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The issue of remuneration continues to make regular appearances in the press and readers will be aware of the UK’s Financial Services Authority's (the "FSA") proposed changes to its Remuneration Code. The changes are yet to be finalised, but given the tight timetable the FSA is urging all affected firms to start preparing for the changes as early as possible. This note summarises some of the key provisions of the FSA's proposals.
On 29 July 2010, the FSA published a consultation paper entitled "CP10/19 Revising the Remuneration Code"1 (the "Consultation Paper") containing proposed revisions to the FSA's Remuneration Code (the "Code"), which came into force on 1 January 2010.2 The Consultation Paper follows the recently approved European requirements on remuneration in the amended Capital Requirements Directive ("CRD 3"), which will come into force on 1 January 2011. The proposed changes are intended to bring the Code into line with CRD 3, as well as other national and international initiatives on remuneration in the financial services sector.3
The FSA's consultation period will be closing shortly on 8 October 2010 and the FSA intends to issue a policy statement in November 2010.
Scope of the Code
Application to Firms
Currently, the Code only applies to 27 of the largest FSA regulated banks, building societies and investment firms (broker-dealers) that "deal in investments as principal", which would include firms engaged in proprietary trading, underwriting and market making. The FSA is proposing to expand the scope of the Code to cover the following types of regulated entities, which will incorporate over 2,500 firms (but not insurance companies):
a) all banks and building societies; and
b) all firms subject to the Markets in Financial Instruments Directive ("MiFID").4 Depending on the activities of the firm in question, this could include investment banks, hedge, private equity, UCITS and other asset managers, stockbrokers and broker dealers, corporate finance firms, futures and options firms, commodities firms, firms engaged in venture capital and general investment advisory firms.5
One of the principal concerns arising from this proposed expansion of the Code is that it fails to take account of the fundamental differences between the types of institutions covered by the rules; primarily between firms that do and do not take principal risk (e.g. between banks and asset managers). While the proportionality principle discussed below may address this concern and produce a tailored regime for non proprietary trading firms, much of this will depend on the outcome of the industry responses to the consultation and the subsequent approach adopted by the FSA.
Application to Groups and Branches
The proposed wording on the territorial application of the Code will likely need further clarification. As drafted, the revised Code should apply as follows:
1) UK Groups – The Code will apply globally to UK headquartered firms within the scope of the Code. It will apply in relation to regulated as well as to unregulated entities within a UK group.
2) UK Subsidiaries - The Code will apply to UK regulated subsidiaries of firms headquartered outside of the UK. The extent to which the Code will also apply to the UK subsidiary’s own subsidiary entities will depend on how the FSA's group risk consolidation rules will apply to the firm in question. Broadly, it is proposed that the Code will apply to all entities within a UK subsidiary's sub-group, including entities in such a sub-group based outside the UK.
3) UK Branches of EEA Firms – The Code will not apply to UK branches of firms whose home state is within the European Economic Area ("EEA"), as the remuneration rules of their home state (implementing CRD 3) will apply.
4) UK Branches of Non-EEA Firms – The Code will apply to UK regulated branches of firms whose home state is outside of the EEA (e.g. London branch of US bank).
The geographical ambit of the revised Code is potentially far-reaching and the FSA has stated that anti-avoidance measures such as setting up special group structures or offshore entities, or allowing or assisting staff to become employed by such structure or entities in order to circumvent the Code, are likely to be deemed non-compliant with the Code.
Application to Employees – Remuneration Code Staff
The revised Code would prescribe: (i) general principles relating to governance, conflicts of interest, risk adjustment, guaranteed variable remuneration and deferral, which the FSA expects will be applied on a firm-wide basis; and (ii) specific rules on remuneration that will apply to those groups of employees (referred to as "Remuneration Code Staff") whose professional activities may have a "material impact" on the firm's risk profile. This will include: senior management, risk takers, persons performing control functions and any employee receiving total remuneration that takes them into the same remuneration bracket as senior management and risk takers.
The FSA has published a non-exhaustive list of key positions that should be part of a firm's Remuneration Code Staff.6 In addition to what one would perceive as the typical risk takers (e.g. heads of sales, trading and structured finance areas), the FSA also considers that heads of legal, human resources, compliance and IT would be subject to the remuneration rules prescribed by the Code.
Definition of Remuneration
The Code will apply to any form of remuneration, including salaries, discretionary pension benefits and benefits of any kind.
The FSA's proposals on the amended Code include new rules in relation to the operation and composition of firm remuneration committees. Firms that were not previously subject to the Code will be required to develop governance and control over remuneration policies and their operation, including the establishment of separate independent remuneration committees by the larger firms.
As part of the amendments being introduced by the Code, relevant firms will need to ensure that employee remuneration is structured in accordance with the following principles:
1) Fixed/Variable Balance - Firms will be required to establish appropriate ratios of fixed to variable remuneration. As part of this, the FSA is also proposing new rules on risk adjustment that will require firms to take into account current and future risks when determining variable remuneration.
2) Bonus Deferrals - At least 40% of the variable remuneration component will have to be deferred with "vesting"7 over a minimum of 3 years for all Remuneration Code Staff, and 60% if the variable remuneration is of a "particularly high amount". In this regard, the FSA is proposing a threshold of £500,000, but also states that firms should consider whether lesser amounts should be considered to be "particularly high" taking account, for example, of whether there are significant differences within Remuneration Code Staff in the levels of variable remuneration.
3) Proportion in Shares - At least 50% of the variable remuneration will have to be paid in shares, share-linked instruments or other equivalent non-cash instruments in the case of a non-listed firm. The FSA has provisionally taken the view that the 50% requirement will apply to variable remuneration as a whole. Therefore, firms can decide whether shares form part of the non-deferred payment, part of the deferred element, or a mixture of both. The FSA acknowledges that compliance with this rule will be challenging, particularly for non-listed companies, and has proposed that the relevant firms be allowed to justify non-compliance until July 2011.
4) Performance Adjustment - All deferred remuneration will be subject to a form of "performance adjustment", which means that firms will have the ability to make amendments to the amount of an employee's unvested deferred remuneration in circumstances where: (i) there is evidence of employee misbehaviour or material error; (ii) the firm or relevant business unit suffers a material downturn in its performance; or (iii) the firm or relevant business unit suffers a material failure of risk management.
5) Guaranteed Bonuses - The FSA has confirmed a ban on guaranteed bonuses other than in exceptional cases for new hires in respect of the first year of employment. Such guaranteed bonuses will still be subject to performance adjustment requirements.
6) Retention Bonuses - Firms will have to restrict retention awards to circumstances where a firm is undergoing a major restructuring and a good case can be made for retention of particular key staff members on prudential grounds.
7) Enhanced Discretionary Pension Benefits - Enhanced discretionary pension benefits will need to be held for 5 years in the form of shares or share-like instruments after the termination or retirement of the relevant employee. The FSA is taking further advice on the application of these pension provisions, but expects that they will only be permitted in limited circumstances and apply to the most senior management.
8) Severance Payments - Payments relating to the early termination of a contract should reflect performance over time and should not be designed in a way to reward failure.
In implementing these requirements, a firm will also need to ensure that the total variable remuneration does not limit the firm's ability to strengthen its capital base. This principle underlines the link between a firm's variable remuneration costs and the need to manage its capital base, including forward-looking capital planning measures. Where a firm needs to strengthen its capital base, its variable remuneration arrangements will need to be sufficiently flexible to allow it to direct the necessary resources towards capital building.
De Minimis Rule
Subject to the publication of EU guidelines by the Committee of European Banking Supervisors ("CEBS") later in the year, the FSA is proposing that Remuneration Code Staff: (i) whose bonus is less than 33% of such Remuneration Code Staff's total remuneration; and (ii) whose total remuneration is less than or equal to £500,000 will be exempt from the rules relating to bonus deferrals, performance adjustment, proportion of remuneration paid in shares and guaranteed bonuses.
The FSA has confirmed its commitment to applying a "proportional approach" (as noted in CRD 3) to the rules within the Code. In this regard, the FSA has proposed an approach that distinguishes between: (i) minimum requirements that will be applicable to all firms; (ii) rules that could be applied proportionally in line with a firm's nature, scale, scope and complexity; and (iii) rules that would be applied on a "comply or explain" basis.
While this will allow many smaller banks and investment firms to adapt the remuneration rules to their circumstances, the FSA is yet to identify the parameters that will determine its expectations for each rule and establish precisely how to apply a proportionate approach to all firms. As such, the exact nature of the proportional approach is still to be determined. A report on proportionality is expected from CEBS in October 2010, and its recommendations are likely to direct the FSA's position on the matter.
Retrospective Application/Transitional Arrangements
The Code will take effect as of 1 January 2011 (in line with the intended implementation date for CRD 3) and will apply to: (i) remuneration awarded on or after 1 January 2011; (ii) remuneration due on the basis of contracts concluded before 1 January 2011, which is awarded or paid after 1 January 2011; and (iii) remuneration awarded, but not yet paid, before 1 January 2011 for services provided in 2010.
The FSA comments that this rule will not require firms to breach their contractual or employment law obligations. However, firms are expected to take reasonable steps to amend or terminate any provisions in employment contracts concluded prior to the publication of the Consultation Paper that will conflict with the Code at the earliest opportunity. In the interim, the FSA expects firms to adopt effective arrangements to manage the risk raised by the retrospective application of the Code.
New FSA Powers - Voiding Provisions
Section 6 of the Financial Services Act 2010 gives the FSA express powers to restrain remuneration practices that contravene the Code by: (i) prohibiting a firm from remunerating its staff in a specified way; (ii) rendering void any provision of an agreement that contravenes such a prohibition; and (iii) providing for the recovery of payments made, or property transferred, in pursuance of a void provision.
The FSA is proposing to add a new rule to the Code defining the circumstances in which breaches of the Code may render a contract void and/or require recovery of payments made. Currently, the FSA proposes to exercise this power only in relation to Remuneration Code Staff, deferral arrangements and guaranteed bonuses. However, it remains to be seen how Section 6 of the Financial Services Act 2010 will interact with UK employment law and general contract law and the extent to which the FSA would be able enforce these powers in non-UK jurisdictions.
What Should Firms Do?
A number of issues remain under consideration by the CEBS remuneration working group and the FSA proposals may be subject to change in light of the outcome of that work. Nonetheless, there are a number of things that firms may wish to start looking at, so as to assess the potential impact of the Code on them, including the following:
a) reviewing existing arrangements on how remuneration policies are set and implemented against the FSA's proposals;
b) drawing up lists of Remuneration Code Staff for 2010 and 2011, and compiling details of their existing remuneration structures to identify areas that are inconsistent with the Code;
c) considering whether employment contracts that are incompatible with the Code can be renegotiated. An immediate consideration is how best to address employees expecting bonus payments under existing contractual arrangements early next year;
d) in light of the proposed territorial scope of the Code, firms will need to review their group structures and determine which entities could potentially be caught by the Code. Due consideration will also need to be given to the rules regulating remuneration in the local jurisdiction of any non-UK entities subject to the Code and conforming the two;
e) deferred compensation schemes may increase a firm's record-keeping and accounting requirements and due consideration will need to be given to the effective administration of the schemes;
f) firms making use of deferred share-based compensation will need to think about whether shareholder approval will be required for issuing shares under the scheme or increasing share buy backs; and
g) implementing the Code will involve employment law, tax, accounting and contractual issues and firms should start planning their legal review alongside their internal policies and procedures.
Upcoming EU Developments of Remuneration
Proposed Directive on Alternative Investment Fund Managers ("AIFMD")
In addition to the revisions to the FSA's Code, asset managers will also need to keep abreast of the remuneration rules being proposed under AIFMD. Some firms within the scope of CRD3/the Code will potentially also be subject to AIFMD. It remains to be seen whether the AIFMD remuneration provisions will be consistent with CRD3 (and thus the revised Code) or if there will be an additional layer of requirements for asset managers to comply with.
The FSA's Code does not currently apply to insurance companies. However, with the upcoming implementation of the Solvency II Directive8 (expected end of 2012 or early 2013) insurance companies may be subject to similar rules in due course. Although the clauses on remuneration in Solvency II are at a higher level than CRD3 (Solvency II being a "framework" directive) and negotiations on Solvency II are still ongoing, the FSA is encouraging insurance and reinsurance firms to start considering the appropriateness of their remuneration policies within the context of Solvency II requirements.9
Undertakings for Collective Investment in Transferable Securities ("UCITS")
In June 2010, the European Commission published a Green Paper on corporate governance in financial institutions and remuneration policies. It sets out, inter alia, the Commission's proposals to change remuneration policies in companies in order to discourage excessive risk-taking. In the FAQ to the Green Paper, the European Commission states that legislative measures similar to CRD 3 are under preparation for UCITS and should be adopted by the European Commission in the course of 2011.
For further information on the London Financial Services Regulatory Practice please contact John Casanova at +44 (0)20 7360 3739 (email:
), Leonard Ng at +44 (0)20 7360 3667 (email:
) or Rachpal Thind at +44 (0)20 7360 3721 (email:
2 The current version of the FSA's Remuneration Code can be found in Chapter 19 to the Senior Management Arrangements, Systems and Controls Sourcebook ("SYSC") of the FSA Handbook at: http://fsahandbook.info/FSA/html/handbook/SYSC/19
3 According to the FSA, it is revising the Code in light of: (i) a number of provisions on remuneration introduced by the Financial Services Act 2010 on 8 June 2010; (ii) recent international developments on remuneration led by the Financial Stability Board; (iii) Sir David Walker’s recommendations on remuneration following the publication of The Walker Review of corporate governance in UK banks and other financial institutions in November 2009; and (iv) the lessons the FSA has learnt to date from implementing the Code.
4 Directive 2004/39/EC.
5 The FSA is hoping that the scope of the revised Code will reduce the competitive concerns that have been expressed by firms currently within the scope of the Code about losing their staff to competitors outside the ambit of the Code. However, with CRD 3 enforcing a remuneration code across Europe, there is now a wider concern that the differences in the regulatory approach at the global level will put EU financial service firms at a competitive disadvantage on the international market.
6 See Appendix 1, Annex B of the Consultation Paper, page 12.
7 "Vesting" is the point at which an individual's remuneration (whether in cash, shares or other instruments) becomes that individual's legal property. Deferred portions of the bonus will not be the legal property of the individual until delivered, and will not have been vested.
8 Directive (2009/138/EC).
The London Financial Services Regulatory Practice of Sidley Austin LLP
The London Financial Services Regulatory Practice represents a broad range of financial institutions and related businesses, from established international groups to start-ups. We act for clients with extensive UK, European and international operations, as well as for clients based in the US or elsewhere that wish to establish financial services businesses in the UK and the EU. We also represent clients before the FSA, including in connection with examinations, investigations and enforcement actions.
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