Final rules on the FSA’s revision to the Remuneration Code: New rules on pay

Final rules on the FSA’s revision to the Remuneration Code: New rules on pay

On 1 January 2011, a revised Remuneration Code is being introduced by the Financial Services Authority (FSA). This is a revision to the existing Code that was brought in at the beginning of 2010 to curb excessive remuneration packages at banks, building societies and broker dealers in the wake of the Lehman collapse. Last week the FSA published the final rules and so this briefing looks at the impact it will have on the 2,500 firms new to the Code. The full version of the FSA’s Policy Statement can be found here: www.fsa.gov.uk/pages/Library/Policy/Policy/2010/10_21.shtml

The new rules extend the Code’s scope to many new firms – primarily those with BIPRU permissions – caught by the Capital Requirements Directive (CRD). The rules also extend to third country BIPRU firms in relation to their activities from establishments in the UK, plus overseas subsidiaries or branches of firms headquartered in the UK. Exempt CAD firms are not included within the scope of the Code.

Proportionality

The FSA’s concept of proportionality is the overarching factor in deciding how the Code rules should be applied to each type of firm. The FSA has devised a four-tier framework that gives an indication of which rules certain firms may be allowed to ‘disapply’. As a result, there will be differing minimum expectations of compliance for firms within different tiers.

The FSA’s expectations for compliance for each tier is summarised below.

Applying the Code to individuals

The rules apply to someone whom the firm has identified as ‘Code Staff’. Code Staff are individuals whose professional activities could have a material impact on the firm’s risk profile. This is likely to include senior managers, risk takers, those in control functions (e.g. compliance, HR) and any employee whose remuneration is in the same bracket as senior managers and risk takers. This may therefore include star traders. The onus is on firms to identify Code Staff, but this will be subject to FSA’s review and challenge

De minimis limit

There is a ‘de minimis’ limit under which the rules on pay below do not apply. It is necessary for both requirements of the de minimis provision to be satisfied in order for an employee to fall within it. These are that:

(a) the individual's variable remuneration is no more than 33% of the total remuneration; and
(b) the individual's total remuneration is no more than £500,000.

As an example this means that if an individual's total remuneration were £200,000 but they received a bonus of £100,000, they would not be exempt under the de minimis provision from the key remuneration mechanisms. As a result the majority of the provisions within the FSA Remuneration Code would apply to such Code Staff. This may be a significant consideration for some firms.

Disclosure requirements

All firms will have to submit an annual data return that sets out aggregate data on remuneration policies and practices, and also certification that the firm’s remuneration policies are compliant with the Code. This is likely to be in the second half of 2011 and be based on 2010/11 remuneration awards. At the same time, all firms will be expected to prepare a Remuneration Policy Statement (RPS). This should be reviewed and approved by the firm’s Remuneration Committee. A proportionate approach will be taken to the content of the RPS so tier three and four firms will be asked to prepare a less detailed RPS on the basis of a questionnaire or template. This won’t need to be disclosed publicly as was previously expected.

Effective date

Because of the late release of the final rules, transitional provisions will apply to firms new to the Code and certain provisions can therefore be implemented over the next six months. Firms are not required to breach existing contracts and instead rely on proportionality provisions to justify non-compliance by 1 January 2011, providing they take reasonable steps to comply and do so by 1 July 2011. There is no guidance as to what this might mean in practice but, in each case firms will be subject to the proportionality rule.

Remuneration Principles (subject to concessions granted to varying tiers)

Remuneration Committees – where RemCos apply the chairman and members must not perform any executive function of the firm.

Guaranteed bonuses – there should be no guaranteed bonuses of more than one year (and only to new hires in exceptional circumstances). The final rules on guaranteed bonuses apply on a firmwide basis and not only to Code Staff.

Retention awards – when these awards can be made has been revisited. It remains the case that these will be exceptional and "where a strong case can be made for the retention of particular key staff members on prudential grounds".

Leverage – firms are required to set a maximum ratio(s) on the variable component of Code Staff remuneration in relation to the fixed component. This could vary between and within firms depending on the role(s) of staff concerned.

Severance payments – the FSA does not intend to prohibit such payments, but they should reflect performance. The aim is to ensure that they do not reward failure.

Allocating the shares/share-linked component between deferred and undeferred components of the bonus – the FSA’s rules dictate that at least 50% of a relevant employee's bonus must be paid in shares or share-linked instruments. This applies to both the upfront and deferred elements of the bonus. The original proposal was that so long as at least 50% was paid in shares, there would be flexibility to allocate this between the deferred and upfront elements of variable pay.

Retention period – variable remuneration issued in shares or other instruments should be subject to an appropriate retention policy designed to align incentives with the longer-term interests of the firm. However, the guidelines do not specify a minimum retention period. Firms and employees will have to address the tax liability that arises when shares vest but remain subject to a retention period. In doing so, they will need to be mindful of the anti-avoidance provisions in terms of using vehicles to reward individuals, and HMRC's recent announcement as to disguised remuneration.

Deferral – where applicable, it is mandatory to defer variable pay. For Code Staff with variable pay below £500,000, 40% should be deferred, while for those with variable pay above £500,000 or for directors of ‘significant influence’ firms (including those within tier one), 60% should be deferred.

Performance adjustment – a significant proportion of the variable pay should be linked to the future performance of the firm, the employee’s division and/or business unit. Risk adjustments should be made before determining the bonus (‘ante risk’) and where there is underperformance by the individual or business unit during the deferral period (‘ex-post risk’). Total variable remuneration must not limit firms’ ability to strengthen capital base.

It should be noted that the FSA can render void provisions of remuneration agreements in breach of the code. There are also anti-avoidance provisions too. These prevent:

• employment through third-party companies;
• paying remuneration through structures which are not covered by the Code; and
• staff hedging or insuring against the risk of the loss of variable remuneration.

What firms should do?

1. Firms should determine whether they fall within the scope of the Code;
2. Review contracts of employment and compare current compensation packages with the revised Code;
3. Identify individuals likely to fall with the definition of ‘Code Staff’;
4. Larger firms should consider the formation of a Remuneration Committee;
5. Review deferral mechanisms already in place, e.g. existing LTIPs;
6. Firms not in a position to issue shares should consider what other instruments might be used;
7. Firms might consider increasing fixed pay or using draws;
8. Firms should draft or amend remuneration policies;
9. Management must consult with staff likely to be affected; and
10. Firms should talk to their professional advisers and ask for their advice on remuneration and tax planning, HR issues, remuneration policies, contracts, and corporate governance frameworks, and general compliance with the Code.

For further information please contact:

Tom Moore
Partner
Tel: 020 7566 3817
tmoore@kingstonsmith.co.uk