Monday, August 9, 2010

FSA to Expand UK Compensation Rules to Cover Fund Managers

On July 29, 2010, the United Kingdom Financial Services Authority (the "FSA") announced in a consultation paper its plans to revise its Remuneration Code in accordance with the Financial Services Act 2010 and the amendments (the "CRD 3") to the Capital Requirements Directive (2006/48/EC and 2006/49/EC) approved by the European Parliament on July 7, 2010 following agreement with the Council. The Remuneration Code, which has been in effect since January 1, 2010, is set out in part 19 of the Senior Management Arrangement, Systems and Controls ("SYSC") sourcebook. SYSC is one of 7 sourcebooks comprising the FSA Handbook "High Level Standards" which set out the standards by which FSA authorised firms and approved persons are expected to conduct themselves and the core regulatory obligations that apply to them. The Remuneration Code requires firms to establish, implement and maintain remuneration policies consistent with effective risk management and provides specific rules to ensure compliance with this general requirement.

The FSA consultation paper is relevant to a wide range of FSA-regulated firms and their advisers, as it proposes to substantially expand the scope of the Remuneration Code, which currently applies only to the largest UK banks, building societies and broker dealers. The FSA estimates that bringing the Remuneration Code in line with the CRD 3 will expand its application from a current estimate of about 26 firms to over 2,500 firms with effect from January 1, 2011, including "all banks and building societies, asset managers, hedge fund managers, UCITS investment firms as well as some firms that engage in corporate finance, venture capital, the provision of financial advice and stockbrokers".

The proposed amendments to the Remuneration Code would enhance the existing rules in a number of areas including:

  • Scope: In light of the expanded scope of the Remuneration Code, the FSA is committed to applying a proportionate approach to its implementation to ensure that "institutions shall comply with the principles in a way and to the extent that is appropriate to their size, internal organisation and the nature, the scope and the complexity of their activities";

  • Code staff: The Remuneration Code will apply to a specific group of employees within a covered firm including senior management and anyone whose professional activities could have a material impact on a firm’s risk profile ("Code staff"). Firms will be required to submit a list of Code staff which will be subject to review and challenge by the FSA;

  • Variable Remuneration (Bonuses):

    1. Deferral: at least 40% (60% for amounts exceeding £500,000) of all bonuses must be deferred with vesting over a period of at least three years for all Code staff and be correctly aligned with the nature of the business, its risk and the activities of the individual in question. Remuneration payable under deferral arrangements must vest no faster than on a pro-rata basis, with the first vesting no sooner than one year after the award,

    2. Cash/Shares: at least 50% of any bonus, taken as a whole, must be made in shares, share-linked instruments, or other equivalent non-cash instruments of the firm, which are subject to deferral or a minimum retention policy,

    3. Guaranteed Bonuses: Guaranteed bonuses are exceptional, may only occur when hiring new staff and are limited to the first year of service,

    4. Performance Adjustments: After bonuses have been announced and paid, firms will be required to make further adjustments to take account of subsequent crystallized risks and developments of an adverse nature. Such adjustment will be possible only on the deferred unvested portion of the bonus and can be achieved through "malus" or "clawbacks",

  • Severance Pay: Payments related to the early termination of a contract will be subject to new restrictions to reflect performance over time and prevent the reward of failure;

  • Pensions: Discretionary pension benefits will be required to take the form of shares or share-like instruments that must be held for at least five years (i) by the firm, in the case of an employee leaving before retirement; and (ii) by the employee, when it reaches retirement.
Remuneration policies similar to the ones included in the CRD 3 and the proposed amendments to the Remuneration Code are also part of the draft EU AIFM directive which will apply to managers of most private investment funds such as hedge funds and private equity funds. However, negotiations on the AIFM directive are continuing, and the current expectation is that it may come into force only towards the end of 2012 or early 2013. In the meantime, certain fund managers will be subject to remuneration restrictions included in the CRD 3 and the Remuneration Code before they come under the remit of the AIFM directive. UCITS are currently not subject to any specific remuneration policies.

The FSA consultation paper is open for comments until October 8, 2010. The FSA intends to publish its policy statement and final rules by mid-November, and the new Handbook text is expected to come in effect on January 1, 2011.