firms with such permissions), including in practice most investment managers.
Tier Four firms are exempted from the most burdensome remuneration provisions. The FSA took this approach because, inter alia, such provisions would be impractical (and even impossible) to apply to these firms, and in contrast to shareholder-owned banks that trade their own balance sheet, asset managers tend to be smaller owner-managed firms that trade as agent on behalf of the funds which they manage.
Structure of the Code
The Code is based around 13 principles, and has a wider objective than merely restricting remuneration structures. Its purpose is to promote effective risk management and curtail excessive risk taking by overhauling organisations’ policies and procedures, and in the process, reforming perceived cultural deficiencies within the financial services industry. However, the key focus for industry has been the specific restrictions on individuals’ remuneration (set out in Principle 12).
The remuneration restrictions will apply to all Code Staff unless they work in an investment management/other Tier Four firm, or are de minimis. For investment banks and others outside these groups, the key restrictions are:
- Balanced Fixed/Variable Remuneration
A requirement that firms have an “appropriate balance” between fixed and variable remuneration (although the new proposals do not impose a universal cap limiting the ratio of variable to fixed remuneration, as had initially been feared).
An obligation to defer at least 40 percent of Code Staff’s variable remuneration, with a vesting period over at least three years, beginning at least 12 months after it accrues (note that this figure increases to 60 percent of variable remuneration when total remuneration exceeds £500,000, and for directors of significant firms).
- Proportion in Shares
Payment of at least 50 percent of any variable remuneration component in shares, share-linked instruments or other equivalent non-cash instruments of the firm. At least 50 percent of both deferred and non-deferred remuneration must be in shares or similar instruments (despite the FSA having originally signalled to the contrary), thus preventing a firm from deferring principally the non-cash component of variable remuneration.
- Performance Adjustment
Payment of an individual’s unvested pool of variable remuneration only if sustainable and justified according to the performance of the firm, business unit and individual concerned.
Risk Adjustment and Multi-Year Framework
Tier Four firms may also take into account the specific features of their type of activity. This applies first in respect of the obligation to ensure that any measurement of performance used to calculate variable remuneration includes adjustment for all types of current and future risk, and takes into account the likelihood of receiving potential future revenues incorporated into current earnings. Second, it applies with regard to the “assessment of performance…in a multi-year framework in order to ensure that the assessment process is based on longer-term performance.” The FSA has declared that it will apply a proportionate approach to the requirement in CRD III, “with our highest expectations concentrated on firms within proportionality.” From this it seems unlikely that the method by which Tier Four firms take into account the specific features of their types of activity will be an immediate priority for enforcers.
Impact of the Remuneration Code for Investment Managers
Although Tier Four firms are exempted from the above Key Restrictions, the Code does limit these firms’ commercial autonomy in other ways. “Guaranteed minimum bonuses” are limited to the first year of a new hire’s employment (unless within the de minimis exemption), and retention bonuses are restricted to “exceptional circumstances” (such as when key staff need to be retained during a merger process or winding down). Also, severance payments related to early termination must not be used to reward failure, and firms can expect to have to explain the criteria they have used in calculating any severance package. Finally, a firm must ensure that its total bonus payments are “considerably contracted” where the firm suffers subdued or negative performance, that total remuneration is based on not only the performance of the individual, but also the business unit concerned and the overall results of the firm, that non-financial criteria are taken into account, and that personal hedging strategies are not used to mitigate reduced remuneration arising from firm risk alignment policies.
In addition to the impact on individuals, firms will also confront increased compliance costs. Tier Four firms are exempted from certain requirements, such as having a remuneration committee. However, the Code does impose a layer of bureaucracy and record keeping. For example all firms are obliged to prepare and submit a Remuneration Policy Statement and annual data returns to the FSA, the latter disclosing details of Code Staff and their remuneration. While this will not be subject to public disclosure, firms must be prepared to explain and justify policies and decisions, and will need to be able to demonstrate compliance with procedural obligations that the Code imposes. Similarly, firms must maintain a record of Code Staff, ensure that the firm’s governing body in its supervisory function adopts and periodically reviews the general principles of the remuneration policy and is responsible for its implementation, and ensures the implementation of the policy is subject to central and independent internal review. Therefore even Tier Four firms are expanding their compliance infrastructures accordingly.
Effect of Breach
The FSA is empowered by the Financial Services Act 2010 to prohibit a firm from remunerating its staff in a particular manner, render void any provision of an agreement that contravenes such a prohibition, and provide for the recovery of payments made, or property transferred in pursuance of a void provision. The FSA has stated its intention to exercise this power only in relation to Code Staff, and to further limit it to deferral arrangements and guaranteed bonuses. As a result, it will only affect investment firms subject to the proportionate approach in respect of guaranteed bonuses. Nevertheless, the powers given to the FSA (and its successor authorities) signals the political determination to ensure the Code is enforced vigorously, and leaves open the potential to broaden the scope of this power in future.
The Code introduces radical proposals restricting the ability of banks and other financial institutions to determine the remuneration of key staff. Having said this, the investment management industry comes off materially better in the final version of the Code given the FSA’s adoption of the principle of proportionality, thereby excluding Tier Four firms from the more burdensome and less workable aspects of the Code.
Davina Garrod, Partner, Antitrust and Trade Regulation/Investment Management Groups
Bingham has unparalleled experience in advising all types of financial services firms on how best to navigate the array of legislation and policy initiatives that have followed in the wake of the financial crisis. While we recognise that many firms and banks will have already adapted their remuneration policies to take account of the Code, those that have yet to do so can benefit from our significant experience advising in this area by contacting the lawyers listed below.
Davina Garrod, Partner, Antitrust and Trade Regulation/Investment Management Groups
Thomas John Holton, Partner, Investment Management Group
Roger P. Joseph, Practice Group Leader, Investment Management; Co-chair, Financial Services Area
Christopher Leonard, Counsel, UK Financial Regulatory Group