European Authorities Cap Bonuses

Big regulatory changes to remuneration are imminent

Originally published in the June 2013 issue

Hedge fund managers should consider the impact of the new bonus cap rules contained within the fourth Capital Requirements Directive (CRD IV) as implementation may be as early as 1 January 2014. Upon implementation, they will be tasked with having to review and potentially modify the way they remunerate their top earners. Following the European Parliament’s recent approval of CRD IV, which carries forward and expands the existing remuneration requirements under the third Capital Requirements Directive (CRD III), the European Banking Authority (EBA) on 21 May 2013 published a consultation paper containing draft guidelines on identifying those staff within European banks and investment firms who have a material impact on the firm’s risk profile. Those staff would be affected by the cap on bonuses for the highest-paid individuals as well as by the general remuneration requirements.

Hedge fund managers are a type of investment firm under the Markets in Financial Instruments Directive (MiFID) and have been subject to the remuneration requirements of CRD III since 1 January 2011. In the UK, those requirements were transposed by the Financial Services Authority using its rule-making powers to revise its Remuneration Code, which until then had only applied to banks, building societies and large broker dealers.

In order to implement the Based III reforms in the EU, in July 2011 the Commission published legislative proposals for CRD IV and a Capital Requirements Regulation (CRR), which will recast and replace the existing CRD III. During the recent trialogues between the Commission, Parliament and European Council, significant amendments were made to the original draft CRD IV provisions relating to remuneration, including the introduction of a cap on bonuses.

What are the new bonus cap rules?
CRD IV will apply to all bonus payments made to “material risk takers” other than payments due under existing contractual arrangements entered into before the draft CRD IV was first published on 27 June 2012. It introduces a maximum limit for bonus payments of 100% of an individual’s basic salary. This cap can be raised to 200% of an individual’s basic salary with shareholder approval, which it appears may be required annually. In addition, CRD IV specifies the following remuneration requirements:

  • 25% of any bonus payment that exceeds 100% of an employee’s basic salary must be deferred for a period of not less than five years. The specifics of the deferral mechanisms will be developed by the EBA by March 2014.
  • 100% of bonus payments may be clawed back in situations where an individual is culpable in future financial losses or where his performance falls below the requisite standard.
  • Subject to the legal structure of the organisation, at least 50% of the bonus payment must be in shares or an equivalent financial instrument.
  • Early termination payments must be performance-specific (to prevent exiting employees from being rewarded for misconduct and failures).
  • Remuneration committees will have to take into account “public interest” when deciding what bonus, if any, will be paid.
  • Remuneration policies will need to identify and make a distinction between criteria used to determine base salary and criteria used to determine bonus payments.

The first tranche of bonuses to be affected by these rules will be those paid in 2015 for 2014 performance.

Who will be affected?
The new rules will apply to individuals who are “material risk takers” within banks and investment firms that are (i) based in the European Economic Area (EEA), (ii) non-EEA-based subsidiaries of institutions and firms with headquarters in the EEA, or (iii) EEA-based subsidiaries of institutions and firms with headquarters outside the EEA. The guidance contained in the EBA’s consultation paper indicates that an individual will be a “material risk taker” for the purposes of CRD IV if:

(A) the individual’s total remuneration exceeds €500,000 per year;
(B) the individual is part of the 0.3% of staff with the highest remuneration in the institution or firm;
(C) the individual’s remuneration bracket is equal to or greater than the lowest total remuneration of senior management and other risk takers; or
(D) the individual’s bonus payments exceed €75,000 and 75% of the fixed component of remuneration.

When will the new rules come into force?
The compromise texts of each of CRD IV and CRR were approved in March 2013. They were acceptable to a qualified majority in the Council and were not supported by the United Kingdom delegation. Assuming CRD IV is published in the Official Journal of the European Union by 30 June 2013, the deadline for implementation in EEA member states will be 1 January 2014. Otherwise, the deadline will be extended to 1 July 2014.

What will the impact be?
The impact of these changes on banks and investment firms is expected to be considerable. Hedge fund managers will have to review and where appropriate overhaul the way that they remunerate their highest-paid staff. They may have to contemplate significant increases to base salary, the introduction of additional contractual allowances, and the increase of “fixed benefits.” These rules may also deter some of the highest performers within non-EEA-headquartered organisations from relocating to London or elsewhere within the EEA. Accordingly, in seeking to constrain what it views as the excesses of the banking culture, the Commission may damage the competiveness of the European Union’s financial sector to the potential benefit of New York, Zurich, Hong Kong, and other major financial centres around the world.

CRD III allows regulators to apply its requirements proportionately, taking account of a firm’s size and complexity. To date in the UK, the Financial Conduct Authority (FCA) has implemented the remuneration requirements of CRD III in accordance with the principle of proportionality so that each regulated investment firm may implement the rules in a way and to the extent that is appropriate to its size, internal organisation and the nature, scope and complexity of its activities. The FCA was able to neutralise some requirements for investment firms that have a lower prudential risk profile. CRD IV carries forward the proportionate approach in which regard we would expect guidance from the EBA prior to the implementation deadline. Hard caps on bonuses may not be susceptible to the proportionate approach.

Proliferation of remuneration guidelines
Hedge fund managers will be familiar with the remuneration requirements imposed under CRD III and the related guidelines on remuneration policies and practices from a prudential perspective of December 2010 issued by the Committee of European Banking Supervisors (CEBS), EBA’s predecessor, and should note that on 11 June 2013 the European Securities and Markets Authority (ESMA) issued final MiFID guidelines on remuneration policies of investment firms from an investor protection perspective. Furthermore, the Alternative Investment Fund Managers Directive (AIFMD), which regulates “managers” of alternative investment funds (AIFMs), establishes its own set of remuneration rules, albeit largely based on CRD III. Incidentally, the AIFMD rules do not set caps on bonuses. In addition, since the draft proposals for a new Undertakings for Collective Investment in Transferable Securities V (UCITS V) directive introduce remuneration requirements for managers of UCITS funds, ESMA will be required to produce remuneration guidelines for managers of UCITS funds. Accordingly, some asset management firms, will have to apply five sets of remuneration guidelines going forward. Hedge fund managers who qualify as AIFMs and that also conduct permitted MiFID activities will have to comply with four sets of rules: the AIFMD guidelines, the CEBS guidelines, the EBA guidelines and ESMA’s MiFID guidelines.

Some commentators have called on ESMA to issue a single set of guidelines, but ESMA has rejected this option on the basis that the various sets focus on different underlying issues and, as such, are complementary.

William Yonge is a partner in Morgan, Lewis & Bockius LLP’s Private Investment Funds Practice, specialising in hedge funds and EU/UK financial regulation. Nick Thomas is a partner in Morgan, Lewis & Bockius LLP’s labour and employment practice, specialising in the financial services sector. Both are resident in London.