Remuneration Code amendments - Considering the potential impacts

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On 27 October 2010 the UK’s Financial Services Authority (FSA) issued its most recent statement regarding its proposed amendments to the existing Remuneration Code (the “Code”) contained in its handbook, with the upshot that the publication of the new rules has been delayed until mid-December, as has the issue of any practical guidance from the FSA or industry bodies. The postponement of the final form rules means that affected firms will now have a window of just three weeks between publication and the date by which compliance is required, 1 January 2011. As might be imagined, this has only served to increase the tension surrounding the revised provisions. In this note we consider the position as it currently stands, the potential impact following implementation and various actions that MiFID compliant FSA regulated firms ("Firms") should consider taking now.

Background

The Code was first introduced on 1 January 2010 as part of the regulatory response to the 2007/2008 banking crisis. It was adopted to regulate the remuneration practices of the largest UK banks, building societies and broker dealers. The Code is now being revised and extended in its scope in order to take into account, amongst other things, the remuneration provisions of the recently amended Capital Requirements Directive (CRD lll) which requires that the Code applies to all Firms.

Current Position

Earlier this year, the FSA published a consultation paper setting out its proposals for amendments to the existing Code. Responses to the consultation paper had to be returned by early October. On 8 October the Committee of European Banking Supervisors (CEBS) published draft guidance on the remuneration policies and practices referred to in CRD III which is not binding on the FSA but which it is obliged to take into account. A final form of the CEBS guidance is due for publication on 11 December with the final form of the Code expected in mid-December.

If implemented in the form set out in the consultation paper the revisions to the Code would have a significant impact on how remuneration policies and practices at Firms are operated. However, there is a growing sense of optimism in the industry that through the petition of industry bodies such as AIMA, IMA and the BVCA and in light of the draft guidelines issued by CEBS the actual impact on most Firms may be less than initially feared.

Potential Impact for Firms – Proportionality

The key to a sensible application of the Code to Firms will be the extent to which they are allowed to apply the concept of proportionality to their obligations under the Code. It is expected that all Firms will fall within the remit of the Code but it is hoped that by applying proportionality and a comply or explain approach Firms will be able to substantially reduce their obligations and may be able to reach a position of ‘complete neutralisation’ in respect of some of them.

In order to put the concept of proportionality into context it is important for Firms to refer back to the overriding purpose of CRD III which is to deal with the “systemic risk” originating in the banking and investment management sector. Although the latest draft of the Code does not do so, it is hoped that in the final draft the focus of attention will be on the impact of remuneration policy in managing a Firm’s contribution to systemic risk.

It is anticipated that proportionality may be applied at two levels; between institutions, based on the size, internal organisation and the nature, scope and complexity of their activities and between individuals within a Firm. A Firm might therefore be able to argue that based on its size and internal organisation it would be disproportionate to establish a separate remuneration committee or that given that a Firm might be set up as an LLP (with no share capital) it would be disproportionate to apply the prescriptive rules on structuring an element of remuneration as shares to its employees/members.

With the rules still in draft form, and the subject of heated debate, the impact on Firms remains in the balance. The application of the proportionality principle will be key and was an area where the FSA invited comments in its consultation paper. The extent to which the FSA allows Firms to apply the principle, and how they do so in practice, will determine the true impact for Firms going forward.

Potential Impact for Firms – Application to Groups

The Code is unclear regarding its territorial application and it is hoped that the final guidance notes will provide clarity. However, it is anticipated that any in-scope UK parent entity will be required to apply the Code to all companies within its group, whether they are off-shore or not, and any in-scope UK entity that is a subsidiary of a third-country (non-EEA) group will be required to apply the Code in relation to all entities within the sub-group, again whether they are off-shore or not.

Actions to be Considered Now

Whilst the detail of the draft rules may change, including the application of proportionality, there are some areas that Firms should be considering ahead of the publication of the final form Code and certainly prior to 1 January 2011:

What policies are in place in respect of remuneration policies and risk at present? There will be a generic requirement under the Code that all Firms “establish, implement and maintain” a remuneration policy that:

  • is consistent with and promotes effective risk management;
    supports the business strategy, objectives, values and long term interests of the Firm; 
  • does not encourage risk taking that exceeds the level of tolerated risk to the Firm; and 
  • includes measures to avoid conflicts of interest

All Firms should consider the policies they already have in place in respect of remuneration and ensure that they formalise and document a remuneration policy incorporating the above principles; 

Which members of staff are likely to be caught by the more prescriptive rules on remuneration structure? The Code introduces a concept of ‘Code Staff’ and persons falling into this category will be the subject of particular scrutiny regarding their remuneration packages. The current draft of the Code requires that all Firms will have to identify and maintain a record of all Code Staff. Again it will be up to the individual Firm to consider which employees/members fall into this category but the draft rules set out that persons being generally senior managers or with a significant influence on the risk profile of the firm and anyone whose remuneration takes them into the same brackets at those people should be considered as Code Staff.

Firms should consider which of its employees/members are likely to fall within this definition and give thought to how they might need to amend the remuneration structure of those persons to take into account the rules on the balance of fixed/variable remuneration, the obligations to defer a proportion of any bonus payable and requirements to deliver a proportion of remuneration as shares (or similar instruments) – subject of course to any proportionality argument they might be able to make. Firms should also be considering how any restructuring that might be required could be implemented and ensuring that all documentation that may need amending, such as employment contracts or partnership deeds, is available;

Should the revised rules be implemented un-amended the prescriptive measures in respect of how remuneration can be paid (and when) will apply to any remuneration paid after 1 January 2011 (even if such remuneration is in respect of work done prior to 1 January 2011). Firms might therefore wish to consider whether they should pay 2010 bonuses ahead of 1 Jan 2011 (and indeed whether they are able to do so); and

Code Staff will require training generally to ensure they understand the implications of their status as Code Staff. The Code introduces a concept called ‘Malus’ which requires that in scope Firms retain an ability to adjust downwards the amount of shares that Code Staff are entitled to as deferred remuneration should the institution perform poorly in subsequent years. The Code requires that Code Staff do not take any steps to ‘hedge’ any impact on their own remuneration as a result of such poor performance and that Firms should maintain effective arrangements to ensure that employees comply with this. Firms may wish to consider how this message will be delivered and how employee compliance will be monitored.

Implementation

Whilst the FSA is expecting all extended scope firms to begin planning for the implementation of suitable remuneration structures, policies and practices now, with the view that it will be ‘desirable’ for such firms to have the appropriate arrangements and procedures in place by 1 January 2011, the consultation paper ‘recognises that other measures take time to implement’. It is therefore expected that there will be a six-month transitional period for organisations to implement the more complex measures regarding prescribed remuneration structures. This, of course, should not dissuade Firms from considering the points listed above and any other matters they consider relevant.

Where Are We Now?

The reality is that we are still waiting for the final form of the Code before any certainty can be applied to the measures that Firms will need to take. Progress is expected to be made in the area of proportionality which will hopefully reduce the obligations on Firms. What can be said is that Firms will certainly need to consider the area of remuneration in detail, especially if they are seeking to apply the proportionality principles to Code Staff.


Adam Hewitson
8 November 2010


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