• FSA's Proposed Amendments to the U.K. Remuneration Code - Impact on Asset Managers With U.K. Operations
  • September 9, 2010 | Authors: James Anderson; Julie M. Bradshaw; Allan G. Murray-Jones; Ezra Zahabi
  • Law Firm: Skadden, Arps, Slate, Meagher & Flom (UK) LLP - London Office
  • 1. Background

    1.1 The United Kingdom Financial Services Authority (FSA) issued a consultation paper on July 29, 20101 proposing revisions to the principles and rules relating to the remuneration practices of certain financial institutions and investment firms operating in the U.K. and authorised by the FSA (Remuneration Code).

    1.2 The Remuneration Code applies to 27 of the largest financial institutions in the U.K., but the revised Remuneration Code would have an extended scope covering approximately 2,500 financial institutions and investment firms authorised by the FSA (Firms). The revised Remuneration Code will cover most U.K. hedge fund managers and those private equity fund managers whose permission covers EU Markets in Financial Instruments Directive (MiFID) business. However, a number of private equity fund managers will be exempt from the scope of MiFID under Article 2 of MiFID, and consequently will not, at this stage, fall within the scope of the revised Remuneration Code. This said, the proposed Alternative Investment Fund Managers Directive, currently being considered by the European legislative institutions (AIFMD), may include similar provisions regarding remuneration such that Firms subject to AIFMD but currently falling outside the scope of the revised Remuneration Code may become subject to the revised Remuneration Code in the future.

    1.3 The revisions to the Remuneration Code proposed by the FSA would bring the Remuneration Code in line with the provisions in the new EU capital requirements directive2 (CRD3) on remuneration practices within the financial services sector, which will come into force on January 1, 2011. The proposed revisions to the Remuneration Code also will implement the requirement in the U.K. Financial Services Act 2010 (FS Act) that the FSA ensure that the Remuneration Code is consistent with the “Implementation Standards” set out by the Financial Stability Board.

    1.4 CRD3 permits the provisions therein on remuneration to be applied in a manner proportionate to the internal structure, size, nature, scope and complexity of the firms to which it applies (proportionality principle). The FSA sets out in the consultation paper its interpretation of the application of the requirements in the revised Remuneration Code to Firms that will be subject to the revised Remuneration Code (Relevant Firms) in accordance with the proportionality principle.3 CRD3 recognises that under the proportionality principle it may not be appropriate for a Firm that does not engage in proprietary trading or underwrite using its own balance sheet (Limited Licence Firms) to comply with all of the remuneration provisions in CRD3. While it is possible to interpret the proportionality principle to allow for the exclusion of Limited Licence Firms (most U.K. hedge fund managers being Limited Licence Firms) from the scope of the Remuneration Code, the FSA’s view is that the proportionality principle does not fully exclude any Firm within the scope of CRD3 from the scope of the revised Remuneration Code.

    1.5 The consultation paper contains three tables, specifying (1) core requirements applicable to all Relevant Firms; (2) rules which will be applied in accordance with the proportionality principle, reflecting the differences between the Relevant Firms’ organisation and activities; and (3) rules which may be applied on a “comply or explain” basis, so that Relevant Firms which do not comply with the rules will be expected to justify to the FSA their noncompliance with reference to the proportionality principle. In order to be deemed to have complied the revised Remuneration Code, the justifications submitted by the Relevant Firms must be acceptable to the FSA.

    1.6 An outline of the proposed revisions to the Remuneration Code, reflecting the relevant provisions in CRD3 and the FS Act as they may impact investment managers, is set out below.

    2. Executive Summary

    2.1 Scope: The Relevant Firms within the extended scope of the revised Remuneration Code are Firms that are (1) subject to MiFID; and (2) not CAD exempt.4 This will include most hedge fund managers operating in the U.K., including U.K. affiliates of U.S. hedge funds.

    2.2 Code Staff: The revised Remuneration Code will apply to the remuneration awarded or paid to staff in certain categories (Code Staff), and the FSA expects it to apply both with respect to employees and to most partners with limited liability, including members of English limited liability partnerships (LLPs).

    2.3 Remuneration policy: Relevant Firms must “establish, implement and maintain remuneration policies, procedures and practices that are consistent with and promote sound and effective risk management.” Certain Relevant Firms may have to establish a remuneration committee. Bonus allocations and calculations of bonus pools should be risk-adjusted and aligned to long-term interests, objectives and financial performance of the Relevant Firm, and the longer term performance of Code Staff, giving due weight to nonfinancial performance criteria (e.g., risk management). Guaranteed bonuses will generally not be consistent with the revised Remuneration Code. The consultation paper does not discuss carried interest or co-investment structures.

    2.4 Proportion of bonus in securities: At least 50 percent of a bonus must be paid in shares or equivalent noncash instruments, or as hybrid capital which will be available to the Relevant Firm in distress situations to use as capital. This may be challenging for some Relevant Firms, depending on their legal structure, as well as raising difficult and potentially harsh commercial and tax issues. A Relevant Firm for whom compliance with this requirement may be unduly onerous may be able to explain to the FSA why it should not apply under the proportionality principle. Converting such instruments into cash at a later date, particularly if there is no market in the securities of the Relevant Firm, clearly will be a problem area.

    2.5 Deferral and performance adjustment: At least 40 percent of any Code Staff bonus must be deferred, vesting over a minimum three-year period. The deferred portion of a bonus exceeding £500,000 must be at least 60 percent. Unvested and deferred element of a bonus must be subject to performance adjustment following the award of the bonus. Again, these provisions raise certain commercial and tax issues. Relevant Firms for whom compliance with these requirements may be unduly onerous may be able to explain to the FSA why they should not apply under the proportionality principle.

    2.6 Balance of remuneration: The balance between fixed remuneration and a bonus needs to be such to allow for no bonus payments to be made, if necessary in certain circumstances, e.g., if a Relevant Firm’s financial performance does not permit or merit making bonus payments.

    2.7 De minimis: The rules relating to guaranteed bonuses, proportion of bonus paid in shares, deferral and performance adjustment of bonus will not generally be applicable to Code Staff whose total compensation package does not exceed £500,000 and whose bonus does not represent more than 33 percent of total remuneration.

    2.8 Timing: Relevant Firms should have the appropriate governance arrangements and procedures, set out in the revised Remuneration Code, in place by January 1, 2011. The FSA will not expect Relevant Firms to have the prescribed remuneration structures (such as minimum levels of deferral and performance adjustment where appropriate) in place until later in 2011. The FSA consultation process will terminate on October 8, 2010.

    3. Pre-Implementation Considerations

    3.1 Self-assessment: All Relevant Firms will be required to undertake a self-assessment exercise to determine which elements of the Remuneration Code apply to them, and to what extent. The Relevant Firms will be expected to explain to the FSA the reasoning for the results of the self-assessment exercise. The FSA may, if it disagrees with the results of a Relevant Firm’s self-assessment exercise, require it to comply with additional requirements in the revised Remuneration Code, or require more extensive procedures to be put in place to ensure compliance.

    3.2 Code Staff: The Remuneration Code applies to the remuneration awarded or paid to staff in the following categories:

    • persons performing a significant influence function, including directors, CEOs, CFOs, senior money-laundering officials or members in LLPs;

    • Senior Managers (as defined in the FSA’s collection of the principles and rules applicable to Firms (Handbook)) and risk takers; and

    • any staff whose total remuneration takes them to the same remuneration bracket as Senior Managers and risk takers, whose professional activities have a material impact on the firm’s risk profile.

    3.3 Relevant Firms are required to identify and keep a list of Code Staff before the time they expects to award variable remuneration (bonus), and to notify Code Staff who may potentially be subject to the Remuneration Code requirements.

    3.4 The Remuneration Code covers remuneration awarded to Code Staff on or after January 1, 2011; remuneration due on the basis of contracts concluded prior to January 1, 2011 but awarded or paid after January 1, 2011; and remuneration awarded, but not yet paid, before January 1, 2011 for services provided in 2010.

    3.5 Noncompliant contracts: If a Relevant Firm is under a contractual obligation requiring it to breach the Remuneration Code rules arising from a contract predating the consultation paper,5 the relevant contract must be amended or terminated as soon as possible6 to ensure compliance with the Remuneration Code. Until such amendment or termination is possible, Relevant Firms must have effective arrangements in place to supervise and manage the risks raised by the noncompliant contractual provision(s).

    3.6 Tax implications: The FSA has acknowledged that there are some difficulties in applying the Remuneration Code, inter alia, to members of LLPs receiving profit shares, which is likely to affect a number of Relevant Firms, including U.K. hedge fund managers which often are structured as LLPs. It is, however, expected that the FSA will apply the revised Remuneration Code rules to the profit shares of members of LLPs. This in turn raises difficult issues regarding the tax treatment of profit allocations from LLPs, and how the U.K. revenue authorities and the FSA will collaborate to ensure fair taxation corresponding to the correct allocation of profits as permitted or required by the revised Remuneration Code, as well as the treatment of any securities granted in order to help comply with the code. For example, discussions are ongoing which relate to the issue of how to mitigate the harshness of taxing a member of an LLP on an allocation, within a tax year, of profits which are subject to a deferral or a clawback; and similarly, how to prevent a taxpayer from being net cash negative in any tax year in which securities are required (under the Code) to be issued in lieu of cash bonus.

    4. Key Provisions Applicable to All Relevant Firms

    4.1 All Relevant Firms are required to comply with certain requirements in the revised Remuneration Code, including the following:7

    (i) Remuneration policy: To “establish, implement and maintain remuneration policies, procedures and practices that are consistent with and promote sound and effective risk management.” The remuneration policy must be documented and include measures to avoid conflicts of interest. In addition, the remuneration policy must be aligned with the Relevant Firm’s business strategy, objectives, values and long-term interests and must not encourage risk-taking at a level which exceeds the level of risk the Relevant Firm is able to tolerate. The governing body of a Relevant Firm must adopt and periodically review the remuneration policy, and be responsible for its implementation. 

    (ii) Code Staff: To maintain a current list of Code Staff, and to ensure Code Staff understand the implications of their remuneration being subject to the Remuneration Code, including that an agreement to pay remuneration outside of Code requirements may be rendered void, and associated payments recovered by the Relevant Firm. 

    (iii) Profit-based allocations: To ensure that the aggregate amount of bonuses paid to Code Staff does not limit the Relevant Firm’s ability to strengthen its capital base. Bonus pool calculations should be principally based on profits (and not on turnover or revenue), and the quantum of total bonuses generally should be considerably reduced if the Relevant Firm’s financial performance is subdued or negative.

    (iv) Remuneration structures: To balance the ratio between fixed remuneration and bonus appropriately so as to ensure a fully flexible policy on bonus payments, including a realistic possibility of making no bonus payments. 

    (v) No avoidance: To ensure bonuses are not paid through vehicles or methods that facilitate the avoidance of the Remuneration Code.

    5. Key Provisions Applicable on a “Comply or Explain” Basis

    5.1 With respect to certain requirements in the revised Remuneration Code, as indicated by the FSA, Relevant Firms are required to comply or to justify non-compliance to the FSA under the proportionality principle.8 Key provisions to which this approach may be applied are set out below:

    (i) Guaranteed bonuses/retention awards: No guaranteed bonus payments to Code Staff are permitted, other than to new employees in exceptional circumstances for the first year of service only and subject to performance adjustment. Retention bonuses are only permitted for key staff in context of a major restructuring. 

    (ii) Payment of proportion of bonus in shares/restriction on cash element: At least 50 percent9 of any bonus must be paid in shares, share-linked instruments or other share-equivalent instruments or hybrid capital.10 The FSA recognises that, for those Relevant Firms that are unable to issue shares (e.g., mutual building societies or LLPs), the requirement is not easily applied. At this stage there has not been a definitive discussion as to suitable alternatives to shares and share-linked instruments, but the FSA will expect the instruments used to meet this requirement to typically form a component of Tier 1 capital and therefore to meet the FSA’s capital requirements. Given the challenges involved in complying with this requirement, Relevant Firms may be able to justify not complying with this requirement by January 1, 2011, provided they take reasonable steps to comply as soon as reasonably possible and in any event by July 1, 2011. 

    (iii) Deferral of bonus: Firms must ensure that at least 40 percent11 of the bonus is deferred for a period of at least three years.12 A deferred bonus must vest no faster than on a prorata basis, with the first vesting no sooner than one year after the award.

    (iv) Performance adjustment: A mechanism13 must be in place to adjust bonuses post-award in case of:

    (1) evidence of misbehaviour or material error; 

    (2) material downturn in the financial performance of the Relevant Firm or relevant business unit; and 

    (3) occurrence of a material failure of risk management in the Relevant Firm or relevant business unit.

    5.2 De minimis exemption: The provisions described in paragraph 5.1 will not apply to Code Staff whose bonus represents no more than 33 percent of total remuneration and whose total remuneration does not exceed £500,000.

    6. Proportionally Applicable Key Provisions

    6.1 In addition to the provisions discussed in paragraphs 4 and 5, certain other requirements in the revised Remuneration Code may be applicable to Relevant Firms, depending on the nature, scale, scope and complexity of their operations.14 These include, inter alia:

    6.2 Annual review of the remuneration policy: The remuneration policy and its implementation must be reviewed at least once a year by an independent internal function (e.g., legal/ compliance).

    6.3 Independence of control functions: Control functions15 must be independent of the business in terms of the roles, authority and remuneration.

    6.4 Risk adjustment of bonus pool: The calculations for the bonus pool must take into consideration future risks.16

    6.5 Performance criteria: Performance criteria for determining Code Staff bonuses must be a combination of financial and nonfinancial performance criteria and the determination should give due weight to nonfinancial performance relating to risk management. Assessment of performance should be set in a multi-year framework to ensure assessment is based on longer term performance of the Relevant Firm and Code Staff. Code Staff should be aware of the criteria and that nonfinancial performance criteria may override financial performance in case of poor risk management.

    7. FSA’s Enforcement Powers

    7.1 The FSA has express powers under the FS Act to prohibit a Relevant Firm from remunerating its Code Staff in a specified way, to render void any provision of an agreement that contravenes such prohibition17 and to provide for the recovery of payments made, or property transferred, in pursuance of a void provision.

    7.2 The FSA envisages using the powers set out in paragraph 6.1 only in relation to Code Staff and only with respect to deferral arrangements and guaranteed bonuses.

    7.3 Where the voiding powers apply in respect of a particular contract (or a particular provision in a contract), the Relevant Firm which has made a payment or transferred property in breach of the revised Remuneration Code will be obliged to recover such payments or property from the recipient.

    8. Alternative Investment Fund Managers Directive (AIFMD)

    It is expected that the AIFMD will contain provisions regarding remuneration practices. It is uncertain at this time whether AIFMD provisions will materially extend or alter the requirements in the revised Remuneration Code for Relevant Firms to whom AIFMD would apply, although this is generally considered unlikely. It is possible that certain Firms which are not within the scope of the Remuneration Code may become so if within the scope of AIFMD.

    9. Equivalent Regulation

    Certain jurisdictions outside the EU may have imposed rules relating to remuneration of key personnel which may be equivalent to the rules contained in the revised Remuneration Code (Non-EU Remuneration Rules). Relevant Firms which are affiliates of non-EU entities operating in the U.K. may have in place internal policies and procedures to ensure compliance with the Non-EU Remuneration Rules they feel are equivalent to the requirements set out in the revised Remuneration Code. Such Relevant Firms may contact the FSA to confirm whether the FSA concurs that such policies and procedures are sufficient to discharge the obligations under the revised Remuneration Code.

    10. Further Developments

    It is possible that the rules and requirements contained in the FSA’s consultation paper on the revised Remuneration Code may change after the end of the consultation period on October 8, 2010. Industry bodies and associations, including the Alternative Investment Management Association, are in the process of preparing responses to the consultation and will engage in lobbying the FSA and the Committee of European Banking Supervisors, as appropriate. The FSA’s proposals for revisions to the Remuneration Code pose significant commercial, legal and tax issues for U.K.-based investment managers and will need to be thoroughly considered before implementation.



    1 http://www.fsa.gov.uk/pubs/cp/cp10&under;19.pdf.

    2 Capital Requirements Directive amending Directives 2006/48/EC and 2006/49/EC.

    3 The Committee of European Banking Supervisors will issue further guidance later in 2010 on the interpretation of the CRD3’s proportionality provisions. The FSA’s views on proportionality set out in the consultation paper are therefore subject to confirmation following such advice.

    4 Broadly, Firms whose only business is giving investment advice and/ or receiving and transmitting client orders are exempt from the requirements of the EU’s Capital Adequacy Directive on regulatory capital (CAD)). Firms who, in addition to giving investment advice and/ or receiving and transmitting client orders, also deal in securities (as agent or principal) will not be “CAD exempt.”

    5 The consultation paper is dated July 29, 2010.

    6 Relevant Firms will be expected to procure the requisite contractual amendments or terminations without delay and may be subject to FSA scrutiny in this respect.

    7 As set out in Table 1 of Annex 5 of the FSA’s Consultation Paper 10/19 of July 29, 2010.

    8 As set out in Table 3 of Annex 5 of the FSA’s Consultation Paper 10/19 of July 29, 2010.

    9 Depending on final interpretation, this restriction may result in the permissible cash element being as low as 30 percent of aggregate variable remuneration. The European Parliament has confirmed that the 50 percent restriction is intended to apply both the immediately payable and the deferred portions of the bonus, whereas the FSA have taken the approach that the 50 percent restriction is applicable to the aggregate quantum awarded overall.

    10 Noncash instruments of the Relevant Firm, and, where appropriate, other long-dated financial instruments that adequately reflect credit quality, subject to the legal structure of the Relevant Firm.

    11 Increased to at least 60 percent when total variable remuneration for the year is in excess of £500,000.

    12 Depending on the nature, scale, scope and complexity of the Relevant Firm’s operations.

    13 These may include clawback of variable remuneration already paid or vested as well as an adjustment of the variable remuneration before it has vested/ been paid, in each case as permitted by employment law.

    14 As set out in Table 2 of Annex 5 of the FSA’s Consultation Paper 10/19 of July 29, 2010.

    15 Including risk management and legal/compliance.

    16 Including revaluations, future termination of contracts, etc.

    17 The voiding powers of the FSA do not have retrospective application.