Not Just Bankers’ Bonuses

Control envelops remuneration at EU banks and fund managers

TAMASIN LITTLE, PARTNER, SJ BERWIN
Originally published in the September 2010 issue

The size of the financial crisis triggered by the collapse of Lehman Brothers fuelled global concerns about the effective strength of financial institutions and the suitability of their regulatory and supervisory systems. The resulting flurry of activity is now producing some concrete legislative action on both sides of the Atlantic, not always as fully aligned as G20 pronouncements would suggest. In Europe, the De Larosière Report issued at an early stage focused mainly on the consideration of remedies for weaknesses in the corporate governance systems of financial institutions and in particular the banks.

It has long been the Commission’s position that “sustainable growth cannot exist without awareness and healthy management of risks within a company” and there has also been a substantial political groundswell against high pay in the financial sector. So it has come as no real surprise that new rules on capital requirements and a cap on bonuses were announced, following negotiations between the European Council and Parliament.

The new rules
The new rules are meant to incorporate and strengthen the Financial Stability Board’s principles to deliver a fair and robust remuneration system. The aim is to “transform bonus culture and end incentives for excessive risk taking”. The new rules are expected to apply from January 2011. A potentially wide group of people will be caught by these new rules as they extend beyond those in control functions or taking risk on behalf of the firm to any other staff whose total remuneration is comparable to senior management and risk takers. All aspects of remuneration will be caught including salaries and pensions. Guaranteed variable remuneration seems to be a thing of the past, although there is a little leeway in to use it in the context of hiring new staff but limited to the first year of employment. So despite the notionally long-term risk management approach there can still be incentives for short term job-switching.

Other key points are:

• Both performance assessment and payment out of performance based pay (individual and in respect of each pool), should be done over several years with adjustment for future and potential risk;
• The norm will now be that between 40% and 60% of bonuses (described as variable remuneration) must be deferred for a period of no less than three to five years and payment or vesting will remain conditional on the performance of the business unit and the firm as a whole;
• At least half of the bonus, whether or not deferred, must be in shares or equivalent instruments linked to the firm’s performance and credit quality and subject to an appropriate retention policy;
• Discretionary pension benefits should also be in the form of such instruments with a five year lock-in;
• Early termination payments should reflect performance over time and in the rather worn phrase “not reward failure”;
• Staff performing control functions (e.g. risk and compliance) should be compensated by reference to their functional objectives, not the performance of the business areas they control;
• Extra limits can be placed on firms which benefit from government intervention, including a ban on bonuses to directors “unless justified” (few firms, of course, make payments which are overtly unjustified).

More detailed guidelines are due to be produced, and consulted on, by the Committee of European Banking Supervisors (CEBS) in conjunction with the Committee of European Securities Regulators (CESR). There is a good deal of scope for these to clarify – and possibly extend or reduce – the requirements. They are likely at least to cover matters such as:

• The permissible ratio between fixed and variable remuneration
• The types of security eligible to satisfy the non-cash part of the bonus, possibly including those which a firm in financial difficulties can convert to equity or otherwise write down even after issue or vesting
• Adjustments for “proportionality” (see below)
• Reporting requirements

Regulators will be able to require firms to reduce the risks of their activities, change their remuneration structures, freeze bonuses or limit them to a particular percentage of net profits or require the firm to use all its net profits to strengthen the capital base. Remuneration policies will need to be part of firms’ individual capital adequacy assessment process and the regulators will also be able to impose additional capital requirements on firms if they dislike the firm’s remuneration policies and procedures.

In addition, specific provision is made for supervisors to conduct thorough and intrusive checks on the individuals caught before they take up their posts, to assess their suitability. The intrusion continues – disclosure must be made of the number of individuals in €1 million plus pay bracket together with quite extensive information about the firm’s remuneration policies and practices for staff caught by these rules, to all stakeholders defined as shareholders, employees and the general public. Further disclosure will be made to regulators to be passed to CEBS for collation across the EU, benchmarking and publication on an aggregated country by country basis.

Although this all sounds quite onerous, it will not come as a surprise to some in the UK. The FSA has, in the last few years, been increasingly more intrusive in its supervision and enforcement actions. ARROW visits have become more targeted by extending the net to interview or question more junior employees and by incorporating a wider range of matters to scrutinise. In fact, almost every FSA speech makes mention of its more intrusive approach especially with regards to interviews for those applying and performing significant influence functions. In addition, the Financial Services Act 2010 provides a legislative structure for the FSA’s remuneration code which has been in operation for banks (and large brokers) since its implementation in November 2009 and some comments in the press suggest that some bankers believe the FSA code to be tougher than these new proposed rules. The big difference is that the FSA sensibly only applied its code to the largest banks and brokers.

What does it mean for asset managers?
The rules are being made by virtue of amendments to the Banking Consolidation Directive (BCD) and the related Capital Adequacy Directive (CAD) which means that most private equity and real estate fund managers will not be affected, for now. Nor will purely advisory firms which do not manage investments, deal as principal or agent or provide placing or underwriting services.

All other firms subject to the Markets in Financial Instruments Directive (MiFID) and all banks and other credit institutions will be caught. Since most hedge fund managers are currently structured as discretionary investment managers subject to the MiFID and CAD, they are caught as are mainstream investment managers and brokers. A few private equity managers also fall into that category.

This will undoubtedly involve an increased administrative and cost burden, as each firm must conduct an individual assessment on each potential individual to determine whether they have a material impact on the risk profile of a firm. Having said that, it is meant to be possible to apply a proportionality test; credit institutions and investment firms may apply the provisions in different ways according to their size, internal organisation and the nature, the scope and the complexity of their activities. What is not yet clear is how this proportionality test will work in practice – will it mean that these rules will all apply but in a proportionate fashion or will only some of the rules apply depending on the criteria listed above? The latter should be the case since late introduced (and hard fought) recitals to the Directive say that:

• It may notbe proportionate for what are known as limited licence (broadly, managers and agency only brokers) and limited activity (broadly those whose principal trading is limited to client order execution) firms to comply with all the principles; and
• It may not always be appropriate to apply all the provisions relating to bonus deferral and the required part payment in shares or other instruments to smaller banks and investment firms.

However, whether a fund manager is caught or not is only a timing relief since the Alternative Investment Fund Managers Directive would apply similar provisions, which include a requirement to defer significant elements of remuneration paid to managers of all alternative investment firms within the ambit of the directive, and would (according to the Parliament’s draft) also cover payments of carried interest and returns on investments made in the fund, none of which appears in the CAD remuneration proposals. A vote in the EU Parliament is currently scheduled to take place in the early autumn with implementation two years later.

Timing
The main remuneration provisions of the Directive are to come into force by 1 January 2011. Moreover some of the usual dash to get contracts or bonus awards made before they are constrained by new rules will be handicapped because firms will also be required to apply the new rules to:

• Remuneration under contracts entered into before 1 January 2011 which is awarded or paid after that date;
• Remuneration for services provided in 2010 which has been awarded but not yet paid (i.e. the bonus will need to be both determined and paid if it is not to be caught retrospectively).

It appears that the provisions will also apply to asset managers, brokers and other investment firms on the same timescale, by virtue of the mechanism by which the CAD automatically applies the relevant provisions of the BCD. So there is very little time for the regulators, as well as the firms, to work out how it should apply in as proportionate and, one hopes, workable a way as possible.

Additional questions
Applying the detail – much still to come in guidelines and implementation – is clearly going to be complex in the extreme for many firms. Rewriting existing contracts and pension schemes is not as easy as the Directive writers would like. And should any attention be paid to comments in recitals that remuneration policies must not only discourage excessive risk taking and be aligned with the firm’s risk appetite, values and long term interests but also be “aligned with the role of the financial sector as the mechanism through which financial resources are efficiently allocated in the economy” and “enhance fairness within the remuneration structures of an institution”?

How many firms will be subject to acute risk of claims as they try to impose these new risk management requirements? Or, since a recital says that the provisions on remuneration shall not prejudice Treaty rights, general principles of national contract and labour law, shareholder rights and the responsibilities of boards of directors and other governing bodies, will all those difficulties allow compliance with the Directive requirements to be kicked into the long grass for many existing arrangements? Will there be a sudden rush among highly paid executives to join or create unions so that they can conclude and enforce collective agreements?

There is no definition of remuneration but it is clearly meant to cover much more than simple employee pay and benefits. There is a specific statement that variable remuneration must not be paid through “vehicles or methods that facilitate the avoidance of the requirements of the Directive” (a Parliamentary proposal had gone further and added in income tax avoidance but that is being left to national taxing authorities). How will the new rules apply to the many independent firms where the top executives and the owners of the business (partners, shareholders and LLP members)are substantially the same? Can their remuneration and their rewards of ownership be separated and if so how?

In tax transparent vehicles such as LLPs how will deferral mechanisms be addressed and can any escrow or other arrangement be made net of tax (since all their profits have to be allocated and taxed whether or not distributed)? There is a requirement for the Commission’s periodic review of the Directive to ensure that the way it is applied does not result in manifest discrimination between firms on the basis of their legal structure or ownership model but it is unclear whether that is meant to be operated to level up or level down the burdens imposed by the Directive.

There is some evidence in the Directive of awareness of the rather obvious potential competitive threats involved for the EU financial sector both internally and against the rest of the world but this principally takes the form of various proposed later reviews of the Directive by the Commission, some of which are expressly required to take into account and make proposals by reference to international developments. The Commission has already stated in its recent Green Paper that in order to prevent distortions of competition between financial institutions in different sectors, other similar legislative measures will have to follow for other financial services sectors, in particular UCITS and insurance companies, so it seems, in Europe at least, there will be no escape – except perhaps to Switzerland!

Even the instinct to leave the continent and head East (or West) may be inhibited to some extent by a cryptic requirement for the principles to be applied at group, parent company and subsidiary levels, including those established in offshore financial centres. How far can that extraterritorial requirement be pushed? The Directives only apply to EU banks and investment firms but most international groups have at least one such firm in the group. Is the requirement just that people working in relevant capacities for the EU entity cannot escape by also having relationships with other group entities and dual contracts? Or are regulators going to seek to apply it more widely, with arguments about group and contagion risk? It is these areas that will need to be watched closely to gauge how the new rules on remuneration work in practice.

Tamasin Little is a partner in the Financial Markets Group of SJ Berwin. She advises hedge, private equity and other fund managers, brokers, banks, investment exchanges, insurance companies and other investment firms on a wide range of regulatory and related matters.