New EU recovery prospectuses 'to reduce time and costs involved in raising capital'
Out-Law Guide | 11 Oct 2010 | 5:31 pm | 13 min. read
This guide is subject to UK law and was last updated on 19th January 2011.
Over 2500 financial services firms are likely to be affected by changes to the Remuneration Code which came into effect on 1st January 2011.
The revised Code requires firms to set up and maintain remuneration policies that are consistent with good risk management. In particular, it requires a proportion of any bonus payable to significant employees (known as Code Staff) to be paid in shares (or similar) and for payment to be deferred over several years.
The original Code, introduced in January 2010, only applied to the largest banks, building societies and broker dealers. Only about 26 firms in the UK fell within its scope.
The revised Code will have an impact on all banks, building societies, asset managers, hedge fund managers, UCITS investment firms and some firms that engage in corporate finance, venture capital, the provision of financial advice and stockbrokers.
It does not, however, apply to insurers (but see: What insurers need to know about the Remuneration Code, an OUT-LAW Guide).
The Financial Services Authority (FSA) was prompted to make the changes by new rules on employee remuneration required by the Financial Services Act 2010, the EU Capital Requirements Directive (CRD3) and recommendations made by the Walker review on corporate governance.
The final revised Code, which appears in SYSC 19A of the FSA Handbook, also takes into account guidelines to CRD3 published by the Committee of European Banking Supervisors (CEBS) in December 2010, as well as the responses received to the FSA's July 2010 consultation.
In addition to the final rules, the FSA has also set out how it intends to apply proportionality to the range of firms that have become subject to the Code.
As a result, not all firms will be required to comply with all of the rules. And firms falling within scope for the first time will have until 1st July 2011 to meet their obligations.
In a parallel process, the FSA has also published its final rules on remuneration disclosure requirements, incorporating relevant provisions of CRD3 and taking into account the CEBS guidance.
The Financial Services Act 2010 contains a number of provisions relating to remuneration. For the most part, these reinforce the key principles of the existing Code, in particular the need to align remuneration practices with effective risk management.
Changes were, however, required to incorporate the express "voiding" powers in the Act (where breaches of the Code may render a contract void and/or require recovery of payments made) and to ensure that the Code is consistent in all respects with implementation standards approved by the G20 Group of finance ministers and central bank governors.
Under the Capital Requirements Directive (CRD3), firms' remuneration policies and practices have to take into account several principles covering the structure, amount and timing of bonus payments.
But, while CRD3 aims to align remuneration practices across the EU, a number of major G20 countries have chosen to implement the Financial Stability Board's Principles on Remuneration (18-page / 87 KB PDF) as guidance rather than as enforceable rules, creating problems for EU firms looking to recruit and retain staff in non-EU markets.
The FSB is due to review the implementation of its standards in the first half of 2011. In the meantime, the FSA says it will monitor developments closely with other EU supervisory authorities. "We will be prepared to consider options for mitigating the adverse competitive implications for firms, within the limitations imposed by CRD3."
The main effect of the changes is to widen the application of the Code to apply to all banks, building societies and Capital Adequacy Directive investment firms.
The FSA expects over 2500 firms will fall within this wider scope, although it will adopt a proportional approach to reflect a CRD3 provision which states: "institutions shall comply with [….] principles in a way and to the extent that is appropriate to their size, internal organisation and the nature, the scope and the complexity of their activities".
In its feedback paper, the regulator clarifies how it intends to apply proportionality by creating four "tiers" of firms and applying different minimum expectations of compliance for each group.
Tiers 1 and 2 contain credit institutions and broker dealers that engage in significant propriety trading/investment banking activities.
Tier 3 is mainly made up of smaller banks and building societies and firms that may occasionally take overnight/short term risks with their balance sheet. Tier 4 contains firms that generate income from agency business without putting their balance sheets at risk.
The proportionate approach will mean that the requirements for tiers 3 and 4 will be less onerous than for tiers 1 and 2. Firms in tiers 3 and 4, for instance, will not be expected to have a remuneration committee or apply some of the more prescriptive elements of the remuneration rules.
The first task for firms is to establish into which tier they fall, which will depend on a firm's specific risk characteristics. The FSA says there will be some degree of flexibility and firms will be able to contact the regulator for individual guidance.
The Code applies to overseas branches of UK-headquartered firms if the UK firm is caught by the Code. It also applies to overseas group members if they form part of a UK consolidation group or EEA sub-group.
UK branches of non-UK EEA firms, however, do not fall within the Code as they will be subject to their home state regulator's requirements implementing CRD3. But other overseas presences in the UK, whether a subsidiary or branch of an overseas company, will need to comply.
Where companies within a group fall within different tiers, the highest possible tier will normally apply to the group.
The Code applies to certain groups of employees within an organisation, known as "Code Staff". These comprise any staff which "have a material impact on a firm's risk profile". All firms within the scope of the Code must collate an annual Code Staff list and update it as appropriate.
The FSA's guidance suggests Code Staff should include:
The guidance sets out a non-exhaustive list of examples of positions and suggested business lines which the FSA believes should be subject to the Code on the basis they are "risk takers".
As well as the more obvious areas, such as sales, trading, foreign exchange, commodities and structured finance, this list includes compliance, internal audit, legal and HR within the suggested business lines.
A “de minimis” rule means that Code Staff who earn less than £500,000 per annum and whose bonus ("variable remuneration") is less than 33% of their total remuneration will not be subject to specific provisions on deferral, part payment in shares, guaranteed bonuses and performance adjustment ("clawback"). This is likely to raise issues of valuation, for which no specific guidance is given.
Guidance is, however, provided on how to deal with certain situations, such as Code Staff who have been employed for only part of the year or who are on secondment.
Risk takers and people with significant influence functions located overseas but employed by a branch or a subsidiary based in the UK may or may not be Code Staff, depending on the extent to which they are in a position to have a material impact on the risk profile of the UK firm.
"We will have close regard for cases with possible avoidance, i.e. where an individual may have been relocated to avoid the impact of the code," the FSA states in its feedback paper.
"However, we may consider cases for exemption where the individual has global responsibilities and where the UK entities form only a part of those responsibilities."
The Code requires "significant" firms to set up a remuneration committee capable of exercising competent and independent judgment on remuneration policies and practices. Significance is measured in terms of size, internal organisation and the nature, scope and complexity of the firm's activities.
The committee and its chairman must be members of the governing body who do not perform any executive function in the firm. In its decision-making the committee must take into account the long-term interests of shareholders, investors and other stakeholders in the firm.
Tier 2 firms with an overseas parent may not need to have a remuneration committee and the rule does not apply to tier 3 and 4 firms, although the FSA says it would be desirable for larger tier 3 and 4 firms to have one.
A new rule requires all firms to ensure that total variable remuneration does not limit the firm's ability to strengthen its capital base.
This will be assessed for larger firms by an annual review of the extent to which remuneration payouts are consistent with capital plans.
Where remuneration is performance-related, the total amount should be based on a combination of the performance of the individual, the business unit concerned and the firm's overall results.
A "significant part" of an individual's assessment should be based on non-financial criteria, with special emphasis on risk management, regulatory compliance and adherence to the firm's values. The guidance suggests a "balanced scorecard" approach is a good technique.
The firm must ensure the assessment is set in a "multi-year framework", taking into account longer-term performance over several years, although the FSA says this could be achieved through appropriate use of deferral and clawback.
There are also rules requiring risk adjustments to be made when the firm is calculating bonuses. Techniques for risk adjustment vary and each firm should chose the methodology most appropriate for its circumstances - and be prepared to provide details to the FSA.
Where a firm makes a loss, the FSA will generally expect no variable remuneration to be awarded. Bonuses may, however, be justifiable in certain circumstances, such as new ventures.
Under the revised Code, 40% of any variable remuneration of Code Staff must be deferred over a period of at least three to five years. At least 60% must be deferred where the variable component is of a particularly high amount (generally over £500,000) or payable to a director of a "significant" firm.
As before, significance is measured in terms of size, internal organisation and the nature, scope and complexity of the firm's activities.
A long term incentive plan (LTIP) award may be included in the calculation of the deferred proportion, where the FSA is satisfied that the upside incentives of the award are balanced by downside arrangements. In addition, the award must be linked to a particular performance year, so that it will count towards the deferral calculation only for that year.
Although the deferral requirements apply only to Code Staff, the guidance makes it clear that the FSA would like deferral to be applied on a firm-wide basis.
At least 50% of any variable remuneration must be made up of an appropriate balance of shares in the firm, share-linked instruments or equivalent non-cash instruments; and where appropriate, alternative capital instruments (probably a form of long-dated bond).
In line with the CEBS guidelines, the rule applies equally to both the deferred and undeferred portions of the variable remuneration.
The shares or other instruments should be subject to an appropriate minimum retention policy. In relation to the non-deferred component of variable remuneration, it is understood that the FSA will allow some shares to be sold to pay income tax and National Insurance so that the retention will apply only to shares "net" of tax liabilities.
This, however, may raise practical problems if a significant number of shares need to be sold in a short timeframe. Firms will need to consider ways in which to structure round these difficulties.
Listed firms in tiers 1 and 2 will be expected to meet the retained shares requirements. Unlisted firms will be able to rely on transitional measures that give them until 1st July 2011 to prepare appropriate instruments in time for the 2011/12 remuneration round. The FSA says it will continue to discuss possible alternatives with relevant firms and trade associations and may provide some further guidance in due course.
Firms in tiers 3 and 4 will not normally be required to apply the rule to their Code Staff.
A new rule provides that guaranteed bonuses of more than one year must not be offered and that guarantees may only be given in exceptional circumstances to new hires for the first year of service only.
The guidance recommends that all guaranteed bonuses (not just to Code Staff) should be subject to the same deferral criteria as other types of variable remuneration.
Variable remuneration in the form of retention awards may be granted in limited circumstances, such as a corporate restructuring and where a strong case can be made for retaining key staff members on prudential grounds. The FSA will expect to be notified of any planned retention awards as part of the firm's general duty to notify anything of which the regulator would reasonably expect to have notice.
This offers little comfort to firms seeking to prevent valued staff members from being poached by their competitors. It is not clear from the wording whether the regulator would consider allowing retention awards in other circumstances if a good case could be made.
Another new rule states that all deferred remuneration should be subject to an appropriate form of performance adjustment ("clawback").
Rather than clawing back an award which has already vested, the focus is on adjusting any unvested deferred variable remuneration as a result of the poor performance of the firm, the relevant business unit or the individual concerned.
Guidance is given on the types of situation where adjustments should be considered, for example employee misbehaviour or material error, a material downturn in financial performance or a material failure in risk management.
A new severance rule means that payments related to the early termination of a contract must reflect performance over time and must not reward failure. Severance arrangements that generate large payouts to senior staff that do not relate to effective performance, or are given where inappropriate risk taking has occurred, will be incompatible with the Code.
Firms will need to set up a framework in which severance pay is determined and be able to explain the criteria for severance pay to the FSA.
To incorporate express powers granted under the Financial Services Act 2010, a new rule sets out the instances where breaches of the Code may render a contract void and/or require recovery of payments made.
The FSA proposes to use this power only in relation to Code Staff and only in relation to deferral arrangements and guaranteed bonuses.
In addition, it is applying a transitional provision so that, for 2011, voiding under the revised Code will only apply to firms which were within the scope of the 2010 Code. During 2011, the regulator plans to bring forward a new limiting provision so that voiding will only apply to firms broadly equivalent to proportionality tier 1.
There are new requirements for enhanced discretionary pension benefits to be held for at least five years in the form of shares or equivalent instruments.
The FSA clarifies that enhanced discretionary pensions are enhanced pension benefits granted on a discretionary basis as part of the employee's variable remuneration package, but they exclude accrued benefits granted to an employee under the terms of their pension scheme.
The new rule is not intended to apply to the employee's standard pension plan or the firm's financial contribution schedule to meet its contractual pension obligations. The intended focus is any non-standard one-off payments on an individual basis.
All firms subject to the Code will have to submit an annual return that sets out the aggregate data on their remuneration policies and practices. Firms will also need to prepare a Remuneration Policy Statement (RPS) in which they will self-assess their compliance.
The firm's Remuneration Committee (if it has one) will play a role in revising and approving the RPS on an annual basis. But the FSA will expect the RPS to be kept up-to-date and can ask to see it at any time.
The RPS for a tier 1 firm is likely to be the most detailed. Firms in tiers 2, 3 and 4 will be able to complete a questionnaire or template.
The first annual return and RPS will need to be completed during the second half of 2011.
Firms already within the scope of the Code are required to comply in full from 1st January 2011. Firms coming within scope for the first time need to comply as soon as reasonably possible and in any event by 1st July 2011.
Subject to this six-month transitional period, the rules apply to:
If a firm is unable to comply with the Code because of an obligation it owes to a Code Staff member under an agreement made on or before 29th July 2010, the firm must take reasonable steps to amend or terminate the agreement in a way that allows it to comply with the Code.
New rules on disclosing information about Code Staff remuneration also came into force on 1st January 2011.
The required information includes how the firm decided on its remuneration policy, the link between pay and performance and key design characteristics such as performance measurement, risk adjustment, the deferral policy and vesting criteria.
There is also a requirement to provide aggregate information about the amount the firm paid Code Staff during the financial year, how much in bonuses, vested and unvested deferred remuneration, performance adjustments and severance payments.
These rules will be applied proportionately according to the same four-tier system. Only tier 1 firms will have to comply in full. For the others, the need to disclose aggregate information will be more limited and tiers 3 and 4 firms will not have to give information on key design characteristics.
Disclosures must be made at least annually. The FSA has set a deadline of 31st December 2011 for the first disclosures in relation to remuneration for 2010.
New EU recovery prospectuses 'to reduce time and costs involved in raising capital'