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
2
How do the rules fit together?
CRD IV
• The CRD IV is a comprehensive review
of the EU's prudential requirements
AIFMD
• Applies to authorised AIFMs
• 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
3
AIFMD
• Regulates the remuneration policies
and practices for the AIFM and their
‘identified staff’
MiFID
MiFID Guidelines
CRD
UCITS
V
• 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’
AIFMD
4
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
5
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
6
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
7
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
8
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
10
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
11
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
12
• 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
UCITS V
13
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
14
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
15
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 internal review
16
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
• 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
18
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
21
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
22
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
23
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
24
MiFID Guidelines
25
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
26
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
27
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
29
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
UCITS V
No variable cap. At least 40% (in
some cases 60%) deferred over a
period of 3-5 years
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 seen as a
matter of good practice – all nonexecs and majority independents
Remuneration Committee all nonexecs – include employee
representatives
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
Annual disclosure requirement. Firms
to disclosure number or individuals
paid over EUR 1m broken down in
pay bands of EUR 500,000
Annual disclosure requirement in
annual report
Annual disclosure requirement in
annual report. Annual internal
independent review of policy
Scope issues for MiFID investment
firms key
Proportionality accepted and ESMA
guidelines published
Implementation 1 January 2014.
FCA and PRA main consultations
expected this summer
EBA consultation in progress on draft
RTS on identified staff - Closes 21
August 2013
30
AIFMD
Broader category of identified staff
other than AIFMD and the Code
Push to align with AIFMD
Broader category of staff than under
the Code likely to catch more fund
managers
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
31
Going forward
• Further alignment UCITS VI and AIFMD II bonus caps
• General corporate governance and political pressure
32