An update to the extended Remuneration Code proposals - the clock is ticking...

The Committee of European Banking Supervisors have now published their draft guidelines on remuneration. As expected, the guidelines are strict on the conditions and structure of variable pay from a risk management and solvency perspective but add little surprise in terms of additional information, as much of the guidance already features in the FSA's draft Remuneration Code. Of most interest is the introduction of ‘neutralisation’ of key areas of concern based on a proportionate approach to implementation. Furthermore, and to add to continued unease, the FSA has announced a delay in its publication of final rules, reducing the time frame for familiarisation and compliance to less than a month.

Our article from August 2010 discussed the FSA’s Remuneration proposals as published in its Consultation Paper CP10/19 Revising the Remuneration Code (“the CP”). Key proposals may require investment firms to apply certain measures to personnel, to include the development of a balance between fixed and variable remuneration, a proportion of variable remuneration to be paid in non-cash instruments and implementing deferral arrangements, amongst other proposals. The aim is to promote more risk focussed remuneration policies at firms which are consistent with effective risk management.

Since the CP was issued in August, a number of key milestones on the road to publication of the FSA’s final rules have been passed. We comment below on some of the key features of these events.

The FSA’s Cost Benefit Analysis

In September 2010, the FSA published its Cost Benefit Analysis (“CBA”), to be read in conjunction with the CP. The FSA noted that it had published the CP before the CBA due to the short timescale for implementation on 1^st January 2011. Key conclusions from the CBA include the following:

• The extension of the existing scope of the Remuneration Code (“the Code”) will require additional resource and reallocation of staff within the FSA, training for staff to understand the remit of the Code and the development of new systems to monitor data, all of which will lead to significant increased costs. (However the FSA failed to explain how these costs will be met.)
• Responses from 60 firms surveyed by the FSA (and that will be within the extended scope of the Code) determined that for investment managers, estimated total costs would include a £7000 one-off cost and an ongoing annual expense of approximately £4000.
• For firms that may have to amend employment contracts not compatible with the Code, the FSA has set up transitional arrangements to facilitate the adjustment process to help mitigate costs.
• The FSA considered competition impacts in the UK, EU and in global markets and acknowledge that certainly in the global context, international standards in other jurisdictions may take a softer approach and therefore there is a risk of UK firms reallocating their business outside the UK. We note that whilst this has not deterred their focus on extending the Code, the proportionality provisions should limit the scope of its application in some of the key areas.

AIMA’s response to the Remuneration proposals

In October 2010, The Alternative Investment Association (“AIMA”) responded to the FSA’s CP addressing a number of key concerns for those in the alternative asset management space. These include the scope of proportionality, the application of the Code to LLP structures (accounting for approximately 80% of hedge fund boutiques) and the definition of Code staff.

 Committee of European Banking Supervisors (“CEBS”) Guidelines

The FSA’s proposed remuneration regime is necessary to implement the provisions of the latest amendment to the EU Capital requirements Directive (“CRD3”) and the role of CEBS in this regard is to provide guidelines on its implementation.

On October 8^th 2010, CEBS issued its Consultation Paper Guidelines on Remuneration Policies and Practices (“CP42”). The public consultation commenced on 8^th October and runs until 8^th November 2010. The positive note is that CEBS take on the proportionality provisions are generally rational and are in line with the FSA’s guidance already issued in the CP. Good news for investment managers and agency brokers.

Key areas of clarification are:

• The CEBS guidelines are helpful in that they recognise not all institutions can give effect to the requirements in the same way, allowing the proportionality principle to be applied to 'neutralise' more restrictive aspects of CRD3. Areas where neutralisation may be applied are in respect of deferral, non-cash instruments and the need for a Remuneration Committee. (Annex 2 of CP42). Although we have yet to fully understand what ‘neutralisation’ will mean in practice.
• Remuneration provisions will apply to certain senior staff and ‘risk takers’ across UK Firms and UK subgroups globally but can also apply more broadly to control staff like risk managers and compliance personnel. Certain principles will apply to certain staff and it is for the firm to determine this based on ‘job function and responsibilities’ not just salary.
• Where neutralisation of certain requirements cannot be justified, the guidelines are less welcome. For example where non-deferred variable pay is given in non-cash instruments, it must be subject to a minimum retention period, even in those securities where vesting has already been deferred. There must also be a cap on variable remuneration as a multiple of base salary (effectively a fixed ratio between fixed and variable remuneration), although no specific guidance on what that percentage should be has been given by CEBS.
• Unlike the FSA’s CP, CEBS has provided more guidance on public disclosure expectations. It is anticipated that firms will disclose information publically on their remuneration policies and procedures as part of their Pillar 3 disclosures. This is not unusual as the provisions come from an amendment to the Pillar 3 obligations under the CRD3.  We note that small or less complex firms will be expected to provided minimal qualitative information and ‘very basic quantitative information where appropriate’. However it is difficult to see how this will be implemented in practice, in particular given the FSA has yet to address this in any detail in its CP.

AIFMD and UCITS Directives

After more than 20 trialogues and numerous attempts at producing a compromise proposal, on Tuesday 26^th October 2010 an agreement on the Alternative Investment Fund Managers’ Directive (“AIFMD”) was reached in Brussels. The agreement clears the way for negotiations and the adoption of the text at first reading on 11^th November in the European Parliament; albeit transposition into national legislation will not occur before 2013. The AIFMD brings forward rules on remuneration, specifically addressed in Article 13 and Annex II. Thankfully current drafting does not deviate hugely from FSA and CEBS proposals although it is also worth noting that in addition to possible changes via the AIFMD the European Commission has announced that it will propose a revision to the UCITS Directive which will also contain provisions on remuneration. The FSA (and its successors) will therefore need to be considerate of the need to ensure that its Remuneration Code does not create conflicts between forthcoming European Directives.

Timeline

On the evening of the 27^th October 2010 the FSA sent out a statement delaying timing of its final rules. The statement was sent out to trade associations and confirms that the FSA’s rules and guidance will not be published until late December 2010 (a week or so before Christmas) rather than mid November 2010 as anticipated.

A delay appears necessary to give the FSA time to reference CEBS final guidelines which are still subject to consultation and expected around 11th-12th December 2010. Suppressing the timeframe for meeting the new code to less than a month leaves little time for implementation at 1^st January 2011. The FSA noted, however, that more detailed aspects, like deferral and retention periods under Principle 12 of the Code, could be neutralised (based on a proportionate approach) or subject to transitional provisions. The FSA also stated that it is aware of the timing issues for firms arising from the revised timetable and in recognising the challenges said firms may rely on the transitional arrangements in CP10/19 (Chapter 4, paras 4.49-4.56) to justify a delay in complete compliance until 1st July 2011.

Where does this leave us?

There continues to be concern in respect of the challenging and tight timeframe for implementation and there are still issues that require clarification. As we mentioned in our previous newsletter article and highlighted above, a large portion of boutique investment firms are proprietor lead businesses paid entirely by firm profits and yet it remains unclear as to how this will be addressed. The CEBS guidance recognises that some remuneration principles may not apply to partners where they receive ‘dividends’ in their capacity as owners of the firm (unless used as an attempt to avoid the requirements). Though it does not go further to explain the extent to which partner receivables will be treated as dividends. One would argue that where partners have no other forms of incentive they should not fall into scope. There also remains uncertainty as to the extent to which the requirements will apply to owners of firms with different legal structures.

Generally whilst the requirement for sound remuneration practices applies across the board, both the FSA and CEBS guidance recognise the need to apply some of the principles in a proportionate way, with some latitude for ‘neutralisation’ in some key areas of concern. We would therefore infer that the FSA’s approach of ‘comply or explain’ in such areas as deferral and share-based remuneration requirements will likely provide material comfort.

Of further interest to a large portion of IMS clients, Dan Waters, Head of the Asset Management Team at the Financial Services Authority (FSA), recognises the "real challenge" posed to fund managers by European proposals and accepted that fund managers "are not banks" and should not be subject to the same policies on remuneration that are designed to reduce risk-taking within banks. He added that the FSA is "committed" to "ensuring that unnecessarily burdensome requirements are avoided". The speech was delivered at AIMA’s Hedge Fund Conference on 23^rd September 2010.

Firms already in scope should continue to comply with the revised Code by 1^st January 2011. For new firms entering the scope of the Code, the FSA expects to provide more information on its proportionality approach before the end of November.

For now firms should continue to review gaps between current practices and those likely to impact them in the revised Code per the proposals in CP10/19. In particular the FSA’s Proportionality tables in Annex 5 to its CP can be used to begin to look at the requirements and necessary responses. Once the new rules are published IMS will be discussing action to be taken with its clients in order to achieve compliance by the 1^st January 2011 implementation date.

[1] CEBS gives advice to the European Commission on policy and regulatory issues related to banking supervision. It also promotes cooperation and convergence of supervisory practice across the European Union, especially through the development of guidelines and recommendations, addressed to credit institutions and national supervisors.