Changes to the remuneration code

The FSA had always intended to review the Remuneration Code in any event one year after it was formally put in place in August 2009 so as to take account of subsequent developments in the Walker report and the Financial Services Act, but it is recent changes at the European level which have had most impact on its proposals.

The Consultation Paper discusses three main areas:

Extending the scope of the Remuneration Code to more firms

Currently the Remuneration Code only applies to the top 26 banks and building societies. The FSA says that the recent CRD3 changes give it no choice but to extend the Remuneration Code to approximately 2,500 firms including all banks and building societies, most hedge fund managers and all UCITS investment firms, as well as others including some firms which engage in corporate finance, venture capital or the provision of financial advice, brokers and multilateral trading facilities (CAD investment firms). UK branches of EEA firms will still be excluded.

The FSA has said that it will look sympathetically at how firms are brought into the scope of the Remuneration Code with the possibility of flexible transitional provisions (with compliance in some areas possible to be delayed until July, or late, 2011). It also proposes a lighter touch or proportionality in many other areas for firms brought within the Remuneration Code. While some principles will be of universal application, others will only be applied depending on the type of firm and its scale and complexity etc, while other provisions will only have to be commented upon if relevant in a “comply or explain” approach. The Consultation Paper sets out some suggested proposals in Annex 5.

Going forward, it separates firms into:

• high impact groups (broadly, those subject to “close and continuous” supervision) who will need to prepare a remuneration policy statement ahead of the end of the financial year, have a specific remuneration meeting with the FSA and may not be able to pay bonuses without FSA agreement. This year, general considerations will be separated from particular remuneration decisions. Governance and controls will be discussed in Q4 2010, with specific decisions being reviewed against the new Remuneration Code in early 2011. This should make the process smoother than last year;

• medium high or medium low groups or firms will have to prepare a report which will be inspected as part of the ARROW review;
• low impact firms will only need to prepare a report if they are part of a thematic review. However, there will inevitably be a de minimis set of remuneration provisions for all firms (who will have to include some remuneration information in their GABRIEL regulatory returns).

The FSA is conscious of giving a competitive advantage to smaller firms over larger ones. The revised draft which is agreed this year is also not necessarily the final position as European Directives covering other areas of financial services, and with remuneration provisions of their own, are expected over the next few years.

Clarifying which employees are targeted by the Remuneration Code

Where the Remuneration Code applies, some employees’ remuneration is subject to particularly close regulation. These are currently known as “Principle 8” or “P8” employees. Due to some confusion over the scope of the definition, the FSA gave further clarification as part of the supervisory framework issued to firms in December 2009. It now proposes to use the term “Code staff”. The FSA has published a table of key positions which it believes should be subject to the Remuneration Code provisions on Code staff (see page 20 of the Consultation Paper) in addition to staff whose remuneration takes them into the same pay bracket. Those who hold SIF positions (e.g. directors, partners and senior managers) are automatically included.

Changing the Remuneration Code itself

Many of the changes are to comply with CRD3, although in most cases these changes are simply making express what would have been implied anyway. There is a general escalation of what was previously guidance into rules although the FSA has comfortingly said that it does not generally expect firms to have to breach contractual obligations to comply with the changes. Of particular interest are some provisions on remuneration structures:

• Deferral – at least 40% of variable remuneration for Code staff should be deferred over a period of at least 3 years, rising to 60% where annual total remuneration is more than £500,000 or in other appropriate cases. However, Code staff whose bonus is less than 33% of their total remuneration and whose annual total remuneration is £500,000 or less are not caught (and also would not be caught by some other rules e.g. guaranteed bonuses or payment in shares). The FSA recognises that this may not be aligned with some other jurisdictions and so could be perceived to be uncompetitive. It is notable though that the FSA does not seem to recommend extending the three year deferral period to five, as had been feared.
• Payment in shares – at least 50% of variable remuneration should be paid in shares or other equivalent non-cash instruments (by building societies, for example). The current Remuneration Code is not so prescriptive here. The FSA recognises that the relevant European legislation is ambiguous and so the up-front bonus can be paid in cash subject to the overall limit. It also recognises that firms not currently caught by the Remuneration Code and in particular non-listed firms will need time to implement this and firms currently in scope may also be able to justify not complying with this provision for 2011 awards so long as they can show that by 1 July 2011 they are compliant.
• Performance adjustment – tougher rules are proposed on employee misbehaviour, employee material error, firm/business unit material downturn or material failure of risk management requiring reduction of variable remuneration in some form.
• Voiding of provisions – currently breach of the Remuneration Code still allows the employee to be paid the relevant remuneration or sue for its non-payment and the FSA has no power to order its recovery. The FSA proposes to introduce relevant provisions to deal with deferred remuneration and guaranteed bonuses for Code staff which breach the Remuneration Code.

The deadline for consultation ends on 8 October 2010 with final FSA proposals due to be published in November 2010 for implementation as of 1 January 2011. Although transitional provisions apply, the revised Remuneration Code catches all remuneration after that date even if awarded previously. This tight timetable is driven by CRD3 which requires Member States to implement the remuneration-related provisions by 1 January 2011. The FSA is separately conducting a cost-benefit analysis of these changes and will issue this in September 2010 having collated the necessary information by early August (relevant firms were sent questionnaires in early July).

Firms should also be aware that many details, such as the numerical relationship between fixed and variable pay, are primarily to be supplied by the Committee of European Banking Supervisors (CEBS) which is not due to report until later in the autumn. There is therefore a very tight timetable for compliance as this means that what has to take effect from 1 January 2011 may not be known until November at the latest.

In particular, firms which are going to be caught by the Remuneration Code for the first time are therefore advised to start putting in place review and compliance programmes as soon as possible anticipating that at least some changes to their processes will be necessary by year end.

Click here to link to the consultation paper.