Remuneration Code - Final Rules Published

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On 17 December 2010, the FSA published the final form of the revised Remuneration Code (the “Code”). In the fourth of our series of papers on the Code we consider the key questions that affected firms should be asking now that the final rules have been published and the practical steps that they should be taking in order to comply with the Code.

Does the revised Code apply to my firm?

As set out in our previous papers, one of the key revisions to the Code is to widen the scope of its application. The final rules follow the draft rules of the consultation paper and in short the Code applies to all firms that fall under the Capital Requirements Directive including all MiFID compliant FSA regulated firms (“Firms”).

The firm is caught, what next?

Firstly it is worth reviewing the wording of the revised Code itself, it is fairly accessible and relatively succinct. The 12 principles that all Firms need to consider are set out at paragraphs 19A.3.7 – 19A.3.53. The supervisory approach, discussed below, is yet to be finalised, but it is likely that given the “comply or explain” approach adopted by the Code, any reporting requirements will be based on the specific rules themselves.

The next step will be to consider which of the rules (or parts thereof) can be disapplied. As discussed in our earlier paper, the FSA accepts that given the wide remit of the Code not all Firms should be required to implement the full ambit of the rules and that some rules, particularly the detailed ones relating to remuneration structures, should be applied on a basis proportionate to the individual risk profile, risk appetite and the strategy of the Firm.

The application of the proportionality principal will assist the majority of Firms to lessen the impact of the Code and, somewhat helpfully, the methodology applied in the final Code is relatively straight-forward. The FSA has adopted a four-tiered structure which categorises institutions based on the nature of the Firm and the size of any capital resources. It expects that those institutions in tier 1 will not use proportionality to neutralise or disapply the provisions of the Code (or will only do so very rarely) whereas those institutions in tier 4 may well be expected to apply the concept of proportionality to neutralise several of the more specific provisions particularly those in respect of remuneration structures.

Chapter 3 of the policy statement that accompanies the final rules sets out the criteria for the basis of the tiering framework and provides that tier 4 Firms will include all limited licence and limited activity firms. It is expected that most hedge fund management firms will fall within tier 4.

Disapplication

Using the concept of proportionality it will be open to tier 4 Firms to disapply the following requirements of the revised Code:

(a)  Remuneration Principle 4 (Governance) – rather than appointing a separate remuneration committee the FSA 
       accepts that it may be appropriate for the governing body of the Firm to act as the remuneration committee;
(b)  Remuneration Principle 12 (Remuneration structures) – the guidance to the revised Code sets out that the FSA 
       would normally expect a Firm in tier 4 to disapply the following remuneration principles when considering 
       remuneration structures:

  • That a substantial portion, which is at least 50% of any bonus, be paid in shares or similar instruments; 
  • That at least 40% of any bonus is deferred over a period which is not less than 3-5 years; 
  • That any bonus is paid only if it is sustainable according to the financial situation of the firm as a whole, and justified according to the performance of the firm, the business unit  and the individual concerned; 
  • The rule on setting ratios between fixed and variable components of total remuneration; and 
  • The requirement to include performance adjustment provisions to take account of poor performance in the years following the award of the bonus. 
  • In addition to the above, the FSA will expect institutions in tier 4 to take into account the specific features of their type of activities when adhering to the requirements to a) ensure that any measurement of performance takes into account current and future risks (Principle 8) and b) ensure that the assessment of performance is set in a multi-year framework in order to ensure that the assessment process is based on longer-term performance.

In the event that a Firm is a member of a group of companies it will be necessary to establish which companies in the group are subject to the Code as all companies within the group will fall within the highest tier that applies to any company in the group.

So (bearing in mind the application of proportionality) what should my Firm be doing?

As noted above, given the structured nature of the revised Code, it is worth approaching the question of compliance in a formulaic manner and the steps a Firm should be taking can be aligned with the 12 Principles of the revised Code:

  • Draft a detailed remuneration policy that is approved by the governing body of the Firm – this should refer to each of Principles 1,2 and 3 (being Risk management and risk tolerance, supporting business strategy, objectives, values and long-term interests of the firm and avoiding conflicts of interest);
  • Note (in board minutes or the remuneration policy) which of the four tiers the Firm falls within and consider whether a separate remuneration committee should be established or whether the governing body of the firm should act as the remuneration committee (this should deal with Principle 4);
  • Identify which employees carry out control functions and review their remuneration packages to ensure they are independent from the business units they oversee and are remunerated in accordance with the achievement of the objectives linked to their functions (Principle 5);
  • Identify Code Staff and review their remuneration packages (this is dealt with further below but will assist a Firm to comply with Principles 6, 10 and 12, namely, Remuneration and Capital, Personal Investment Strategy and Remuneration Structures);
  • Train Code Staff so they understand their obligations generally and specifically their obligation not to take measures to avoid the Code. Any training will need to be given on a rolling basis so that new starters that qualify as Code Staff are also made aware of their obligations. Amend employee handbooks to include a section dealing with Code Staff (Principle 11 - Avoidance of the Remuneration Code);
  • Note (in board minutes or the remuneration policy) that remuneration Principle 7 (namely Exceptional government intervention) does not apply to the Firm (assuming of course it does not) and consider, given the type of activity carried on by the Firm, whether Principle 8 (Profit-based measurement and risk adjustment) should be disapplied; and
  • Review the pension policy of the Firm to ensure compliance with Principle 9 (Pension Policy). This effectively restricts enhanced pension benefits (over and above their basic contractual entitlement), granted on a discretionary basis by a Firm to an employee as part of their bonus package.

Identifying Code Staff

This will be an important practical step to take both from an internal and external compliance perspective. Whilst the supervisory approach is yet to be settled the revised Code does require a Firm to maintain a record of its Code Staff and chapter 2 of the policy statement sets out that Firms in tier 4 ‘may be asked to provide their list of Code Staff as part of supervisory interaction’.

The definition of Code Staff covers ‘senior management, risk takers, staff engaged in control functions and any employee receiving total remuneration that takes them into the same remuneration bracket as senior management and risk takers, whose professional activities have a material impact on the firm’s risk profile’. Those persons within a Firm that have responsibility for compliance with the revised Code will therefore need to consider the application of this definition carefully and draw up a list of Code Staff accordingly. This process should also take into account the de minimis provision whereby an employee that would be Code Staff will fall outside the revised Code if both of the following conditions are met:

  • His bonus is no more than 33% of total remuneration; and
  • His total remuneration is no more than £500,000.

It should be noted that there is no specific exemption for partners of LLP’s from the definition of Code Staff and, consistent with the all-encompassing approach of the Code, the FSA requires partners to rely on disapplications that the firm of which they are a partner may be able to take advantage of, rather than exempting individual partners from the scope of the Code.

Once the identity of a Firm’s Code Staff has been established the remuneration packages for those employees will need to be reviewed to ensure compliance with the Code and the relevant employee will need to be made aware of their status as Code Staff and be informed of their obligations not to try and circumvent the application of the Code.

Firms that fall within tier 4, and that take advantage of the opportunity to disapply those requirements of Principle 12 referred to above, may need to make only minimal changes to the remuneration packages of Code Staff. The following specific provisions of Principle 12 will need to be applied however:

  • non-financial performance metrics should form a significant part of the performance assessment process;
  • a firm must not award, pay or provide a guaranteed bonus unless it is in the first year of service and is exceptional; and
  • severance payments related to early termination must not be used to reward failure.

In addition, any remuneration package would need to comply with the overarching requirement (that affects the remuneration of all employees) of Principle 12 that the structure of remuneration is consistent with and promotes effective risk management.

Transitional Provisions

The FSA has maintained the transitional provisions set out in the draft rules. These allow those Firms that are coming into scope for the first time in 2011 additional time (up to 1 July 2011) to comply with the provisions relating to remuneration structures under Principle 12. The FSA expects all firms to be broadly compliant with the rules under the remaining principles by 1 January 2011. The policy statement sets out that ‘Any shortfalls should be identified and a time specific plan prepared to rectify them should be in place by the end of January 2011’.

Supervisory approach

Firms will be required to submit an annual data return to the FSA setting out aggregate data on their remuneration policies and practices, and also a certification that the Firm’s remuneration policies are compliant with the Code.

In addition to the annual data return all Firms will be expected to prepare a Remuneration Policy Statement (“RPS”) which will record the Firm’s self-assessment of compliance with the Code. The FSA expects that the RPS will be less detailed for those Firms in a lower tier and the policy statement suggests this document may be akin to a questionnaire.

The FSA expects to issue a form for the annual data return and templates/questionnaires for completing the RPS ‘later in 2011’.

Conclusion

As predicted, the FSA has taken a sensible approach to the application of the Code to firms within tier 4. The Code does of course represent further regulation that needs to be considered by Firms and this requires a level of understanding even if the practical implication is fairly minimal for some. This of course is not the end of the story, and the interaction of the Code with AiFMD will be followed with interest in the coming months and years. 


Adam Hewitson 
6 January 2011 


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