Financial Sector Pay - The Latest Instalment - Employee Benefits & Compensation

There have recently been very well-publicised European developments restricting banking pay. However, the important thing to note is that all financial sectors (not just the banking sector) will, sooner or later, be affected by remuneration restrictions originating in European law and so this is just the start of wider changes across the industry.

Last week's news coverage was prompted by the passing of amendments by the European Parliament to the Capital Requirements Directive (CRD), which affects credit institutions and investment firms, in the form of an amending Directive known as CRD3. CRD3 is now almost finalised at the European level. However, this is just the first of many Directives likely to contain remuneration provisions. Not only do they feature in the Alternative Investment Fund Managers (AIFM) Directive expected to be passed in September but remuneration provisions are also anticipated for the Undertakings for Collective Investments in Transferable Securities (UCITS) IV and under Solvency II Level 2 Directive implementing measures.

What really matters now though is how the FSA chooses to amend and/or extend its Remuneration Code in response to and anticipating all these developments, which in some cases exceed the G20 remuneration proposals. The remuneration restrictions clearly capture all firms subject to CRD (which means credit institutions and the majority of MiFID firms) but crucially the provisions are to be applied in a proportionate way. In particular, according to the recital of CRD3, certain types of MiFID firm may not be subject to all of the principles. While most media and European Parliamentary reports have been about "capping" and "preventing bonuses", the underlying European legislation is more flexible than has been portrayed and is required to be implemented proportionately. However, it is possible that the FSA will apply the CRD3 proposals strictly and CRD3 gives the FSA considerable discretion to do so. In addition, the Financial Services Act implemented earlier this year would generally seem to allow relevant changes to be made by the FSA without any further primary legislation.

The FSA had already promised to consult this summer on changing its Remuneration Code and extending its application. It also wants to respond to market developments since it published its Remuneration Code last year and international developments at the G20 level, where the G20 principles were published after the FSA produced its own code. We understand that a paper from the FSA is expected by the end of July with proposals to take effect from 1 January 2011.

The attached article gives more details of the current position and other relevant European developments. However, until further guidance is issued at EU level and the Treasury and FSA publish their proposals it will not be clear how CRD3 will be implemented in practice in the UK. However, one thing is for certain, pay will now be a hot regulatory topic across the financial services sectors in the next year or so.

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The enclosed article gives more details of the current position and other relevant European developments. However, until further guidance is issued at EU level and the Treasury and FSA publish their proposals it will not be clear how CRD3 will be implemented in practice in the UK. However, one thing is for certain, pay will now be a hot regulatory topic across the financial services sectors in the next year or so.

What European legislative development has recently occurred?

The EU has for some time been proposing changes to the CRD to prevent a repeat of the banking instability of the last few years. These were proposed in the form of a draft amending Directive (known as CRD3) and principally address capital adequacy, but remuneration structures were also increasingly seen as relevant on an international basis. The Commission therefore last year inserted remuneration provisions into CRD3 so as to give the G20 remuneration proposals greater force as a formal part of the European regulatory framework.

The European Parliament's various committees and sponsoring MEPs then considerably expanded the Commission's proposals. This went significantly further than the Remuneration Code and the G20 guidelines in terms of restrictions on pay practices and was the cause of many of the headlines. In the event, the version passed by the European Parliament considerably watered down the most controversial proposals. The final version has now emerged after Parliament's vote. Council and final adoption is expected soon with very few further changes.

Are the changes prescriptive – do Member States have to implement them in full?

The short answer is no, despite media headlines. Member States and relevant European and national supervisory bodies are required to "take account" of the remuneration provisions in a way which is proportionate.

The references to proportionality in CRD3 have been welcomed by the industry but different conclusions seem inevitable among Member States as to which size and type of banks/credit institutions are affected and Member States will have different thresholds or de minimis levels. The devil will, as always, be in the detail of national implementation, which may provide opportunities in terms of regulatory arbitrage. FSA had previously indicated that it may consider gold-plating the CRD3 rules and that in any event the Remuneration Code is indicative of best practice for all significant firms. The FSA may therefore take a rather more extensive view of how to apply these new requirements "proportionately" than might otherwise be the case.

What are the key proposals which differ from the Remuneration Code?

Apart from some key headline matters, most of the remuneration elements in CRD3 are part of the FSA's existing Remuneration Code. Less change to the Remuneration Code may therefore be needed to comply with the European principles than is popularly supposed.

The following are the key areas of divergence:

What is the minimum proportion of variable remuneration which must be deferred and what is the minimum deferral period?

The principle in CRD3 is that between 40 and 60 per cent must be deferred, with a higher level of deferral the greater the amount of variable pay. Clawbacks would operate during the deferral period. The Remuneration Code says that "a reasonable starting point" is that at least two thirds of a bonus should be deferred where it is significant compared to salary and so in this respect the relevant CRD3 principle (based on G20 principles) seems less strict than the Remuneration Code. It is therefore possible that the FSA may propose that the deferral limits in the Remuneration Code are scaled back.

On the other hand, CRD3 provides that full payment should not be received within 5 years of the performance year in question and vesting should be pro rata each year. In contrast, the G20 guidelines and the Remuneration Code simply refer to at least a three year deferral and it will be interesting to see whether or how the FSA decides to change the Remuneration Code to deal with this.

What about the up-front bonus?

Press releases have been adamant that only 20% to 30% of bonuses could be received in up-front cash. The various original European Parliament Committee proposals were much harsher. The reasoning for describing a 20% to 30% limitation seems to be a provision in CRD3 that at least 50% of variable remuneration consists of shares or "contingent capital" (i.e. debt instruments which convert to equity) since only 60% to 40% of a bonus can be paid up-front, and only half of that can be paid in cash as opposed to shares/debt. This then means only 20% to 30% can be paid in up-front cash. However, the wording of CRD3 would seem to allow a bank to pay out a bonus in cash first and only then pay out in shares later rather than have to pay pro rata. Whether this will be permitted by the FSA is quite another matter. Accordingly, how the 20% to 30% up-front cash restriction emerges will be eagerly awaited.

The Remuneration Code currently does not require payment in either shares or debt. It says that this may be suitable, but does not go as far as CRD3, which requires at least 50% to be paid in this way.

The UK's high tax rates also make for an interesting analysis of the payment schedule. Let us say someone is awarded a bonus amount of 100 (and there is no other variable remuneration e.g. options, restricted stock or LTIP arrangements). If his up-front bonus is equally split between cash and shares which cannot be sold for 2 years, then presumably the cash payment needs to be fully used to pay the tax due (at 50%) on the overall cash and shares amount, and so no cash is received. Additional employee's NICs at 2% might mean that the employee needs to use his own cash resources to pay the tax due! It is therefore hoped that employees will be able to sell shares otherwise restricted to meet tax liabilities.

These and other issues will all have to be addressed by the FSA in its consultation paper.

Which firms and employees are caught?

The Remuneration Code currently applies to the top 26 banks, broker dealers and building societies. CRD3 applies to all credit institutions and all investment firms which are caught by the Capital Requirements Directive, albeit that not all of the remuneration provisions will apply to all firms within scope due to the principle of proportionality. As stated above, a key point for the FSA's review will be whether it will extend its Remuneration Code to more entities if it feels it is appropriate to do so (and bearing in mind that the AIFM Directive may have similar provisions to CRD3 when it is implemented).

In terms of the employees caught, the provisions in CRD3 and the Remuneration Code both focus on those in management affecting risk and those on similar levels of remuneration (this latter point is not explicit in the current Remuneration Code although it is expected that this will become so in the revised version to be issued later this year).

Additional provisions in CRD3 require that financial penalties can be enforced by Member States for "risky remuneration". It also provides for public disclosure of remuneration details, but the Financial Services Act already provides for this to occur in the UK.

What provisions proposed by the European Parliament committees were not approved by the full Parliament?

Two key provisions were completely dropped in addition to others which were substantially moderated. The provisions which were dropped were a provision limiting variable pay to 1 times salary which, if implemented, would have sent shockwaves around the financial services world, and a provision preventing variable remuneration at an entity benefiting from exceptional state support. In both cases, variable remuneration must now be "appropriate", which seems a better solution.

What further work is going to occur?

Now that the CRD3 European legislative process is almost over, national governments and regulatory authorities will start work as will the Committee for European Banking Supervisors (CEBS), the co-ordinating body for national banking regulators, which is required to draw up guidelines to implement the remuneration principles included in CRD3. CEBS had in fact already drawn up guidelines, many of which found their way into CRD3, and so it will be interesting to see how much further their revised guidelines go. In addition, the Commission is also directed to undertake a substantial amount of technical and co-ordinating work, and there is to be a review in 2012/2013.

At the UK level, the FSA is due to produce a paper suggesting changes to its Remuneration Code. This is due to be published in late July. It will contain most of the relevant UK proposals for the changes proposed in CRD3 and so will be the key document and set of provisions so far as UK firms go. It will be these rules that they have to comply with and where breach will lead to enforcement action. Whether the FSA is going to exceed European and G20 principles or trim them back will be closely monitored – on the one hand the banking sector will want to ensure there is a level playing field but on the other hand stakeholders from the non-banking sectors will be anxious to ensure that inappropriate read-across from the banking sector is avoided.

The FSA review of its Remuneration Code will also take into account its experience of the Remuneration Code in the first year of its operation, market reaction and any perceived undesirable practices which have emerged, as well as what is happening internationally so the UK does not lose undue competitiveness.

When will the CRD changes take effect?

There is an unusually tight implementation timetable. Member States are required to ensure that they or their regulatory bodies have complied with/implemented the remuneration provisions contained in CRD3 by 1 January 2011. It seems we should expect to see anti-avoidance measures to make sure that remuneration which would normally be paid in 2011 is not artificially accelerated to subvert the new rules. Equally, the new rules would appear to apply on their face to remuneration packages already agreed leading to the possibility that they may have to be amended to comply with CRD3 from 1 January 2011, although whether this would be applied in practice must be doubtful in all but the most outrageous of cases.

As stated above, the FSA already has legislation in place to allow it to implement most provisions with effect from this date.

What other European developments are occurring?

The CRD remuneration policies are part of a wider cross-sectoral clamp down on remuneration and risk management that has been instigated at EU level. The European Commission in its Green Paper entitled "Corporate governance in financial institutions and remuneration policies" and the accompanying Commission Staff Working Paper has recently endorsed the approach being taken to ensure that the financial system is strengthened in an even handed way. In this context, as well as the reform of the European supervisory architecture through the creation of three European Supervisory Authorities and a European Systemic Risk Board, a host of legislation is currently being developed containing remuneration provisions relevant to individual sectors.

The AIFM Directive, which is currently expected to be voted on in Parliament in September, is an example of this. Although the final specifics of the Directive have not yet been agreed on, fund managers to which it applies will be required to implement policies, which currently include rules on deferral of payments, to staff whose professional activities have a material impact on their risk profile or the risk profiles of the funds under management. For the insurance sector, the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) has advised the European Commission to include remuneration requirements into the Solvency II Directive regime. These provisions are expected to be in place by the end of 2012. Finally, further measures affecting remuneration are also expected for UCITS managers under UCITS IV.

The European Banking Federation (a banking sector trade body) has recently highlighted the importance of maintaining a level playing field throughout the implementation of these cross-sectoral remuneration policies as a key element in maintaining fair competition. In particular it was emphasised that if the remuneration policies of banks become subject to stricter regulation, then the same should apply for other financial institutions. However, as stated above, stakeholders from other sectors have also been lobbying against inappropriate read-across from the banking sector.

This article was written for Law-Now, CMS Cameron McKenna's free online information service. To register for Law-Now, please go to www.law-now.com/law-now/mondaq

Law-Now information is for general purposes and guidance only. The information and opinions expressed in all Law-Now articles are not necessarily comprehensive and do not purport to give professional or legal advice. All Law-Now information relates to circumstances prevailing at the date of its original publication and may not have been updated to reflect subsequent developments.

The original publication date for this article was 13/07/2010.

UK: Financial Sector Pay - The Latest Instalment