24 July 2013
Practice Group:
Investment
Management, Hedge
Funds and
Alternative
Investments
Addressing Remuneration Requirements
for the EU Fund Management Industry
By Sean Donovan-Smith, Philip Morgan and Luke Garfield
Increasing regulation of remuneration is being introduced across the European Union, including
the possibility of limits on the amounts of bonuses that may be paid by certain firms. Recent
European Union ("EU") legislation, including the Capital Requirements Directive and Regulation
(together, "CRD IV"), proposed amendments to the EU Directive for Undertakings in Collective
Investment in Transferable Securities ("UCITS") and provisions in the EU's Alternative
Investment Fund Managers Directive ("AIFMD") all impose remuneration requirements on
applicable institutions. The implications are significant and wide-ranging, and we summarise
these below, together with some of the practical implications for alternative investment fund
managers ("AIFMs") of alternative investment funds ("AIFs") and for UCITS management
companies.
The possibility of limitations on bonuses has been amongst the most controversial elements of the
various proposals. The industry received at least a partial reprieve on 3 July 2013, when the
European Parliament voted against caps on variable remuneration and against restrictions on
performance fees for UCITS funds that were proposed in the current UCITS amending directive
called "UCITS V". This is welcome news for UCITS management companies and also for
AIFMs, as there was a possibility that the UCITS V proposals would be extended to the AIFMD.
However, CRD IV does contain a similar restriction, and this will be implemented in the EU from
1 January 2014. As CRD IV’s impact on fund managers is expected to be mitigated by the
application of proportionality principles, and because the precise extent of this mitigation is
currently unknown, this article focuses on UCITS V and AIFMD, which are more directly tailored
to the fund management industry.
Below we consider the key remuneration requirements for both the AIFMD and UCITS V,
including scope, key definitions, remuneration structure, oversight and disclosure.
Scope
An EU manager of any AIF (or AIFs in aggregate) above the relevant threshold (EUR 100 million
in assets under management for open-ended funds, and EUR 500 million in assets under
management for five-year fixed-term, closed-ended funds), must comply with the remuneration
requirements set out at Article 13 and Annex II of the AIFMD, as implemented in EU Member
States. The AIFMD's provisions are supplemented by further regulations addressing exemptions,
general operating conditions, depositaries, leverage, transparency and supervision (the "Level 2
Regulations").
The UCITS V proposals will apply to all UCITS management companies.
Timing
The requirements of the AIFMD, subject to Member State implementation of it being on time and
to member State transitional relief outlined below, applied from 22 July 2013 across the EU and
the Level 2 Regulations became "directly applicable" throughout the EU, similarly subject to such
transitional relief, from 22 July 2013. Accordingly EU Member States have no discretion as to
how the Level 2 Regulations will apply in their jurisdictions. AIFMs in the UK managing funds
established prior to 22 July 2013 will have a one-year transitional period in the UK to comply with
Addressing Remuneration Requirements for the EU
Fund Management Industry
the AIFMD remuneration provisions and other transitional relief applies in other circumstances.
Other EU Member States may have a different approach to transitional relief and in certain
Member States certain remuneration provisions will be applicable even during the one year
transitional period.
The proposed amendments to the UCITS Directive were voted on by the European Parliament on
3 July 2013 in plenary session. The European Council must now agree a common position on the
proposed text, before the proposal returns to the European Parliament for a final reading. The
current text is therefore subject to further scrutiny and potential amendments. The implementation
of UCITS V at the Member State level is currently expected to be towards the end of 2015. In the
UK, the Financial Conduct Authority (“FCA”) is expected to release a Consultation paper on the
implementation of UCITS V and ESMA are currently expected to release technical advice and
guidelines at the end of 2013.
Key Definitions
New concepts and definitions are introduced in the remuneration requirements of the AIFMD and
UCITS V proposals. Below we consider the key concepts, including the definition of
remuneration and the categories of staff that are relevant to the remuneration provisions of the
AIFMD and the UCITS V proposals.
Remuneration
The definition of "remuneration" for the purposes of compliance with the AIFMD requirements is
very wide in scope. As additional guidance on the AIFMD remuneration provisions, the European
Securities and Markets Association ("ESMA") produced a set of guidelines on sound
remuneration policies in February 2013 ("AIFMD ESMA Guidelines"). The AIFMD ESMA
Guidelines state that remuneration consists of all forms of payment or benefits paid by the AIFM,
any amount paid by the AIF itself, including carried interest, and any transfer of units or shares of
the AIF, in exchange for professional services rendered by the AIFM "identified staff".
Remuneration is divided into fixed remuneration (payments or benefits without consideration of
any performance criteria) and variable remuneration (additional payments or benefits depending
on performance or, in certain cases, other contractual criteria). Given the breadth of the
application of the AIFMD requirements, AIFMs must ensure that variable remuneration is not
paid through vehicles (or other methods) that artificially evade the provisions of the AIFMD and
the AIFMD ESMA Guidelines.
For the purposes of the UCITS requirements, the remuneration policies and practices established
by the management company would cover fixed and variable components of salaries and
discretionary pension benefits. We await further guidance from ESMA to clarify the definition of
remuneration under the UCITS requirements, but we anticipate this definition will also be wide in
scope, and probably something very similar to the AIFMD concept.
Identified Staff
“Identified Staff” of the AIFM includes executive and non-executive members of the governing
body of the AIFM, senior management, staff that hold control functions, staff responsible for
heading the portfolio management, administration, marketing and human resources activities, and
other risk takers (broadly, staff who have authority to take material risks. Such staff could include,
for example, sales persons, individual traders and specific trading desks). “Identified staff” also
includes any other employees or persons whose total remuneration takes them into the same
remuneration bracket as senior managers and risk takers. If it can be demonstrated that any of the
above staff do not have a material impact on the AIFM's risk profile, or on an AIF it manages,
then such staff can be excluded.
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Addressing Remuneration Requirements for the EU
Fund Management Industry
Dividends or similar distributions received by partners (including members of LLPs) as owners of
an AIFM are not covered by the AIFMD remuneration provisions unless the material outcome of
such payment results in a circumvention of the AIFMD remuneration rules, regardless of the
intention. The AIFMD ESMA Guidelines establish further criteria that AIFMs must follow to
check whether they are capturing the correct staff members, which include an assessment of staff
members 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 they manage.
A UCITS management company’s remuneration policies and practices would need to be applied
to staff of the UCITS management company, whether temporary or contractual staff, whose
professional activities have a material impact on the risk profile of the management company or
the UCITS they manage, including fund managers, persons who take investment decisions that
affect the risk position of the fund, persons who have the power to exercise influence on staff
(including investment policy advisors and analysts), senior management, risk takers, personnel in
control functions, and any employee receiving total remuneration that falls within the
remuneration bracket of senior management and risk takers.
It is expected that the remuneration requirements for both the AIFMD and the amended UCITS
Directive will be aligned with the principles and guidance established by the Capital Requirements
Directive and the European Banking Authority (“EBA”). The EBA has recently published a
consultation paper in which it sets out criteria for the identification of categories of staff who have
a material impact on a firm’s risk profile. The EBA considers that individuals with total gross
remuneration of over EUR 500,000 or variable remuneration that exceeds 75% of fixed
remuneration will be deemed to be identified staff unless a firm can demonstrate that such staff do
not have a material impact on the firm’s risk profile.
Remuneration Structure
The AIFMD and UCITS V remuneration provisions set out detailed requirements that must be
implemented by relevant firms. Below we cover the detail of the remuneration policy, delegation
and proportionality under the AIFMD and UCITS V proposals.
Remuneration Policy
Article 13 and Annex II of the AIFMD establish a set of regulations regarding remuneration and a
basic requirement for AIFMs to have remuneration policies and practices for all identified staff.
The new Article 14a in the UCITS Directive introduces a similar requirement for the UCITS
management company to introduce remuneration policies and practices. These regulations require
AIFMs and UCITS management companies to design compensation to include bonus deferral and
claw-back provisions to prepare additional internal policies and procedures, to establish a
remuneration committee, and to provide certain disclosures to investors.
The AIFMD ESMA guidelines, published in February 2013, provide additional guidance on the
AIFMD remuneration policy provisions. From these guidelines, it is clear that AIFMs will have to
significantly change their policies and practices on pay. However, the precise impact of the
AIFMD ESMA Guidelines in particular EU Member States still has an element of uncertainty, as
national regulators are still considering whether they will require local compliance with all of
those guidelines. The amended UCITS Directive also states that ESMA shall issue guidelines on
remuneration policies for UCITS management companies, and such guidelines are currently
expected to be published in draft at the end of 2013.
Annex II of the AIFMD requires AIFMs to establish a remuneration policy that "is consistent with
and promotes sound and effective risk management and does not encourage risk taking which is
inconsistent with the risk profiles, rules or instruments of incorporation of AIFs they manage".
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Addressing Remuneration Requirements for the EU
Fund Management Industry
Annex II outlines the main principles that the AIFM should take into account in establishing a
remuneration policy:
• At least 50% of any variable remuneration shall consist of units or shares of the AIF concerned
or equivalent ownership interests, or share-linked instruments (unless the management of AIFs
accounts for less than 50% of the total portfolio managed by the AIFM, in which case the
minimum of 50% does not apply).
• A substantial portion (at least 40%) of the variable remuneration component must be deferred
for at least 3 to 5 years. At least 60% must be deferred if the variable remuneration component
is of a particularly high amount.
• AIFMs shall establish a remuneration committee.
• The AIFMs remuneration policy should be in line with the business strategy of the AIFM and
the AIFs it manages or the investors of such AIFs.
• Staff engaged in control functions (e.g., risk, compliance) are to be compensated in accordance
with the achievement of the objectives linked to their function, independent of the business
areas they control.
• Assessment of performance must be set in a multi-year framework appropriate to the life-cycle
of the AIFs managed by the AIFM.
• Guaranteed variable remuneration shall be “exceptional” and only for first year.
Article 14b of the amended UCITS Directive proposes the introduction of a similar requirement
on UCITS management companies to have a remuneration policy that promotes sound and
effective risk management. The proposed remuneration policy requirements for a UCITS
management company are broadly similar to that of an AIFM; at least 50% of any variable
remuneration would consist of units or shares of the UCITS concerned, or share-linked
instruments or the like; a remuneration committee would be required if applicable; the
remuneration policy should be in line with the business strategy of the management company, the
UCITS and the investors of the UCITS; guaranteed variable remuneration is exceptional also and
limited to the first year.
However, under UCITS V at least 25% (40% under the AIFMD) of the variable remuneration
component would be deferred for three to five years. However, 60% would be required to be
deferred in the case of larger bonuses, which is consistent with the AIFMD.
UCITS V also proposes a similar "malus" provision as the AIFMD. Where the financial
performance of the management company or of the UCITS is poor, variable remuneration would
be reduced. This would apply to current remuneration and reductions in amounts previously
earned, including through malus and clawback arrangements.
Delegation
Where an AIFM appoints a third party to provide risk management or portfolio management
services, the AIFMD ESMA Guidelines require an AIFM to ensure that the delegate is either
subject to remuneration requirements that are equivalent to the AIFMD or that contractual
arrangements are put in place to ensure that there is no circumvention of the remuneration
requirements under AIFMD. There is no specific requirement in the AIFMD to impose
remuneration requirements on sub-delegates, and it is hoped that the FCA's approach to
implementation will clarify the extent to which remuneration principles must be applied to subdelegates. It is also hoped that the UK FCA may give some relief to delegates based outside the
EU which may not find it easy to adopt internal processes to accommodate EU requirements.
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Addressing Remuneration Requirements for the EU
Fund Management Industry
Currently under UCITS V, it is unclear how such provisions would apply to delegates, such as
when investment management is delegated to a separate legal entity (including non-affiliated
entities). We anticipate that the delegate position may match that under AIFMD, but we await
confirmation on this from ESMA when its UCITS V remuneration guidance is released.
Proportionality
In line with remuneration requirements imposed by CRD IV, both the AIFMD and the UCITS
remuneration requirements are subject to the principle of "proportionality". The concept of
proportionality means that not all AIFMs and UCITS management companies will have to comply
in full with the remuneration requirements outlined at Annex II of the AIFMD and Article 14b of
the amended UCITS Directive.
The AIFMD ESMA Guidelines set out criteria for AIFMs to consider in the application of
proportionality, such as the AIFM’s size, its internal organisation, and the nature, scope and
complexity of its business and activities. The AIFMD ESMA Guidelines also state that, when
applying proportionality, AIFMs should focus on the combination of all the above criteria and any
other additional criteria that the AIFM considers to be relevant. It is the AIFM’s responsibility to
assess its own characteristics and to develop and implement remuneration policies and practices
that appropriately align the risks of its business and to provide adequate and effective incentives to
its staff. In the UK, further rules and guidance are expected from the FCA, perhaps in early
September or possibly sooner, to clarify how AIFMs should address proportionality.
Under UCITS V, the management company would have to comply with the remuneration
provisions to the extent that is appropriate to the management company's "size, internal
organisation and the nature, scope and complexity of their activities". We await further guidance
from ESMA and national regulatory authorities (including, in the UK, the FCA) on how
proportionality could be applied by UCITS management companies.
Oversight
All AIFMs and UCITS management companies that are significant in terms of their size of the
AIFs or UCITS they manage, and subject to other proportionality requirements, are required to
establish a remuneration committee ("RemCo"). In summary, the RemCo shall be responsible for
all decisions regarding remuneration. For AIFMs, based on the proportionality principle, the
ESMA Guidelines sets out two limited examples where a RemCo is not required:
a. where the value of the portfolios of AIFs that an AIFM manages does not exceed EUR 250
million; and
b. where an AIFM is a subsidiary of an EU credit institution which itself is obliged to set up a
RemCo and which performs its tasks and duties for the whole group.
For both a UCITS management company and an AIFM, the remuneration committee would be
chaired by a member of the management body who does not perform any executive functions in
the management company concerned, and the remuneration committee would include employee
representatives. UCITS V states that when preparing its decisions on remuneration the
remuneration committee shall take into account the long-term interest of stakeholders, investors
and the public interest.
Disclosure
The AIFMD remuneration requirements also set out certain information regarding remuneration
that must be disclosed to investors. There is no mandatory requirement for remuneration
disclosures to be made public. Article 22(e)-(f) require an AIFM to include in its annual report, or
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Addressing Remuneration Requirements for the EU
Fund Management Industry
a separate document that is provided to investors, the following information in respect of
remuneration:
a. the total amount of remuneration for the financial year, split into fixed and variable
remuneration, paid by the AIFM to its staff, and number of beneficiaries, and, where
relevant, carried interest paid by the AIF; and
b. the aggregate amount of remuneration broken down by senior management and members of
staff of the AIFM whose actions have a material impact on the risk profile of the AIF.
The amended UCITS Directive contains a similar requirement for the above information to be
disclosed in annual report of the UCITS and management company in relation to the total amount
of remuneration paid by the management company and by the investment company.
Under UCITS V, the management company would also disclose to investors information on the
remuneration policy, including a description of how the remuneration has been calculated. There
would also be comprehensive, accurate and timely disclosure of information about remuneration
practices to all "stakeholders". In addition, details of the remuneration policies and the basis on
which they have been decided shall be included in the Key Investor Information Document.
The Level 2 Regulations require an AIFM to disclose the total remuneration amount required
under Article 22(e) (at (a) above) in relation to (1) the entire staff of the AIFM (together with the
number of beneficiaries), (2) AIFM staff who are fully or partly involved in the activities of the
AIF (together with the number of beneficiaries), or (3) the proportion of the total remuneration of
the AIFM’s staff attributable to the AIF (together with the number of beneficiaries).
The AIFMD ESMA Guidelines impose a further requirement on AIFMs to disclose detailed
information regarding their remuneration policies and practices to investors, albeit one that will
apply "proportionately". This includes, but is not limited to, information concerning the decisionmaking process used for determining the remuneration policy, the composition and the mandate of
the remuneration committee, information on pay and performance and the main parameters and
rationale for any bonus scheme and other non-cash benefits.
Next steps
Firms that are within scope of the remuneration proposals and requirements above should take
steps now to ensure compliance with the remuneration proposals and requirements outlined above.
These new requirements are likely to require material changes to current market practice and to
the way that fund management staff are remunerated. Particularly, firms impacted by these
remuneration proposals and requirements are likely to need to prepare detailed remuneration
polices and also may need to implement additional governance arrangements.
Authors:
Sean Donovan-Smith
Philip Morgan
Luke Garfield
sean.donovan-smith@klgates.com
+44.(0).20.7360.8202
philip.morgan@klgates.com
+44.(0).20.7360.8123
luke.garfield@klgates.com
+44.(0).20.7360.8198
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Addressing Remuneration Requirements for the EU
Fund Management Industry
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