Capital Requirements Directive

Amendments put strict rules on remuneration

Originally published in the September 2010 issue

On 7 July 2010 the European Parliament approved amendments to the Capital Requirements Directive (the Directive) concerning remuneration. The amendments impose some of the strictest rules in the world on financial sector pay, ostensibly to try and protect the interest of creditors and improve financial stability. The significance for hedge funds is that they will be covered, for the first time, by the burgeoning restrictions already being imposed on banks and building societies.

Financial Services Authority’s Remuneration Code

Prompted primarily by the Directive, the FSA, which is in charge of implementing the changes in the UK, is in the process of consulting on proposed amendments to its existing Remuneration Code (the Code). The FSA published its Consultation Paper, Revising the Remuneration Code (CP10/19), on 29th July 2010. The consultation runs until 8 October 2010.

The Code originally applied to a group of the largest banks, building societies and broker dealers with effect from 1 January 2010. However, it is not only the scope, but also the substance of some of the rules in the Code, which is to be changed, with effect from 1 January 2011. From the point of view of hedge funds, which have not previously been in scope, it matters not which elements in the revised Code were there previously and which have been introduced in response to the Directive. In the context of employment or other contractual relationships within hedge funds, the rules which are of most interest are those which address the following:

1. The balance between the fixed and variable components of the remuneration. Firms must set appropriate ratios between the fixed and variable components of total remuneration and ensure that the fixed component is high enough to allow them to operate a fully flexible policy on the variable element, including paying no variable remuneration (19.3.42).

2. The balance between cash and shares in the remuneration package. At least 50% of the variable remuneration must consist of an appropriate balance of shares (or equivalent non-cash instruments in the case of a non-listed firm) and capital instruments (19.3.45 R).

3. The balance between the immediate and deferred elements of the remuneration. At least 40% of the variable remuneration (60% for a large bonus of £500,000 and above) must be deferred over a period of three to five years (19.3.46 R).

4. Guaranteed bonuses. These are banned except in exceptional circumstances in the context of new hires, and limited to the first year of service (19.3.38 R).

5. Profit-based performance measurement and risk adjustment. Several rules deal with this and require that bonus calculations should take account of all types of current and potential risk, the cost and quantity of the capital and the liquidity required (19.3.22 R); that assessments of financial performance be based principally on profits (19.3.25 R); and that total variable remuneration should be “considerably contracted where subdued or negative financial performance of the firm occurs” (19.3.27 R).

6. Performance adjustment. The bonus should only be paid or vest if it is sustainable according to the financial situation of the firm as a whole and justified according to the performance of the firm, the business unit and the individual concerned (19.3.48 R).

The general requirement of the revised Code is that remuneration policies must be consistent with and promote effective risk management. There are various provisions about firms’ overall remuneration policies, avoiding conflicts of interest, remuneration committees, total variable remuneration not limiting the firm’s ability to strengthen its capital base, and so on, which are beyond the scope of this article.
All of the principles of the revised Code will apply to Code Staff, which include:

1. A person who performs a significant influence function for a firm;

2. A Senior Manager;

3. All staff, whose total remuneration takes them into the same bracket as senior management and risk takers, whose professional activities could have a material impact on a firm’s risk profile.

The FSA expects firms to identify and compile lists of Code Staff so they can notify staff who will be potentially subject to the Code’s rules. The FSA retains the right to challenge the lists if they are not consistent with the guidance given by the Code. However, the rules relating to deferral, performance adjustment, proportion of remuneration paid in shares and guaranteed bonuses will not apply to staff whose bonus is less than 33% of their total remuneration and whose total remuneration is less than or equal to £500,000 (the de minimis exception).

The FSA will be issuing guidelines in respect of Non-Code Staff to recommend that firms should also give consideration to applying the remuneration principles on a firm-wide basis subject to proportionality.

The Financial Services Act 2010 has given the FSA powers to prohibit a firm from remunerating its staff in a specified way; 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 that it intends to exercise these powers only in relation to Code Staff and only in relation to the rules covering bonus deferral arrangements and guaranteed bonuses. However, all of the Code will need to be applied to Code Staff (subject to the de minimis exception) and in some cases this may necessitate changes to their terms and conditions of employment or other contracts. In the case of LLP Agreements, Shareholders’ Agreements, Articles of Association and Partnership Agreements, this may simply be a case of negotiations among equals to align existing arrangements with the new regulatory framework, but changing employees’ terms and conditions raises other considerations.

Implementing changes to employees’ terms and conditions
Hedge funds will need to review the wording of employees’ service agreements and bonus schemes carefully before implementing any changes to them. If service agreements and bonus schemes are not purely discretionary, allowing hedge funds to change how and when bonuses are paid, then hedge funds will need to consider the best method of varying the contractual bonus arrangement.

Even where such arrangements are fully discretionary, employers will need to give careful thought to the re-education of expectations and awareness-raising about the new rules by which they are constrained, if poor morale and staff losses are to be avoided. For example, the FSA recommends that firms should have a performance adjustment scheme which is documented and communicated to all Code Staff, details of which should be available for the FSA to review on request. This is in the context of the requirement that a significant proportion of bonuses should be linked to the future performance not only of the firm, but of the employee him/herself and the division or business unit in which they operate.

Consent to the changes
Where it is necessary to make changes to employees’ remuneration and bonus schemes, hedge funds should first seek their written consent to any proposed changes before implementing them; otherwise the changes could give rise to legal challenges. This needs to take place as early as possible before the proposed changes will take effect. As noted above, the Code will come into effect on 1 January 2011, and the FSA has stated that it expects those coming within its scope for the first time to begin planning as soon as possible. However, they will not expect such firms to have the prescribed remuneration structures in place until later in 2011.

The hurdle is how to deliver the proposal in such a way that it will be supported by those affected. The hedge fund will need to explain the nature and the proposed timing of the changes as well as the reasons for the changes. The hedge fund should make clear the likely implications for the fund and the employee if the changes are not implemented, for example, the FSA could try and recover bonus payments from the employee if the bonus arrangement does not comply with the Code’s deferral provisions. In view of the provisions of the revised Code it is likely that many employees will appreciate the reasons for the change and support the proposals. If a firm needs to increase the fixed component of remuneration in order to implement a fully flexible policy on the variable element, this may be perceived by some to be an advantage in uncertain economic times.

If the changes are agreed by all affected employees then the hedge fund should send a letter to each employee setting out the proposed changes and asking them to countersign to evidence their written agreement. It is important to have such evidence, particularly in view of the recent Court of Appeal case of Khatri where a trader did not sign a letter setting out amendments to his bonus scheme and the Court found his continued employment did not amount to acceptance of the changes.

If all the employees do not agree to the changes, the hedge fund has the following options:

1. Unilaterally impose the proposed change and rely on the employee’s conduct to establish implied agreement to the change.

2. Terminate the existing contract and offer continued employment under new terms.

Unilaterally impose the change
The hedge fund could unilaterally impose the change and hope that, although the employees have not expressly agreed to the change, they can show that the employees have implicitly agreed to the change. The hedge fund might be able to show this if the employees continued to work for the firm (but not under protest), but this is highly fact-sensitive, as the case of Khatri illustrates.

However, it is possible that some employees might claim that their employer had breached the contract of employment by imposing the contractual change without their express or implied agreement. In such a situation, as a matter of law, the original terms of the contract will remain in place.

The employee could respond to the breach in the following ways:

1. Work under the new terms under protest and bring a claim for breach of contract or unlawful deduction from wages (but see below for the difficulties inherent in such claims in these circumstances).

2. If the breach of contract is a fundamental breach going to the root of the contract, the employees could bring a claim for constructive dismissal. If they could establish that the change amounted to a reduction in remuneration this is likely to be sufficient to amount to a fundamental breach of contract. However, the fact that a dismissal is constructive does not automatically mean that it is unfair. If the hedge fund could show a business need for the changes and has followed reasonable procedures for handling the change, the end result could be a fair dismissal. But the employee would still have a claim for wrongful dismissal (covering his salary during the notice period) and might be entitled to a protective award (the employee’s normal weekly wage up to an upper limit of 90 days) if the hedge fund had unilaterally imposed the change on 20 or more employees without fulfilling its collective consultation obligations.

Terminate the existing contract and offer continued employment under new terms
Where employees refuse to accept the changes, the best option is likely to be terminating the existing contract and offering continued employment under new terms. The hedge fund would need to write to employees setting a deadline for obtaining written agreement to the new terms and stating that if agreement is not obtained at that stage, the hedge fund will contemplate terminating the employees’ employment for a refusal to agree to the (reasonably requested) changes, and offer employment on new terms.

The fund would need to follow a three step process to dismiss an employee by writing to invite them to a disciplinary meeting, holding the meeting, and allowing the employee to appeal the decision to dismiss. If the hedge fund is contemplating dismissing and re-engaging 20 or more employees, a collective redundancy situation would exist, giving rise to more onerous consultation obligations prior to dismissal.

The hedge fund would need to show that there was a fair reason for the dismissal and that it had acted reasonably in dismissing the employee for that reason. In the context of changing terms of employment, employers usually rely on the potentially fair ground of “some other substantial reason” (SOSR). It is likely that an Employment Tribunal would find that a sound business reason was sufficient to establish SOSR for dismissing an employee who refused to accept a change in his or her terms and conditions in circumstances where it has been explained that the employer is implementing regulatory requirements – and where the changes did not go beyond what was reasonably required to do so.

The hedge fund would need to serve due notice under the contract of employment (to avoid a wrongful dismissal claim) and state that the new terms would take effect on expiry of the notice period.

There are two elements to the award a Tribunal can make if unfair dismissal is proved: a basic award (calculated purely on age and length of service and capped at £11,400) and a compensatory award. The latter is based on the loss which the employee has actually suffered, but is capped at £65,300, so is unlikely to prove adequate compensation for most hedge fund employees of the type falling within the Code’s scope.

The Tribunal’s jurisdiction to deal with breach of contract claims is £25,000 (provided the contract has ended), so most such claims would need to be pursued in the High Court, with its attendant costs risks. Wherever the claims fell to be adjudicated, provided the changes had been reasonably and proportionately implemented in the light of the Code’s rules and guidance, it is very difficult to see any Court or Tribunal ordering payment of compensation where this would effectively circumvent FSA rules. In the unlikely case of a continuing employee suing for breach of contract or claiming an unfair dismissal (despite having accepted re-engagement on the new terms), the claim would be even more difficult to run. The employee would have to establish his losses by comparing what he would have earned under the old regime, which might be voidable by the FSA or contrary to the provisions of the Code, with what he would earn under the new regime, by definition a long-term calculation, taking account of such matters as deferral and performance over three to five years.

There will always be cases which are less clear cut, where, for example, there has been no consultation or where it is alleged that the Code has been used as an excuse to implement wider changes than required. But most will, it is suggested, find it preferable to stay put and accept the revised terms than to be dismissed and take their chances in relation to such arguments.

Sue Kelly is a partner and Louise Lawrence a solicitor in the employment team at London-based law firm, Winckworth Sherwood. They have extensive experience of advising those involved in the Financial Services sector.