September 2011

LEGAL EASE: Paying by the rules

Snaders--WhiteheadIn response to the financial crisis of 2007-2008, the European Commission took the view that existing remuneration structures within financial services firms promoted excessive risk taking in order to achieve short-term profits, without considering the long-term financial health of those firms.

As a result, CRD3, the third limb of the Capital Requirements Directive, was published in December 2010 and sets out certain remuneration principles with which firms must comply. Member states were required to implement those parts of the directive that dealt with remuneration by 1 January 2011. Not all member states have yet complied.

The UK has implemented the remuneration principles set out in the directive by amending the FSA’s Remuneration Code. The code, as amended, now applies to over 2,500 FSA-authorised firms (the previous version of the code having only applied to a mere 26 of the largest banks and building societies in the UK) such as asset management firms, hedge fund managers, Ucits investment firms and a number of private equity firms. It includes twelve remuneration principles covering areas such as remuneration policy, governance and risk management.

The code applies to remuneration awarded for services provided by ‘code staff’, that is those individuals who perform significant influence functions for a firm, such as senior managers, all staff whose total remuneration takes them into the same bracket as senior management, and risk takers whose professional activities could have a material impact on a firm’s risk profile. All firms are now required to draw up a list of code staff although, in some circumstances, there is a de minimis exemption for those staff earning less than £500,000 (e572,000) per annum and whose variable remuneration accounts for a third or less of their total remuneration.

The code is broad in scope. It generally prohibits guaranteed bonuses which are only permitted in the first year of employment. This has led to concerns that it will increase staff turnover. However, against that, firms are expected to defer the payment of bonuses: 40% of variable remuneration should be paid over a period of not less than three to five years and this amount rises to 60% if that person’s variable remuneration is of a “particularly high” amount. In addition, a proportion of variable remuneration should be paid in appropriate non-cash instruments, such as shares and share-linked instruments. Firms are also required to apply minimum retention periods during which employees will not be able to dispose of their shares.

The code also requires firms to assess remuneration on an individual’s long-term performance taking into account non-financial indicators (such as good risk management) and performance of the firm as a whole. Severance payments should reflect performance over time and must not reward failure.

Last-minute amendments to the wording of the directive brought an element of proportionality which categorises firms into four different tiers: those firms in tier 1 must comply with all requirements whereas firms in tier 4 are able to disapply certain requirements. However, the impact for smaller firms especially is that significant management time may have to be spent interpreting the rules in order to determine which exemptions will apply as well as reviewing employees’ existing contracts. 

Compliance will be monitored through the obligation to make an annual attestation that all code staff have been identified and listed. There are additional rules requiring annual disclosures, although the level of disclosure will depend on the tier of the firm. The FSA reserves the power to render void any payments which have been made in breach of the code and firms will be obliged to recover any such payments.

It is worth noting that the code does not seek to set caps on remuneration but requires that it be paid in a more considered and risk-averse way. Broadly, the response to the directive has been one of acceptance: firms have realised that it forms part of the increasing regulatory environment to which they must adjust. However, whether it will be another factor that encourages firms to set their sights outside Europe remains to be seen.

• William Saunders is a partner and Alexa Whitehead an associate in the corporate finance group at Stephenson Harwood

©2011 funds europe