UK: New EU and US Proposals on Investment Manager Remuneration

European Union Proposals on Remuneration for Investment Firms

British Foreign Secretary William Hague's first major foreign policy speech yesterday in London, Britain's Foreign Policy in a Networked World, identified .... "a generation gap developing in the British presence in parts of the EU where early decisions and early drafting takes place." There is no better example of the consequences of this for the UK financial services industry than the agreement reached in Brussels late this Tuesday evening on the extension of detailed remuneration requirements, including bonus restrictions designed for the banking sector, to investment firms, including alternative investment fund managers.

This agreement, at least as it relates to bankers' bonuses,¹ was announced in a European Parliament press release on 30 June 2010. The full text of the agreed draft directive was published that day by the European Council and can be found at http://register.consilium.europa.eu/pdf/en/10/st11/st11527.en10.pdf. The proposals are subject to approval by a vote of the European Parliament, scheduled for Wednesday 7 July 2010, and then by the European Council.

The draft directive would amend the EU Capital Requirements Directive ("CRD"), which comprises the Banking Consolidation Directive (2006/48/EC) ("BCD) that applies to EEA banks and the Capital Adequacy Directive (2006/49/EC) ("CAD") that applies to EEA investment firms. The provisions would apply to remuneration and bonuses payable or paid from 1 January 2011.

The draft directive is based on the Financial Stability Board (FSB) Principles for Sound Compensation Practices and the G20 proposals for remuneration requirements in the financial sector approved at the recent Toronto summit, and would apply not only to banks but also to all investment firms subject to CAD. These include all firms subject to the Market in Financial Instruments Directive (2004/39/EC) ("MiFID"), with the exception of so-called "exempt CAD" firms which are restricted from carrying on any MiFID investment business other than reception and transmission of orders and investment advice. There is some leeway for national regulators in the EEA member states to apply the provisions in different ways according to the size, internal organisation and nature, scope and complexity of the activities of the investment firms concerned (the proportionality override).

Thus whilst some advisory-only investment firms will be exempt from the new requirements, MiFID investment managers will generally be caught by them. It is therefore likely that they will apply to most UK hedge fund managers and many of the larger private equity firms, notwithstanding that such firms do not, in prudential or systemic terms, pose the same risks to the financial system, as say the large investment banks. In determining the proportionality tests to be applied, the UK's Financial Services Authority (or its replacement) is likely to have an important role.

However, a recital in the draft directive acknowledges that it may not be proportionate for the investment firms referred to in articles 20(2) and 20(3) of CAD to comply with all of the remuneration provisions in the directive. Such firms include those that do not operate a trading book for their own account and are referred in the FSA rules as BIPRU limited license firms and BIPRU limited activity firms. Most UK hedge fund managers would be categorised as BIPRU limited licence firms. Accordingly, the FSA (or its replacement) would have some flexibility in applying the proposed directive's remuneration restrictions to hedge fund managers and other relevant firms in a proportionate manner. It could decide on this basis not to apply certain of the remuneration requirements to hedge fund managers, but would be unlikely to be able to disapply them entirely. It should also be noted that the role of the new EU Securities and Markets Authority (ESMA) has not yet been fully scoped; and depending upon its eventual role, relevant aspects of this implementation may be decided by ESMA rather than the FSA.

Where the new requirements do apply, their general effect will be that firms must ensure an appropriate balance between fixed salaries and variable remuneration (referred to in the Parliament's press release as "bonuses"). The term "variable remuneration" is not defined in the draft directive; however, the references to bonuses in Parliament's press release suggest some element of discretion might be required. The draft directive's new "technical criteria" on remuneration, which would need to be taken into account by the FSA in implementing it, include the following:

• at least 40% of any variable remuneration (or 60% for particularly high remuneration) to be deferred for at least three to five years and can potentially be recovered if relevant investments perform poorly;

• at least 50% of the total variable remuneration to be paid in the form of contingent capital (i.e. funds that can be called upon firm if the firm gets into difficulty);
• variable remuneration to be balanced appropriately with fixed remuneration; and
• exceptional pension payments must be held in instruments, such as contingent capital, that link their final value to the strength of the firm.

The Parliament's press release also indicated that cash bonuses would be capped at 30%, with a 20% cap for "particularly large" bonuses. The draft directive also includes measures designed primarily in the context of banks, that place further restrictions on the payment of bonuses at those banks which have received taxpayer support.

Many of these requirements are also included in the 11 June 2010 draft of the Alternative Investment Fund Managers' Directive ("AIFMD") proposed by the European Parliament's ECON Committee. The rapporteur in charge of negotiating the draft CRD amendments for the European Parliament has indicated that she would liaise with the rapporteur for the AIFMD in order to align the remuneration provisions in the drafts. However, the proposed CRD amendments could become law as soon as next week, and legislative progress on the AIFMD has been delayed until at least September 2010 and will be the subject of substantial further negotiation and debate. Accordingly, there is a real risk that any "alignment" of the directives' remuneration provisions in the next few days will be substantially different from the final AIFMD provisions.

Moreover, the AIFMD remuneration provisions would likely apply to hedge fund managers in lieu of the proposed CAD requirements once the AIFMD is implemented. Current drafts of the AIFMD suggest a 24-month implementation timetable. This would indicate that, if the AIFMD were passed in September 2010, the new CAD remuneration requirements would apply to hedge fund managers in the period from 1 January 2011 until September 2012, when potentially different AIFMD requirements would be implemented. The AIFMD appears as a priority in the Belgian work programme to 31 December 2010 of the Belgian Presidency of the Council of the EU published on 30 June 2010.

We will be issuing a further update with a more detailed analysis once the regulatory proposals on remuneration are in the final form.

Proposed US Remuneration Restrictions Potentially Applicable to European Investment Managers

Some large European investment managers may have additional constraints placed on their remuneration structures as a result of recent developments in the US. The Dodd-Frank Wall Street Reform and Consumer Protection Act contains a provision that requires US Federal regulators to adopt rules requiring covered financial institutions (including investment managers) with more than $1 billion in assets to disclose the structures of all incentive-based compensation arrangements offered by the covered financial institution so that the Federal regulator may determine whether the compensation structure (i) provides an executive officer, employee, director or principal shareholder of the covered financial institution with excessive compensation, fees or benefits; or (ii) could lead to material financial loss to the covered financial institution. The provision also requires Federal regulators to adopt rules that prohibit any types of incentive-based payment arrangements that the regulators determine encourages those sorts of inappropriate risks.

While the scope of the extraterritorial application of these provisions of the US reform package may ultimately be limited by the regulations adopted, it is likely that large investment managers to hedge funds and/or private equity funds that are required to register with the Securities Exchange Commission because those funds have US investors will be subject to any restrictions placed on incentive-based compensation schemes.

The Dodd-Frank bill is expected to be considered by the US Senate early in the week of 12 July 2010 and, depending on the outcome of the Senate vote, may be presented to President Obama for signature as early as the middle of that week.

Following the enactment of the bill, Dechert will be publishing an analysis of the provisions which will affect non-US firms the most.

Footnotes

^{1 The Parliament's Press Release only referred to bankers' remuneration. It will be recalled that the European Commission had published a consultation on further amendments to CRD in July last year. These amendments included measures on remuneration policies requiring banks to have remuneration policies that discouraged excessive risk-taking (as well as provisions relating to the treatment of resecuritisations and banks' trading books for regulatory capital purposes).}

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