Incentive-based compensation: comparing Remuneration Code requirements in UK and Europe to US

While the UK is still deliberating on its Remuneration Code guidance in relation to rules which came into force on January 1, 2011, the US regulatory framework established under the Dodd-Frank Wall Street Reform Act has recently issued draft rules on the same area.

Essentially, the US is catching up with its international obligations in respect of pay structuring and risk management. Although it is lagging behind Europe's accelerated and politicised implementation, it would appear that the US may be doing a better job of identifying institutions which have a significant financial impact on the market, therefore avoiding unnecessary regulatory burden for managers and brokers that would be otherwise subject to the rules.

An initial review of the proposed rules suggests that managers/advisors who are already subject to European/UK requirements, but have less than $1bn in consolidated assets, are likely to be unaffected. Those above this figure will probably only be required to adopt some of the provisions of the remuneration policy as provided under Europe's capital adequacy requirements.

Differences in regimes

Apart from the limited scope, the major difference between the two regimes is that in Europe, a public disclosure of remuneration is required, whereas in the US, firms are not currently required to report actual compensation figures as part of their disclosures. The content of the proposed report is intended to allow US regulators to make a determination about whether the firm's payment structure or its features are likely to provide those to whom the rules apply with excessive compensation, fees or benefits. The draft US rules require firms to report to their respective regulator in a format which has yet to be determined.

In simple terms, the US has proposed to prohibit excessive compensation, or any feature of an arrangement which would encourage inappropriate risk taking, and has placed responsibility on firm's executives to justify how their arrangements remain compliant on an annual basis. The detailed requirements relating to policies are probably more flexible than those laid down in the UK's Financial Services Authority implementation, but are broadly similar to the European requirements once they have been applied.

If a firm has already established its UK policy there is scope to make some simple adaptation. Where clarity has been absent in the UK it has, in the main, been provided within the US proposals. The draft rules usefully provide an explanation of what would be considered excessive. They also include a comparative element and define covered persons with sufficient clarity to make the process of dealing with the rules more straightforward.

Definitions relating to covered persons

1. A principal shareholder is defined as a person who directly/indirectly owns, controls or has the power to vote 10 per cent or more of any class of voting securities of a covered institution.
2. All employees are covered by the prohibition on excessive compensation, but as the ban relates to excessive compensation paid, the scope is determined by how the firm pays its employees and what it determines as excessive under the defined criteria.
3. Executive officer is defined as president, chief executive, executive chairman, chief operating officer, chief financial officer, chief investment officer, chief legal officer, chief lending officer, chief risk officer or head of a major business line.

More onerous provisions, such as the 50 per cent deferral of incentive-based compensation for no less than three years, paid on a pro-rata basis and loss-adjusted, are applied to executives of firms which have $50bn or more in consolidated assets. In such firms, the board or executive committee is charged with identifying those persons who individually have the ability to expose the covered financial institutions to possible losses that are substantial in relation to the firm's size, capital or overall risk tolerance. It is worth considering this definition in the light of the FSA's definition of covered persons who have a material impact on the risk profile of the institution.

It has been pointed out by some commentators that a prohibition is yet to be inserted on personal hedging and there may be some confusion over the definition of assets for the purposes of determining application. Currently, the de minimus (i.e., $1bn) purely relates to the consolidated balance sheet assets of the investment adviser (the equivalent of a discretionary manager in the UK), as distinguished from their assets under management, and as such even managers of large pools of "off balance sheet" assets may not be covered.

Therefore, it is not likely to result in dual application to European management companies unless their US parent is a significant financial institution with over $1bn in assets on their consolidated US balance sheet.

The good news seems to be that the majority of these rules will not be enforced on the small- to medium-sized asset managers that are already dealing with enough regulatory upheaval, and that the more onerous rules will be only enforced on firms of significant impact, which was the original intention of the regulatory architects when they considered the causes of the most recent banking crisis.

The US requirements are currently under consultation until May 31, 2011.

By Derek McGibney

Originally published on www.complinet.com © Thomson Reuters, 26th May 2011