The FSA is encouraging all FSA-authorised firms to review their remuneration policies having regard to the principles underpinning its code of practice on remuneration published on 18 March 2009 (the “Code”). The FSA notes that:

• The basic principles behind the Code – good governance in making remuneration policy and implementing it effectively, sound practices in the measurement of performance for determining bonuses, and ensuring that remuneration structures do not encourage an excessively short term approach or excessive risk taking – are good practice for all firms, whatever their size or the nature of their business;
• The general requirement that a firm must establish, implement and maintain remuneration policies, procedures and practices that are consistent with and promote effective risk management is “self evidently a high-level requirement which should be followed by all firms”; and
• It will, as soon as possible, be taking steps to increase its focus within its supervisory programmes on the potential risks posed by inappropriate remuneration practices in all FSA-authorised firms.

As a result, it is advisable for all FSA-authorised firms to begin to assess their current remuneration policies having regard to the draft Code and specifically to assess whether their remuneration policies, procedures and practices are consistent with and promote effective risk management.

The Code
The FSA consultation paper formally consults on whether to incorporate its code of practice on remuneration into the FSA Handbook and its application to large banks and broker dealers. The consultation paper is also inviting discussion on the idea that the Code should be applied to all other FSA-authorised firms. If the FSA decides to apply the Code to all FSA firms, FSA- authorised hedge fund managers will also need to adhere to the Code.

The Code has a general requirement that a FSA “firm must establish, implement and maintain remuneration policies, procedures and practices that are consistent with and promote effective risk management”. This would become a FSA Handbook rule. The consultation paper also proposes that the Code’s remaining 10 principles are put into the FSA Handbook to help guide firms on the evidence the FSA will focus on when assessing compliance.

Who will the Code apply to?
The Code’s rules and evidential provisions would apply to certain FSA-authorised large banks and broker dealers, defined as follows:

• FSA regulated banks and building societies which meet either of these criteria:
– total regulatory capital in the UK banking entities in excess of £1 billion; or
– are part of an international financial group whose regulatory capital is in excess of £20 billion or the equivalent amount in another currency.

• FSA regulated BIPRU ‘730k’ firms which meet either of these criteria:
– total regulatory capital in the UK authorised entity in excess of £750 million or its equivalent amount in a foreign currency; or
– are part of an international financial group whose regulatory capital is in excess of £5 billion or its equivalent amount in a foreign currency.

These criteria will extend the Code to about 45 of the largest banks, building societies and broker dealers operating in the UK.

The consultation paper is, however, also inviting discussion on the idea that the Code should be applied to all other FSA-authorised firms. Hedge fund managers will generally fall within this bracket. Hedge fund managers (other than managers to whom it is proposed the Code would apply directly) should take comfort that some parts of the Code may not be directly relevant to them – for example if they have no remuneration committee – but should instead focus on any material risks applicable to their particular business, taking into account its scale and particular characteristics.

Timing as to implementation
The FSA has stated that it proposes publishing final rules in August and that the Code will take effect in November 2009.

The consultation paper notes that in order to be effective, policies on remuneration should be implemented globally and in a consistent manner, and in deciding whether to implement its plans the FSA will take into account whether there is a satisfactory alignment of implementation plans by regulatory authorities in other major financial centres. There is therefore the possibility that the Code may be dropped, although that may be unlikely given the political will of G20 leaders to be seen to be doing something.

The consulting period on implementation of the Code for larger banks and broker dealers will run until 18 May. The period for discussion and feedback on the idea of extending the Code to other firms regulated by the FSA, such as hedge fund managers, will run until 18 June. AIMA has recently stated that it intends to submit a formal response to the FSA and wishes to have members’ input, comments and suggestions on the proposals and the draft Code.

Hedge fund managers should be wary that implementing any final recommendations by the FSA may be problematic from an employment law and benefits scheme perspective. It is probable that much thought will need to be given to existing and future employee contract terms. Executive compensation arrangements may also need to be restructured. Appropriate legal advice should be sought before implementing any changes to such agreements or arrangements. There follows below a summary of the FSA’s proposals for the Code:

General Requirement: Proposed Rule
A firm must establish, implement and maintain remuneration policies, procedures and practices that are consistent with and promote effective risk management.

The FSA’s proposed guidance on the rule states that if a firm’s remuneration policy is not aligned with effective risk management it is likely that employees will have incentives to act in ways that might undermine effective risk management. It also comments that the actions a firm must take to comply with the Code will vary according to the nature, scale and complexity of the firm and its activities.

Proposed Remuneration Principles

Principle 1: Role of bodies responsible for remuneration policies and their members
A remuneration committee should: (a) exercise, and be constituted in a way that enables it to exercise independent judgment; (b) be able to demonstrate that its decisions are consistent with a reasonable assessment of the firm’s financial situation and future prospects; (c) have the skills and experience to reach an independent judgment on the suitability of the policy, including its implications for risk and risk management; and (d) be responsible for approving and periodically reviewing the remuneration policy and its adequacy and effectiveness.

The FSA’s proposed guidance states that remuneration committees should normally include one or more non-executive directors with practical skills and experience of risk management, and should receive regular reports directly from the firm’s risk management function on the implications of the remuneration policy for risk and risk management.

Principle 2: Procedures and input of the risk and compliance functions
Procedures for setting remuneration within a firm should be clear and documented, and should include appropriate measures to manage conflicts of interest. A firm’s risk management and compliance functions should have significant input into setting remuneration for other business areas.

The FSA’s proposed guidance states that conflicts of interest can easily arise when employees are involved in the determination of remuneration for their own business area. Where these could arise, they need to be managed by having in place independent roles for control functions including, notably, risk management departments. It is good practice to seek input from a firm’s human resources function when setting remuneration for other business areas.

Principle 3: Risk and compliance function remuneration
Remuneration for employees in risk management and compliance functions should be determined independently of other business areas. Risk and compliance functions should have performance metrics based on the achievement of the objectives of those functions.

The FSA’s proposed guidance on this principle states that the need to avoid undue influence is particularly important where employees from the control functions are embedded in other business areas. Remuneration Principle 3 does not prevent the views of other business areas being sought as an appropriate part of the assessment process. However, the FSA would generally expect the ratio of the potential variable component of remuneration to the fixed component of remuneration to be significantly lower for employees in risk management and compliance functions than for employees in other business areas whose potential bonus is a significant proportion of their remuneration. Firms should ensure that the total remuneration package offered to those employees is sufficient to attract and retain staff with the skills, knowledge and expertise to discharge those functions.

Principle 4: Profit-based measurement and risk-adjustment
Assessments of financial performance used to calculate bonus pools should be based principally on profits. A bonus pool calculation should include an adjustment for current and future risk, and take into account the cost of capital employed and liquidity required.

The FSA’s proposed guidance states that measuring performance based wholly or mainly on revenues or turnover can provide an incentive for employees to pay insufficient regard to the quality of business undertaken or services provided, or their appropriateness for the client. Profits are a better measure, but they should be adjusted for risk, including future risks not adequately captured by accounting profits.

Principle 5: Long-term performance measurement
The assessment process for the performance-related component of an employee’s remuneration should be designed to ensure assessment is based on longer-term performance.

The FSA’s proposed guidance notes that profits from a firm’s activities can be volatile and subject to cycles, and so the performance-related component of remuneration should not be assessed solely on the results of the current financial year.

Principle 6: Non-financial performance metrics
Non-financial performance metrics should form a significant part of the performance assessment process. Non-financial performance metrics should include adherence to effective risk management and compliance with the regulatory system and with relevant overseas regulatory requirements.

The FSA’s proposed guidance comments that poor performance in non-financial metrics such as poor risk management or other behaviours contrary to firm values can pose significant risks for a firm and should, as appropriate, override metrics of financial performance.

Principle 7: Measurement of performance for long-term incentive plans
The measurement of performance for long-term incentive plans, including those based on the performance of shares, should be risk-adjusted.

The FSA’s proposed guidance comments that common measures of share performance, such as earnings per share (“EPS”) and total shareholder return (“TSR”), are not adjusted for longer-term risk factors. If incentive plans mature within a two to four year period and are based on EPS or TSR, strategies can be devised to boost EPS or TSR during the life of the plan, to the detriment of the true longer-term health of a firm.

Principle 8: Fully flexible bonus policies
The fixed component of remuneration should be a sufficient proportion of total remuneration to allow a firm to operate a fully flexible bonus policy.

The FSA’s proposed guidance comments that if the fixed component (typically, base salary) of employee remuneration is low, a firm will find it difficult to cut or eliminate a bonus in a poor financial year. One measure of the effectiveness of this principle would be the ability of a firm (or part of it) not to pay a bonus in a year in which the firm (or part of it) makes a loss.

Principle 9: Deferment of the majority of any significant bonus
The majority of any bonus should be deferred with a minimum vesting period if, when compared with the fixed component of an employee’s remuneration, the bonus is a significant proportion of that fixed component.

The FSA’s proposed guidance comments that an example of good practice would be for at least two-thirds of the bonus to be deferred. The vesting period of the deferred element should be appropriate to the nature of the business and its risks.

Principle 10: Linking deferred elements to the firm’s future performance
Any deferred element of the variable component of remuneration should be linked to the future performance of the firm as well as the employee’s division or business unit.

The FSA’s proposed guidance comments that if variable remuneration is paid out without any link to future performance, employees have less incentive to take future risk into account, and firms are exposed to the risk of paying out variable remuneration which proves not to be justified by results.

Deferred remuneration paid in shares can meet Remuneration Principle 10 provided that the scheme meets appropriate criteria, including risk-adjustment of the share performance measure as described in Remuneration Principle 4. In addition deferred remuneration paid in cash should also be subject to performance criteria.

Danny Asher Brower is a partner and Head of the K&L Gates Hedge Funds practice in London. He advises clients of all sizes on various aspects of the financial services industry. Brower’s practice focuses on issues related to the establishment, structuring and marketing of investment funds and investment managers. Brower has extensive experience regarding hedge funds and regulatory matters affecting investment managers. Prior to joining K&L Gates, Brower was Head Legal Counsel for Vega in London (renamed Proxima Alfa). At Vega, Brower dealt with most aspects of running a leading hedge fund manager.

K&L Gates is one of the largest international law firms with approximately 1,900 lawyers in 32 offices located in North America, Europe and Asia and represents a number of major hedge funds.