Financial Services seminar:Managing regulatory change for the buy-side

Breakout session: Remuneration

Kennedy Masterton-Smith - Associate

Norton Rose Fulbright LLP

30 July 2013

Setting the scene• The global mandate

– Wide public perception that the financial crisis was, at least partly, the result of bankers and others in financial services receiving large bonuses and incentivising them to take large and ill thought out risks

– G20 2009 Pittsburgh summit: “excessive compensation in the financial sector has both reflected and encouraged excessive risk taking. Reforming compensation practices is an essential part of our effort to increase financial stability.”

• The starting point– General remuneration guidance: CRD III and CEBS guidelines which FSA

implemented through the Remuneration Code (the Code)– EU keen to introduce consistent requirements on remuneration – CRD IV - Tackle excessive risk taking– AIFMD and UCITS V rationale - Key concept is investor protection– ESMA Guidelines on remuneration policies and practices under MiFID

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How do the rules fit together?

CRD IV

• The CRD IV is a comprehensive review of the EU's prudential requirements

• Same objectives as CRD III - view that CRD III was implemented incorrectly

• Applies to MiFID investment firms and credit institutions

• Includes a bonus cap

• Applies to AIFMs when undertaking ancillary services set out in Article 6(4) of AIFMD

UCITS V

• Focuses on undertakings for collective investment in transferable securities

• Applies to UCITS management companies and UCITS investment companies that do not designate a management company

• Detailed ESMA guidance expected Q4 2013 on application of rules

AIFMD

• Applies to authorised AIFMs

• Regulates the remuneration policies and practices for the AIFM and their ‘identified staff’

MiFID Guidelines

• Focused on ensuring investor protection when investment services are provided under MiFID

• Applies to MiFID investment firms and those AIFMs and UCITS management companies when they are providing investment services of individual portfolio management or non-core services

• Bottom up approach with regard to ‘relevant persons’

UCITS V

AIFMD

CRD

MiFID

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AIFMD

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Nuts and bolts: AIFMD• Where to find the key provisions

– Article 13 AIFMD– Annex II AIFMD– ESMA guidelines on sound remuneration policies under the AIFMD

• The general principles– AIFM to have remuneration policies and practices consistent with and promote

sound and effective risk management – Remuneration policy to be in line with the business strategy, objectives, values

and interests of the AIFM and the AIFs it manages or the investors of such AIFs

• What remuneration?– All forms of payments or benefits paid by the AIFM– Any amount paid by the AIF itself including carried interest– Any transfer of shares or units in the AIF

– When in exchange for professional services rendered by the AIFM’s Identified Staff

– Excluding reimbursement of costs and expenses made directly by the AIF

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Recap on key requirements (1)• Fixed and variable remuneration to be appropriately balanced

– No variable remuneration cap (contrast with CRD IV)

• At least 50% of variable remuneration should consist of units or shares of the AIF– Unless the management of the AIFs account for less than 50% of the total

portfolio managed by the AIFM; shares to be subject to retention provisions

• Deferral– At least 40% variable remuneration to be deferred over 3-5 years (unless AIF

life cycle is shorter)– Where variable remuneration exceptionally high at least 60% to be deferred

• Contraction– Total variable remuneration to be considerably contracted where there is

subdued or negative financial performance of the AIFM or the AIF

• Ex-post risk adjustment – performance adjustment

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Recap on key requirements (2)• Guaranteed variable remuneration

– Exception rather than the norm– Limited to new hires and first year of employment

• Performance criteria– Based on individual performance, performance of the business unit or AIF and

the overall results of the AIFM– Based on multi-year framework that reflects the life cycle of the AIF

• Remuneration committee– AIFMs significant in terms of size or the size of AIFs managed, their internal

organisation and the nature, the scope and complexity of activities– All non-executive members of the AIFM and majority of members must be

independent

• Disclosure– AIFMs seeking authorisation will need to disclose details of remuneration policy– Underlying requirement that fixed and variable remuneration and the number of

beneficiaries be disclosed in AIF’s annual report

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Who is in: Identified Staff• Non-executive and executive directors of the AIFM

• Senior management

• Staff responsible for heading the portfolio management, administration, marketing and human resources

• Other risk takers such as staff whose activities can exert a material influence on the risk profile of the AIFM or the AIF

– Criteria that AIFMs can use include an assessment of staff members or a group, whose activities could potentially have a significant impact on the AIFM’s results and/or balance sheet and/or on the performance of the AIFs managed

• Control functions

• Other employees

– Remuneration takes them into same bracket as senior management or risk takers

– Professional activities have a material impact on the AIFM or AIFs managed: Includes staff of entities to which portfolio management or risk management have been delegated by the AIFM

• Rules on governance apply to AIFM as a whole

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Restrictions on avoidance• AIFMs should ensure that variable remuneration is not paid

through vehicles or using methods to avoid the rules on remuneration

• The governing body of the AIFM has the primary responsibility for ensuring that the ultimate goal of having sound and prudent remuneration policies and structures is not improperly circumvented

• Delegation covered expressly• Situations that pose greater risk

– Using other forms of benefit (including non-monetary benefits)– Outsourcing to firms outside scope– Use of tied agents– Transactions with third parties where risk takers have a material interest– Using structures that involve the payment of dividends or performance fees

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Delegation

• Delegate portfolio management or risk management activities – new requirement regarding remuneration– AIFM must ensure that entities which have been delegated to are subject to

“regulatory requirements on remuneration that are equally as effective as those applicable to the AIFM”OR

– Contractual arrangements are put in place with the entities to ensure that there is no circumvention of the remuneration rules

• No guidance on whether there is a de-minimis in relation to the level of delegation that is captured

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Proportionality

• Principle that remuneration provisions are applied in a way and to an extent that is appropriate to their size, internal organisation and the nature, scope and complexity of their activities

• Some requirements may be dis-applied if it is reconcilable with the risk profile, risk appetite and the strategy of the AIFM and AIF

• May dis-apply rules in relation to – Retention– Deferral – Variable remuneration in instruments – Ex post risk for variable remuneration

• No express proportionality levels – size only one aspect of the analysis

• Firms need a robust audit trail should they dis-apply a requirement

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Timing and UK approach• EU AIFMs start complying with

AIFMD from 22 July 2013 but note transitional provision providing a one year grace period for remuneration provisions

• But staff with performance and salary years ending 31 December 2013 will need to be assessed to ensure relevant requirements are met on 22 July 2014

• Non-EU AIFMs must adhere to remuneration requirements should they wish to benefit from the marketing passport in 2016

• In 2019 national private placement regimes may end and non-EU AIFMs may be required to become an authorised AIFM and will then be subject to the remuneration requirements

• FCA Policy Statement on AIFMD implementation 28 June 2013

• Consultation on certain remuneration aspects deferred until later in 2013: (i) changes to FCA Handbook to integrate ESMA guidance (ii) guidance on the AIFMD proportionality framework

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UCITS V

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Nuts and bolts: UCITS V• Where have we got to?

– Commission legislative proposal published in July 2012 – Co-decision procedure still on-going: Latest Council compromise proposal

dated 11 December 2012 but European Parliament adopted amended version of an ECON report on 3 July 2013– Crucially the proposed bonus cap was removed– Express restriction concerning where the fund is not distributed exclusively to

professional advisers also removed– FCA to publish consultation on UCITS V (depending on when Level 1 text is

agreed)– ESMA to publish technical standards, advice and guidelines in Q4 to include

guidance on partial neutralisation– Originally envisaged that UCITS V would apply from end of 2014 but now end

of 2015 looks more likely

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Nuts and bolts: UCITS V• Key concepts

– Implement remuneration policies that are consistent with and promote sound and effective risk management of the UCITS fund they manage

– Idea is to reduce incentive to increase the level of risk in the portfolio in order to increase returns

– Disclose the amount of remuneration in each financial year with appropriate detail in the UCITS fund’s annual report – encourage accountability

– Remuneration requirements to be consistent with the equivalent provisions of the AIFMD

• What remuneration?– Remuneration of any type paid by the management company and to any

transfer of units or shares of the UCITS in respect of Identified Staff– Remuneration paid from the fund to the management company

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Recap on key requirements (1)• Fixed and variable remuneration to be appropriately balanced

– Currently no proposal for a bonus cap (still subject to change)

• Non-cash remuneration– At least 50% is payable in cash and 50% in units/shares in the UCITS that is

managed, unless UCITS is half of the total portfolio of funds under management where the 50% minimum does not apply

• Deferral– At least 25% variable remuneration to be deferred over 3-5 years (unless the

UCITS life cycle is shorter)– Where variable remuneration is very high at least 60% shall be deferred but like

AIFMD remuneration there is no explicit reference to what the upper threshold would be

• Guaranteed variable remuneration, contraction, performance criteria – Similar to AIFMD proposals – specific investor protection concern

• Independent review– Remuneration policy must be subject to at least annual central and independent

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Recap on key requirements (2)• Disclosure

– The annual report shall set out– The total remuneration for the financial year, split into fixed and variable

remuneration and the number of beneficiaries and, where relevant, the carried interest paid by the UCITS

– The aggregate amount of remuneration broken down by categories of staff of the financial group, the management company and the investment company

• Proportionality– UCITS management companies to apply the requirements according to their

size and complexity of activities and the size of the UCITS they manage– No guidance on proportionality so far– ESMA to work with the EBA and issue guidelines on sound remuneration

policies in the asset management sector (Q4 2013)

• Remuneration committee– Includes employee representatives

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Who is in: Identified staff

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• Includes those in a UCITS management company and UCITS investment company who are:– Fund managers– Senior management– Persons who take real investment decisions that affect the risk position of the

fund– Persons with the power to exercise influence on such staff including investment

policy advisers and analysts– Risk takers– Control functions– Staff receiving total remuneration that takes them into the same bracket as

senior management and decision takers and whose professional activities have a material impact on the risk profiles of the management company or the UCITS they manage

• Makes specific reference that the above applies to temporary or contractual members of staff at fund or sub-fund level

CRD IV

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Nuts and bolts: CRD IV• CRD IV published in Official Journal on 27 June 2013• Provisions come into effect on 1 January 2014 – will effect

remuneration paid in respect of services provided during 2014• No guidance on transitional provisions• FCA and PRA consultation paper on UK implementation due end

of July/beginning of August • Focus on prudential regulation• Same objectives as CRD III – address the concern that CRD III

failed because was not implemented correctly

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Scope issues – Which firms are in? (1)• Application of CRD IV

– Credit institutions and investment firms undertaking MiFID business

• Carve out in the CRR definition of ‘investment firm’ • Firms are excluded from the scope of the CRR if

– Only authorised to carry on one or more of these MiFID activities – reception and transmission of orders, execution of orders, portfolio management and investment advice AND

– Not allowed to and do not safeguard and administer assets AND– Not hold client assets

• National regulators must ensure that when establishing policies for code staff under CRD IV, firms must comply with the principles in a way that is appropriate to their size, internal organisation and the nature, scope and complexity of their activities

• Previous carve-out under CRD III – FSA did not take this approach in relation to the application of the Code

• Pending FCA consultation paper on application– Question re proportionality

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Nuts and bolts: CRD IV (1)• Fixed and variable remuneration to be appropriately balanced

– A basic ratio of fixed and variable elements at 1:1 which can only increase to 1:2 with shareholder approval (with a quorum of 50% of shareholders, 66% of votes in favour would be required, and, if that quorum is not reached, 75% of votes in favour)

– Defined approval process– Bonus cap applies to staff or subsidiaries operating outside the EEA

• Use of long-term incentives– Maximum 25% of total bonus can consist of long term financial instruments,

discounted with reference to factors reflecting risk inherent in the instruments– Long term instruments shall be fully subject to clawback

• Disclosure– Existing rules in chapter 11 of BIPRU – CRR requires firms to disclose the number of individuals being remunerated €1

million or more per financial year, broken down into pay bands of €500,000

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Nuts and bolts: CRD IV (2)• Non-cash remuneration

– At least 50% of variable remuneration shall consist of a balance of shares or equivalent interests and where possible other instruments that can reflect the credit quality of the institution

• Deferral– At least 40% variable remuneration to be deferred over 3-5 years– Where variable remuneration is very high at least 60% shall be deferred - no

explicit reference to what the upper threshold would be

• Independent review– Remuneration policy must be subject to at least annual central and independent

internal review

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Who is in: Identified staff• Identified Staff

– Senior management and risk takers– Control functions – Employee receiving total remuneration that takes them into the same bracket as

senior management and risk takers, whose professional activities have a material impact on the risk profile

• EBA survey on implementation

• EBA consultation on draft technical standards

• Draft RTS provides that individuals must satisfy one or more of the internal, qualitative and/or quantitative criteria

• Captures a much larger group of individuals

– Specified roles– Employees with the ability to commit the firm to trading book or credit exposures– Overall pay – gross remuneration of more than €500,000– Highest paid 0.3%– Employees whose variable pay is both 75% of fixed remuneration and more than

€75,000– All employees whose gross total remuneration in either of the two preceding years

was equal or more than the lowest remuneration received by a person undertaking a specified role

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MiFID Guidelines

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MiFID Guidelines• MiFID guidelines published by ESMA in June 2013• General provisions similar to those in other pieces of legislation –

with a different focus and different targeted staff• Applies to MiFID investment firms and AIFMs and UCITS

management companies when they are providing the investment services of individual portfolio management or non-core services

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Key requirements• Align policies with effective conflicts of interest and conduct of

business risk management • Remuneration policies should be set with clients’ best interests in

mind • Firms should use qualitative assessment criteria and avoid

quantitative criteria • Outsourcing • Proportionality in MiFID applies to these guidelines

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Who is in – Relevant staff• Relevant staff

– Those persons who can have a material impact on the service provided and/or corporate behaviour of the firm and include customer-facing staff and sales force staff

– May also include other staff indirectly involved in the provision of investment or ancillary services whose remuneration may create inappropriate incentives to act against the best interests of the client– Line managers– Financial analysts– Persons involved in complaints handling, claims processing and client

retention– Persons involved in product design and development– Tied agents

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The Jigsaw

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Drawing the different streams together

CRD IV

1:1 cap on variable remuneration – shareholders can extend cap to 1:2. At least 40% (in some cases 60%) deferred over a period of 3-5 years

Implementation 1 January 2014. FCA and PRA main consultations expected this summer

Annual disclosure requirement. Firms to disclosure number or individuals paid over EUR 1m broken down in pay bands of EUR 500,000

EBA consultation in progress on draft RTS on identified staff - Closes 21 August 2013

Scope issues for MiFID investment firms key

AIFMD

No variable cap. At least 40% (in some cases 60%) deferred over a period of 3-5 years

Remuneration Committee seen as a matter of good practice – all non-execs and majority independents

Broader category of staff than under the Code likely to catch more fund managers

Annual disclosure requirement in annual report

UCITS V

Currently no proposal for a variable remuneration cap. At least 25% (in some cases 60%) deferred over a period of 3-5 years

Remuneration Committee all non-execs – include employee representatives

Push to align with AIFMD

Annual disclosure requirement in annual report. Annual internal independent review of policy

Implementation 22 July 2013 but note one year transition period. FCA deferred consultation

Still in co-decision procedure. Implementation end of 2015 now looks likely

Proportionality accepted and ESMA guidelines published

Broader category of identified staff other than AIFMD and the Code

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Group context• No carve-out for AIFMs who are subsidiaries of a credit institution• Where an AIFMD is providing ancillary services will be subject to

– CRD III – CRD IV– MiFID Guidelines

• Where a person is considered to be Identified Staff under CRD and AIFMD the individual rules should apply to their remuneration on a pro rata basis

• Possible to extend the same analysis to UCITS management companies

• Group policies may need to be applied differently for each entity or at the highest level

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Going forward• Further alignment UCITS VI and AIFMD II bonus caps• General corporate governance and political pressure

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