The FSA has published its final Remuneration Code (“the Code”) rules which provide better news than first anticipated for all asset managers and brokers (other than the largest full scope firms). Commonly these types of firms have a lower risk profile than banks and full scope investment firms, so accordingly they have been given an opportunity to apply the proportionality measures in the Code more fully than other firms.
The FSA first published its proposals to implement the Code as required under the third Capital Requirements Directive (“CRD3”) in July 2010 (click here to read our article on the proposals). The proposals have attracted unprecedented comment from the industry and now just days from the implementation deadline the FSA has published its final rules, with the Code coming into force on 1 January 2011. Limited transitional provisions have been provided which run until 1 July 2011.
The Code is set out in SYSC 19A in the FSA Handbook. It applies to about 2,500 credit institutions and investment firms and to members of their UK Consolidation Group (effectively group members subject to Consolidated Supervision by the FSA) and so can include unregulated activities and overseas group members. Groups with differing businesses will apply rules based on the firm with the widest scope in the Group.
The Code does not apply to; firms which only operate a collective investment scheme (including UK onshore private equity funds, unit trust and OEICs); Occupational Pension Scheme Managers and adviser/ arrangers (including called Exempt CAD firms). Accordingly, some firms are checking their permissions and are reducing them to stay out of the scope of the Code. Anti-avoidance measures prevent firms from utilising off-shore structures to avoid the provisions of the Code. We anticipate that the FSA will extend many of the Code’s rules to all firms as guidance in due course. The Code is published in PS 10/20 (click here)and related disclosure requirements in PS 10/21(click here).
Application of the Code
The Code acts in three ways, requiring:
- Robust governance arrangements which apply to all firms and their staff
- Remuneration controls for identified staff members whose professional activities have a material impact on the risk profile of the firm (so called Code staff)
- Qualitative and quantitative disclosure of remuneration policies and practices
Firms should have remuneration policies and procedures in place to determine remuneration that are clear, well documented and internally transparent to all staff. The FSA expects firms to use the principles set out in the Code to evaluate their remuneration arrangements and to assess their remuneration risks in the firm’s ICAAP.
Firms should seek to achieve as much independence as they can in their remuneration arrangements. Non-executive members may be used in determining the remuneration of the control functions (risk management, compliance and HR function) and care should be taken to minimise conflicts of interests on the pay of controlled functions. Control functions pay should also be weighted to fixed amounts. Generally a remuneration committee will not be required.
The Code includes specific proportionality measures which aim to match the remuneration policies and practices with the risk profile, risk appetite and risk strategy of the firm. These measures apply across most aspects of the Code other than specific numerical criteria (e.g. deferral period of 3 to 5 years) and so the Code allows some provisions to be neutralised.
The FSA has introduced four tiers of firms and so each firm will need to identify their category based on their prudential categorisation and/or their capital resources or total assets. The tiers are defined as follows;
- Tier 1 – Banks and building societies with capital resources exceeding £1b; full scope BIPRU €730k investment firms with capital resources exceeding £730m; and all third country BIPRU firms with total AUM (for the branch) exceeding £25bn
- Tier 2- Banks and building societies with capital resources between £50m-£1bn; full scope BIPRU €730k investment firms with capital resources between £100m and £750m; and all third country BIPRU firms with total AUM (for the branch) between £2b and £25b
- Tier 3- Any banks, building society and full scope BIPRU firm that does not fall within tier 1 or 2; and all third country BIPRU firms that are not covered by tiers 1 and 2
- Tier 4 - BIPRU Limited Licence, or Limited Activity firms (including third country BIPRU firms with these prudential categorisations
The tier system will simplify the application of neutralisation. Tier 1 firms are the largest, most complex credit institutions and will be required to apply the Code most strictly, while those in Tier 4 can dis-apply some parts of the Code and either comply or explain their non-compliance in other areas. As the tiers are broad, not all firms within a tier will apply the principles in the same manner.
Limited Licence and Limited Activity firms within Tier 4 are required to comply with the following principles:
- Risk management and risk tolerance
- Supporting business strategy, objectives, values and long term interests of the firm
- Avoiding conflicts of interest
- Governance, except that a Remuneration Committee is not needed
- Control functions
- Remuneration and capital
- Exceptional government intervention
- Profit based measurement and risk adjustment, except that firms can take into account their specific features in complying the requirement
- Pension policy
- Personal investment strategies
- Avoidance of the Remuneration Code
- Remuneration Structures will apply except that firms will be able to take into account their specific features in complying the requirement to have a multi-year remuneration framework and they will specifically be able to dis-apply the requirements for:
- Variable remuneration leverage limits based on the amount of fixed remuneration
- At least 50% of variable remuneration to be retained on shares or other instruments
- Deferral of vesting of a substantial portion (40-60%) of variable of remuneration over 3 to 5 years
- Performance adjustments to reduce unvested variable pay
Full scope BIPRU Firms that fall within Tier 3 are required to comply with the same principles as Tier 4 firms with the exception of 12 (a) above. In effect they cannot disapply the need to create ratios between fixed and variable remuneration. Also they will not be able to take into account the specific activities of the Firm in respect of Principle 8 and the need to apply a multi year framework to their remuneration structures.
It was Principle 12 that caused the most significant issues for asset managers and brokers and hence the latest approach to proportionality represents a considerable improvement in the arrangements. Firms will need to evaluate their remuneration policies, procedures and practices against the Code and then apply them to their staff.
Remuneration controls for Code staff
The Code applies to all remuneration that is payable to Code staff (E.g. salary, bonus, LTIP amounts, options, sign on payments, severance packages and pension arrangements) whether paid by the firm or a seconding organisation.
Code Staff fall into five categories:
- Executive senior management (Board level)
- Senior management responsible for day to day management of significant business lines (if any)
- Senior Compliance, risk management and HR staff – described as control functions
- Other risk takers who can exert influence on the firm’s risk profile
- Other staff who put them in the same pay bracket as senior managers and risk takers
The FSA expects persons holding Significant Influence Functions (“SIFs”) to be Code staff, including non-executives directors (although they are less likely to receive variable remuneration). Partners are therefore included too, but firms may take advantage of the proportionality approach to reduce their scope. Payments may fall outside the code where they relate to ownership interests of partnerships. Dividends that are received as owners of an institution are not covered by the Code and instead the owners need to abide by the FSA Threshold Conditions for authorisation and the Capital Adequacy rules set out in GENPRU and BIPRU (Pillar 1 and 2 capital requirements). Where a SIF is an individual located overseas and has global responsibilities, of which the UK forms part, they may be exempt from the requirements. Although, firms should not relocate staff overseas to avoid compliance with the Code.
Firms should compile a list of Code staff ahead of a bonus allocation period and carefully consider any other staff that they include in the list, particularly other risk takers who may be excluded if constrained by the firm’s internal controls and limits. Firms must then explain the implications of the Code to all staff affected.
The Code precludes any arrangements that are put in place just to circumvent the Code, which could include the use of ownership interests. Subject to transitional provisions the Code applies to remuneration made or awarded after 1 January 2011, including the payments of 2010 bonuses.
The FSA are able to declare provisions in employment contracts void if they are contrary to the Code. The power derives from the Financial Services Act 2010 and relates to declaring void guaranteed bonuses (other than for first year sign on payments), and un-deferred variable remuneration. However, the voiding provisions do not apply to variable remuneration of up to 33% total remuneration and total remuneration of less than £500,000 per annum or agreements made before 29 July 2010, although firms will need to take reasonable steps to amend the arrangements. The Code has provisions for firms to recover void amounts.
Qualitative and quantitative disclosure of remuneration policies and practices
The FSA will be collecting data for supervisory purposes and we anticipate that they will create a further annual Gabriel data item to collect aggregate data on remuneration policies and practices and also certification that the firm’s remuneration policy complies with the Code. The FSA expect to request this data item in the second half of 2011 relating to 2010/2011 remuneration. FSA will also require firms to prepare a “Remuneration Policy Statement” which supports the firm’s assessment of its compliance with the Code. Later in 2011 the FSA will issue the requisite data form and associated templates for each tier of firm.
The FSA’s rules also include provisions relating to the annual public disclosure of remuneration policies and practices as part of the existing Pillar 3 disclosure using the same mechanisms as currently (i.e. Annual accounts or website disclosure such as www.pillar3.eu). As with the Code itself, the disclosures apply on a proportionate basis using the tier arrangements discussed above. The disclosures for Tier 3 and 4 firms are less onerous. The FSA expect Firms to make their first public disclosure in respect of 2010 remuneration as soon as practicable and no later than 31 December 2011.
The FSA has extended its notification requirements in respect of significant breaches of the Code. In particular firms will be required to advise the FSA of breaches of the voiding and recovery provisions.
Firms are expected to be in broad compliance with Principles 1-6 and 9-11 by 1 January 2011 but there is a transitional rule for remuneration structures (Principle 12) which gives firms until 1 July 2011 to implement the Principle. In addition the recovery and voiding measures are not to be applied to before 1 January 2012, and the FSA may decide not to apply them at all.
While the Remuneration Code is not as bad as first feared for asset managers and brokers, firms will have considerable work to:
- Identify the tier that the firm falls under and establish areas of dis-application, including identifying which principles fall within the ‘comply or explain’ regime;
- Establish which principles can be dis-applied in respect of Code Staff;
- Evaluate remuneration policies, procedures and practices against the Code;
- Amend arrangements as required and establish a written remuneration policy;
- Create a list of the firm’s Code Staff and notify Code Staff that they are caught;
- Review the firm’s ICAAP to ensure that it considers the risks highlighted in the Code; and
- Update the firm’s compliance manual and monitoring plan.
A side effect of the Code will be shifts in the remuneration structures at the big banks and full scope firms. Higher fixed pay is already being paid and variable pay is being paired back. Undoubtedly, these forces will change the financial services industry significantly in the years to come.
IMS will consult with clients in order to initiate compliance for the 1st January 2011 implementation date.