The Alternative Investment Funds Mangers Directive (AIFMD) contains rules for remuneration for fund managers of AIFMs, but much was left to implementation at national level in accordance with European wide guidelines published by ESMA, in particular where the cut-off point for implementing the toughest rules in the remuneration provisions would lie.
After much debate and industry consultation, the ESMA guidelines on the remuneration aspects of AIFMD were published in final form last year. They did not particularly address where the cut-off point lay and in September the FCA published its much shorter consultation paper on some of the outstanding points – particularly on which firms would be caught by the toughest aspects of the AIFM Remuneration Code, which require part deferral and retention of variable remuneration using AIF units, and potential clawback of deferred pay, which the FCA referred to as “the Pay-out Process Rules”. Click here for a link to our Law-Now on the consultation paper.
The FCA has now published final guidance on this and other aspects of guidance in this area.
Are you caught?
All AIFMs who are full-scope will be caught by the new AIFM Remuneration Code, but the FCA has created a test for whether the Pay-out Process Rules apply to AIFMs which is much flexible than the equivalent test under the banking Remuneration Code rules.
The FCA’s final guidance says that AIFMs managing AIFs which are:
- have no redemption rights within 5 years, and
- which have assets under management ("AUM") of £5 billion or more
will prima facie be expected to apply the Pay-out Process Rules, whereas those with the same leverage and redemption characteristics but lower AUM will not prima facie be expected to.
AIFMs running other AIFs should apply an AUM test of £1 billion.
The FCA decided to set financial levels at the mid-point of its consultation range. It will be interesting to see how much of a European benchmark this becomes.
However, the AUM test is not conclusive either way. Firms may consider other aspects of their operations which may change the presumption applied above. Factors tending towards applying the Pay-out Process Rules include having a large number of staff, being listed (perhaps strange, since listing might be thought already to bring requirements to have risk alignment and transparency), complexity and particular risk issues or anything other than a low FCA risk impact score. Factors tending towards not applying the Pay-out Process Rules include a large part of the business being owned by those who work in it and incentive arrangements which already align pay and investors (which may mean that existing or alternative remuneration arrangements may not need to be changed at all to meet the Pay-out Process Rules). There is no prescribed weighting attached to any measure though and so firms currently in the process of applying, or which have already applied for authorisation, as an AIFM need to balance these and any other relevant factors in the light of their own circumstances.
One other point to note which is different from the banking Remuneration Code is that the FCA appears to accept that some parts of the Pay-out Process Rules can be disapplied even if others are required to be complied with – with the banking Remuneration Code there is blanket application if a firm is in Levels 1 and 2. However, on the other hand, the FCA is saying that all firms covered by the AIFM code need to review whether to they should comply with the Pay-out Process Rules. The FSA/PRA has been relatively relaxed that firms in Level 3 can relatively easily default into disapplying the tougher structural pay rules under the banking Remuneration Code: that does not seem to be the case with AIFMs where the FCA is still (at least on the face of it) requiring firms to go through individual assessments of applicability.
If the AIFM is caught by the Pay-out Process Rules, then its senior management have to receive at least 50% of variable pay in the form of “instruments”, but there are a number of reasons why this might not have to happen.
The instruments concerned are intended to be instruments in the underlying AIFs, but the FCA recognises (as indeed does the Directive) that this will not always be possible – not least because some AIFs do not permit individual investment, or require a minimum investment amount which is above the level of what is being deferred, or indeed it is simply too expensive. This seems surprisingly generous and may lead to many AIFMs thinking that they can avoid implementing arrangements using instruments altogether. The tenor of the FCA’s guidance though is that if an AIFM takes the legitimate view that use of these instruments is not possible, then it is clear that the FCA expects alternative arrangements to be put in place whether linked to the AIFM (or its parent) or cash linked to AIF/AIFM performance. What is interesting is that the FCA’s guidance does not expressly require this to happen if AIFs cannot be used. It is unclear from the guidance what would happen if it were not used, for whatever reason.
Once “vested”, instruments have to be retained for at least 6 months before sale, although sales for tax at the retention stage (but note not at the deferral stage) are permitted.
Unlike with the banking Remuneration Code which on the whole only dealt with companies who were predominantly listed, the AIFM Remuneration Code in the UK affects quite a large number of partnerships which are LLPs.
Deferral with partnerships creates some difficult tax issues. Tax will still be payable up-front on the deferral (whether of AIF units or otherwise) even though money has clearly not been received. This is because UK partners are taxed on the profits for a year, regardless of when cash or other payments in respect of those profits are received. This is now being addressed by the UK tax authorities in proposed legislation, the effect of which is that any tax payable on deferred remuneration under the Pay-out Process Rules will be due from the partnership rather than the individual as a whole and so will not be a personal cost to the partner (though parallel changes in the taxation of UK LLPs generally to combat disguised employment mean that there are also other factors to consider). The partner will receive a credit for any tax paid as and when the deferral is released. The proposed change is just as well because the FCA says that it is otherwise unable to provide relief as AIFMD does not permit personal access to deferred pay to meet tax liabilities until the deferral is over.
Partnerships also have some difficulties working out what is remuneration as opposed to a return as an owner (which is not caught by the AIFM Remuneration Code). Again, this was not a problem that had to be addressed when the banking Remuneration Code was introduced as, with companies, the distinction between dividends and remuneration is much clearer. Partnership profits then further have to be sub-divided into what is fixed and variable (again a much easier task with remuneration from companies). The FCA guidance contains some helpful comments here on this split, giving firms a choice between structural analysis of pay, reference to return on capital or benchmarking with other comparable firms.
The issue of ensuring that individual managers at delegates who are key staff in relation to the AIFM have AIFM compliant pay arrangements is a challenge which banking Remuneration Code firms also did not have to face. If the delegate complies with an equivalent regulatory pay regime this is tantamount to complying with AIFM requirements, but the FCA has limited compliant regimes to CRD or EEA equivalents, not any outside the EEA which comply with international guidelines under the FSB’s principles, for example.
When the AIFM Remuneration Code affects firms and disclosure requirements
The FCA has confirmed that the AIFM Remuneration Code will only apply to firms in their first full performance year after authorisation (note not just application), and so for many firms the actual impact of the AIFM Remuneration Code is still some way away, although their applications for authorisation need to address relevant issues. So for a calendar year end AIFM, which becomes authorised as a full-scope AIFM in May 2014, the first year to which the new rules apply is the year beginning 1 January 2015. A recent ESMA question and answer also confirms that this is their approach to implementation. Strictly, disclosure of pay comes in sooner. However, the FCA has also said that in many cases, a firm can await disclosure of remuneration until it has had its first performance period. Given the sensitivity with which some firms regard their remuneration arrangements, even a limited delay here may be welcome for some.
Click here for a link to the FCA’s final guidance and click here ESMA’s recent Questions and Answers.