Remuneration Code: Proportionality is key!

• bonuses  to be based principally on profits
• a deferral of 40-60% of bonus amounts
• development of a balance between fixed and variable remuneration
• payment of a proportion of variable remuneration in shares, non-cash instruments or other share-equivalent instruments (subject to the legal structure of the firm)
• a claw back on deferred bonuses if the firm or the employee suffers a performance adjustment
• restrictions on severance pay

These are possibly the most intrusive regulatory proposals ever made in UK, as they have a direct impact on the basis and timing of remuneration earned by investment professionals. 

Background

The Code originally came into effect on 1 January 2010 and currently applies to 27 FSA authorised firms, primarily the largest banks, building societies and broker-dealers.  The FSA's consultation is necessary to implement changes that are required to the Code for significant financial institutions[1] and to implement the remuneration provisions of the latest amendments to the EU Capital Requirements Directive, commonly referred to as 'CRD3'.  CRD3 is due to come into force on 1 January 2011.  This might not even be the end of the story as the Alternative Investment Fund Managers Directive ("AIFMD"), which is still under negotiation but likely to be effective by late 2012 or early 2013, also contains similar but not identical remuneration provisions, to those in CRD3.

Scope of the Code

The Code's aim is to ensure that firms have risk focused remuneration policies which are consistent with and promote effective risk management.  CRD3 will extend the scope of the Code to all investments firms to which CRD3 applies, approximately 2,500 firms.  These firms (who will recognise themselves as BIPRU firms) will be made up of:

• Banks;
• Building societies;
• UCITS investment firms;
• Asset managers and hedge fund managers;
• Most brokers; and
• Certain, corporate finance and private equity firms.

Other investment firms, 'exempt CAD firms', usually adviser/arrangers, are seemingly not caught since CRD3 and so the Code does not apply to them. However, the FSA may provide for the Code to apply by way of guidance, and therefore these firms will need to consider the extent to which the Code is relevant to their business.

The Code requires that UK groups apply it to all entities within the group, whether regulated or unregulated and whether or not inside the UK.  UK subsidiaries of overseas groups together with any other members of their sub-group (regardless of location) must also comply with the Code.  Of course all EU countries will need to implement similar provisions to meet CRD3, though non EU members of the FSB, which include Switzerland and the USA, are not covered by the extension beyond systemically important institutions. The extension of the Code is therefore significant from a territorial point of view, which inevitably raises issues pertaining to the UK's competitiveness as a business venue pending a global harmonisation of remuneration standards.

Code Provisions and Proportionality

The FSA's proposed rules include a general requirement that firms must establish, implement and maintain remuneration policies, procedures and practices that are consistent with and promote sound and effective risk management.   The Code itself contains twelve principles (as amended by CRD 3) which determine the extent to which a firm is in compliance with the general requirement.

CRD 3 itself contains the provision that firms should 'comply . . . in a way and to the extent that is appropriate to their size, internal organisation and the nature, the scope and the complexity of their activities'.  In response the FSA has said that while . . 'proportionality cannot be interpreted as a complete exemption from the Code for any firm within the scope of CRD3, applying the full Code may be inappropriate and/or overly burdensome for some firms'. To this end, the FSA consultation proposes three sets of rules to apply as follows: (To view the proportionality table please click here)

• Proportionality Table ('PT') 1: Minimum requirements expected of all firms
• PT 2: Rules which will be applied to some firms in line with their nature, internal organisation, scale, scope and complexity, and
• PT 3: Rules where some firms may apply a "Comply or Explain" approach based on their nature, internal organisation, scale, scope and complexity. It is notable that the most contentious elements of the code (including deferral, and payment by share based awards) are within this group.

The FSA is also consulting on the group of employees to which the Code will apply, or 'Code Staff'.  Its starting point is:

1. Senior managers, including those in non-controlled functions such as HR or IT.
2. Any person who performs a Significant Influence Function
3. Anyone whose professional activities could have a considerable impact on the risk to a firm's business.
4. Staff whose total remuneration takes them to the same level as Senior Management.

The Code which must be applied to Code Staff includes the following express expectations:

• There is an appropriate balance between fixed and variable elements of total remuneration payable (PT1);
• The total variable remuneration to be paid by the firm should not limit its ability to strengthen its capital base (PT1);
• Total variable remuneration must be significantly reduced when a firm produces a reduced or negative financial performance (PT1);
• Remuneration policies should also provide for the adjustment of a bonus to reflect performance even after the employee has been notified of the bonuses (PT3);
• At least 50% of any variable remuneration consists of an appropriate balance of shares or other ownership interests (PT3);
• No variable remuneration can be paid unless at least 40% (60% if over £500k) of it is deferred for at least 3 years (PT3); and
• A flexible bonus policy is maintained with the possibility of paying no bonus at all;

With regard to paying variable remuneration in shares or other ownership interests, the FSA demonstrates some awareness of the difficultly for many (if not most) firms in providing shares given that the sector is dominated by owner managed LLPs. Where a firm cannot exempt itself using the proportionality exemptions (PT3) other possibilities to company shares could include phantom partnership units or shares in managed funds, the latter constituting the consummate alignment of interest between employee, employer and client performance.

Anti-avoidance measures

Firms are not allowed to use vehicles for the payment of remuneration or even non-recourse loans.  Similarly, employees should be asked not to use personal hedging strategies or take out insurance contracts against any downward adjustment to their remuneration as such practices would largely or wholly negate the attempt at risk alignment.

The FSA now has statutory power to stop firms paying remuneration to staff in a certain way, render a contract void or require recovery of payment.  The FSA has said that it will only use this power in relation to deferral arrangements and guaranteed bonuses (which are permissible only in the first year for a new employee, or other exceptional circumstances) affecting Code Staff and will not use it retrospectively.

Issues to be clarified and resolved

The timeframe is challenging for all concerned given the number of issues still to be clarified or resolved.  The CRD3 text will shortly be reviewed by the European Commission's jurist/linguist process to clarify ambiguities in the text.  Certain provisions have been referred to the Committee of European Supervisors ("CEBS") which plans to publish guidelines certain issues, primarily proportionality, in October.

It is striking that the Consultation is silent on whether the Code applies to proprietor profits and the related appropriations of these amounts.  Boutique investment firms are mostly proprietor lead businesses generally in the form of Limited Liability Partnerships ('LLP').  LLP members are paid entirely from the profits of their firms (and receive nothing if the business loses money). LLP members are considered to be self-employed by HMRC and so it is difficult to see how much of the detail of the Code should apply to them, not least as their tax treatment is very different from an employee and their obligations as members to ensure that the LLP has adequate resources.

The extent of the tax, territoriality and contractual issues already appears huge and may become even more evident as a result of informed responses to the consultation. It appears that issues such as the LLP member who pays tax at the rate of 50%, but has 60% of the amount taxed on deferred, simply have not been considered by the FSA.

Central to the debate is how the FSA intends to implement CRD3 within the flexibility conferred to it. Trade bodies may have some success in pointing out that the business models of their constituencies are strikingly dissimilar to those of banks, for whom the Code was manifestly drafted, and on whom the FSB is focussed.  We would be keen for the FSA to recognise that many of these proposals are disproportionate to boutique limited licence firms.

What do firms need to do . . . now . . . . and by the end of the year?

Firms who will be subject to the Code for the first time are required to use reasonable efforts to comply by 1 January 2011 or as soon as reasonably possible afterwards. There is a hard back stop date of 1 July 2011 by which point firms must have amended their arrangements. Logistically this will be very challenging for the 2,500 firms and their advisers.

Firms should determine now whether they fall within the enlarged scope. This will be straightforward if you know that you are a MiFID investment firm subject to CRD (i.e. a BIPRU firm).

Firms should then consider whether each staff member is likely to be in or outside the scope of the Code with reference to the seniority and risk profile of their role and also the de minimis rule for remuneration.  All staff within scope should be notified of this fact and also that this will impact how they are remunerated going forward.  Firms will be required to confirm on an annual basis, through the FSA's GABRIEL regulatory returns system, that all Code Staff have been identified.

Existing policies relating to the salaries, benefits and bonuses of Code Staff should be revisited with reference to the likely new provisions of the Code. Firms will wish to pay particular attention to the proportionality provisions contained within PT3 to determine to what extent they may be able to justify non-compliance based on their nature, scale, scope and complexity etc. An action plan should be put in place to remedy any gaps between the current policies and procedures and the Code's requirements. In the absence of any such policies, appropriate procedures should be prepared with reference to the Code and the overarching requirement to ensure that remuneration policies promote sound and effective risk management. Larger firms should consider a Remuneration Committee, comprised of non-executive directors, to oversee the implementation, delivery and maintenance of the necessary remuneration policies and practices.

Firms should also consider how they will meet the requirement that a proportion of variable remuneration be paid in shares, or equivalent instruments although they may have to 1 July 2011 to comply with this one.

Inevitably, the FSA's proposals present several complications from a tax perspective. For LLPs and companies, the recognition of income ahead of a related bonus or profit share may cause a mis-match in the timing of the receipt of the income and the tax payments.

The concern for LLP partners will be the taxation of their undistributed profits. Conceivably, members could find themselves being taxed on the recognition of profits but would not be allowed to withdraw funds in time to pay the related tax liability. There is a potential mis-match between how much is deemed to be distributed to individual members under tax law and annual amounts distributed and deferred under the Code.  Further complications could arise should the deferred element be clawed back in future years, given that income tax could already have been paid in the preceding year out of the profits on which the profit share arose.

In addition, it is common for members of a LLP not to have a fixed element of remuneration. Therefore to create a balance between fixed and variable remuneration, as required, could also be difficult.  Consideration of the interaction of accounting standards, the Code and tax legislation and the related impact on existing structures is underway.

Timeline

Due to the tight timeframe involved, the FSA's Cost Benefit Analysis will be published subsequent to the consultation, in early September 2010. Firms receiving questionnaires from the FSA are urged to provide feedback in order to inform the FSA as much as possible as to the full cost implications of these proposals.

Responses to the consultation itself are due by 8th October 2010 with the FSA Policy statement expected the following month. Firms should take the opportunity to ask the FSA to use the flexibility afforded to it in this legislation to provide certainty and proportionality to smaller wholesale firms which are certainly not systemically important.

The new FSA rules will apply from 1st January 2011, although some firms may be able to justify non compliance at this date with certain provisions if they have taken reasonable steps to comply and at any rate are compliant by 1st July 2011.

The Code in its proposed form is being heavily debated by the industry, their advisers and industry bodies and there is chance that we may see changes, if not in scope, in its application before or by the end of the year. Proportionality is key!