On 26 February 2008, the FSA published a wide-ranging draft code of practice on employee remuneration policies (the "Code"). Please click here to view it.
As foreshadowed in the "Dear CEO" letter on remuneration, issued by the FSA in October 2008, the Code requires significant changes in the design of remuneration (including much greater bonus deferral and moving away from purely profit-based remuneration), and the formal involvement of FSA-regulated firms' regulatory function in setting and signing off remuneration. This will need to be carefully documented as the FSA may ask to inspect relevant documentation and for annual reports on remuneration policies to be drawn up. For many, the Dear CEO letter and the Code have required/will require sea-changes in the way that remuneration is operated, both in the way that staff are rewarded and in the internal supervisory environment.
While the FSA indicates it will start consulting on the draft during March, it is likely that the Code will be adopted broadly in the form in which it has been published. In practice, it will need to be followed as soon as possible because it is an indication of the standards the FSA will expect firms to meet (and demonstrate compliance with) when formally adopted.
The enclosed article sets out the key points of the Code and the likely difficulties in applying it in practice. It follows our Law-Now last week on the changes in summary form. We are planning to respond to the consultation process and so would be interested in your views. We are also planning a client seminar to discuss these issues further. The HR and regulatory functions will need to discuss remuneration much more frequently in future and operational guidance will need to be given.
The Code is also of interest for those interested in remuneration generally. Although designed for FSA-regulated firms, the development of remuneration principles in the Code may influence general remuneration practice in the UK and elsewhere.
The Code comprises a general over-arching principle, followed by specific principles with FSA commentary.
This Law-Now sets out these principles and relevant issues for compliance officers, HR professionals and board members to consider.
When reading this Law-Now, companies should be asking themselves whether they currently comply with each principle and, if not, what changes are needed within their organisation so that they can comply. Are the proposals too impractical and prescriptive or will they work in practice?
The general principle is that "Firms must ensure that their remuneration policies are consistent with effective risk management".
This will apply to all FSA-regulated firms (including UK subsidiaries and branches of foreign-based firms) and compliance with best practice and measurement of risk in this area will now contribute towards the FSA's assessment of a firm's risk. The FSA may ask firms for evidence of how they have approached this area, but our prediction is that many firms operating in what are perceived to be "high risk" areas, at least in the early years, should anticipate having to make disclosure. HR and risk management functions, therefore, need to start thinking now about how they will draw this evidence together and the systems for this.
The Code goes on to establish ten specific principles, in four loosely-related groups.
1. Boards and relevant remuneration committees should exercise independent judgement and demonstrate that their decisions are consistent with the firm's financial situation and future prospects.
Their members should have the skills and experience to reach an independent judgment on the suitability of the remuneration policies, including the implications for risk and risk management.
Going forward, non-executive directors will need to be involved in remuneration policy to a greater extent to ensure this independence.
Traders etc. should not normally be involved in taking decisions on key design features. This is likely to lead to a significant change in City practice, as managers will in many cases no longer determine bonus arrangements – these will (as is already the case for quoted companies) be determined at least at the macro level by the remuneration committee.
The extent to which the remuneration committee should determine individual arrangements below board or senior executive level is likely to be a subject of debate over the next few months. The requirement for relevant experience is very similar to the Smith Report's recommendation on audit committee representation for quoted companies and may lead to increased fees being payable for service on remuneration committees, eligible non-executives (ie those who are "dual-qualified" in both remuneration and risk) being at a premium. There may also be greater training requirements to ensure the relevant questions are asked and committee members are aware of the risks to look out for.
The FSA also says that remuneration committees should be given regular reports on how remuneration policies are impacting on risk and vice versa. This will need to become a standard agenda item, and the reporting and assessment procedures and timetable for these meetings will need to be considered.
The FSA says that it may ask for an annual statement to be made on how remuneration policies address the principles in the Code. Firms will presumably anticipate this and prepare a statement in any event. It is not clear whether this statement would be made public, although requests to the FSA under the Freedom of Information Act may indirectly result in disclosure. The FSA may ask for a meeting with the remuneration committee chairman to discuss the report, although this is only likely to be in cases where excessive risks have been detected or suffered.
Many companies may feel that an annual report is excessive, particularly if it could be made publicly available, thus giving away valuable information to competitors. A question that needs to be asked over the next few months is whether sufficient protection can be achieved without a formal annual review.
Although not all FSA-regulated firms need to have non-executive directors or remuneration committees, the FSA will clearly require appropriate analogous measures to be built into the approach such firms adopt – and it may be easier for them to have non-executive directors just to deal with these issues.
HR professionals may have additional concerns because publishing an annual report may indirectly enable more transparency and so support equal pay claims, which have been a long-standing City issue. Lack of transparency has been one of the key complaints about the lower pay of women in the City compared with their male peers and access to this information could provide very useful ammunition for these claims.
2. The procedures for setting compensation within the firm should be clear and documented, and they should include measures to avoid conflicts of interest.
Risk and compliance functions (in consultation with the firm's HR function as may be deemed appropriate) should have significant input into setting compensation for business areas.
The risk and compliance functions will need to understand the remuneration schemes available, the proposed targets and various models of outcomes – and cautious businesses will no doubt want to include them early in the process to avoid unanticipated issues arising later on.
They will need to provide input into the remuneration committee review (probably privately) and supervise documentation. As the year progresses, they will need to review risk and likely remuneration outcomes and then finally report on the outcomes – which will no doubt feed into future remuneration design.
As these measures will add to the compliance function's work, firms should expect calls for increased budgets and resources.
3. Compensation for staff in the risk and compliance functions should be determined independently of the business areas. They should have different performance metrics, with greater emphasis on the achievement of their own objectives.
This should not necessarily lead to risk and compliance staff having a lower bonus potential relative to salary than other parts of the business but suggests they should not participate in profit-linked bonus pools, for example.
The impact of this principle will vary according to an individual firm's past practice.
The remainder of the Code then sets out a number of principles on how remuneration should be designed.
B. Measure of performance for the calculation of bonuses
4. Assessments of financial performance to calculate bonus pools should be principally based on profits. The bonus pool calculation should include an adjustment for current and future risk, and take into account the cost of capital employed and liquidity required.
Variable remuneration should be based principally on profits, rather than on turnover or sales. Although this can be calculated at team, divisional or corporate level, appropriate risk-based measures must be included to adjust performance against risk taken. The FSA says that it will expect firms to be able to provide the FSA with information supporting calculations.
There are various ways of measuring risk and the determining of the correct underlying method is clearly important. Market practice may emerge here and the public discussion over the next few months is likely to shape future practice on what the relevant methods should be.
5. Firms should not assess performance solely on the results of the current financial year.
The Code suggests that this goal can be achieved in a number of ways.
For example, a longer performance cycle could be tested (eg an average profit level over two years). There are also other ways of assessing and rewarding employees' longer term achievements through good quality risk assessments, balanced appraisals, and deferral of remuneration (all of which are discussed further below).
6. Non-financial performance metrics, including adherence to effective risk management and compliance with regulations, should form a significant part of the performance assessment process.
The subjective quality of any individual risk decisions should alter any mathematically determined result: ie if a "bad" risk has been taken then, even if that risk has ultimately not caused any loss, the employee should see a reduction in his bonus.
The FSA says that it may consider requiring firms, in appropriate circumstances, to produce documentary evidence that they have applied this override where appropriate. Adherence to compliance principles is already a key part of appraisal systems, but firms will now have to show directly that it has some financial impact and may be under greater pressure in the short-term to demonstrate that they are applying this part of the Code with vigour. Firms will also have to comply with their employment law responsibilities, however, which may constitute a check on firms being over-zealous for punishing disciplinary breaches.
C. Measurement of performance for long-term incentive plans
7. The measurement of performance for long-term incentive plans, including those based on the performance of shares, should also be risk adjusted.
Most of the Code deals with annual bonus schemes, but the Code also states that long-term incentive schemes should not just have profit-based or relative share price performance targets, but also appropriate additional risk-based measures. The Code states that "the FSA will press for a wider review of the use of unadjusted share performance measures in longer term performance based remuneration schemes in the corporate sector".
Earnings per Share or Total Shareholder Return measures, which have been the mainstay of many plans for some time, may on their own no longer be sufficient for financial services firms. It will also be interesting to see if and how this development flows through into the practices of other quoted companies.
D. Composition of Remuneration
8. The fixed component of remuneration should be a sufficiently high proportion of total remuneration to allow the company to operate a fully flexible bonus policy.
The clear implication is that firms should contemplate being able to pay no bonus at all. This will be a key discussion point as salaries have remained low relative to overall remuneration and the regular payment of bonuses is currently absolutely central to City culture. The whole thrust of the Code is to move away from this. Changing the ratio between fixed and variable remuneration is intended to change risk taking cultures and make bonuses a more realistic reward for performance. Companies should however be aware of the risks in unilaterally withdrawing or amending bonus terms in light of recent case law, which has highlighted the limitations on employees' powers to do this. To achieve this, salaries will have to rise and bonuses opportunities may fall (and anecdotally this is already happening).
9. The major part of any bonus which is a significant proportion of the fixed component should be deferred, with a minimum vesting period.
The FSA says that not less than two-thirds of such bonuses should be deferred. Although some City firms have been deferring payment to an extent over the last few years, this level of deferral could be a significant change. The FSA does not mention how long the deferral should be, which is not surprising as FSA pronouncements are not normally this detailed. There will doubtless be debate on this as firms will not want to be uncompetitive. Market practice is likely to emerge here.
10. It is highly desirable that the deferred element of variable compensation should be linked to the future performance of the division or business unit as a whole.
This is what is referred to as "clawback" and gives rise to significant issues in practice. The FSA acknowledges that "clawback" arrangements are difficult to administer but says that some leading investment firms have introduced them and encourages them to be adopted more generally.
However, it is likely to be some time before any generally accepted way of operating clawback surfaces and in many cases it is easier to retain bonuses and only release the money/shares as and when future performance is known. Businesses will therefore need to think about what kind of clawback provisions they should operate and whether to include a general right to renegotiate reward structures even after payment has been made.
Guaranteed bonuses offered to new employees to compensate them for bonuses lost when changing employer would clearly erode the risk-control element the FSA wants to see included in paying bonuses in the future and so may become less common.
The FSA will consult with the industry on the Code. It is due to publish the next stage of its remuneration policy along with other announcements in March. The Code was published earlier than expected (and therefore in draft) as it needed to accompany the bank asset protection and insurance scheme, and so, particularly as there is consultation, thinking is unlikely to be finalised on remuneration until later. However, the Code is expected to be published in final form well before bonus pools are set in the autumn. Accordingly, companies would be well-advised to start discussing the proposals set out in the draft Code and consider how implementation could be effected as soon as possible, unless clearly inappropriate. In part, best practice and existing management information requirements will cover some ground already, but overall there are likely to be a substantial number of new processes which are going to need to be developed and documented in most firms over the coming year.
Feedback on the draft is to be encouraged. Although the flavour of the Code is probably already well-established, the detail is certainly up for consultation. The FSA is normally very keen to hear of impractical or uncompetitive measures, although in this case it is unlikely that any changes will be able to undermine the central objectives of the Code, given the political pressure to implement it.
International responses may also flavour the debate. In the US, limits have been placed on the salaries of executives of banks bailed out by the US government. In Europe, the European Commission is expected to complete its review on executive pay in the spring. The international responses may also have direct implications for banks with overseas interests or headquarters who may find that they have to operate under several regimes. International buy-in is needed because very few of the clearly targeted firms are actually headquartered in the UK, and the UK ultimately will not want to be an uncompetitive environment so that key financial players move away from the UK because their remuneration has been capped.
The Code does not at the moment adequately distinguish between the size of firm covered. The Code should clearly not apply to all firms to the same level – the principles are clearly designed for larger firms and to address the City bonus culture. It would seem impractical for the Code to apply equally to all firms. The principles-based approach should give appropriate flexibility, but some of the Code seems to be directed at banks, others only at quoted companies. Further precision is needed.
The Code also does not differentiate how it applies to employees at differing grades or seniority, although it is very much targeting the business end of remuneration issues. Policies like the Retail Distribution Review and Treating Customers Fairly are clearly intended to influence commissioned-based pay structures in the retail environment.
Going forward, incorporating these principles into future schemes is likely to make them more complex and companies will need carefully drafted schemes to make them effective.
Finally, how the City workforce will itself react needs to be considered. Even if the procedural requirements will be quickly accommodated in FSA-related processes, quite how much power HR, risk and compliance functions will have to implement these changes (which may involve altering contractual arrangements which employees may well resist) and, longer-term, how much real attention will be paid to the Code remain to be seen, particularly if and when the recruitment market picks up.
This article originally appeared in Law-Now, CMS Cameron McKenna's Free Online Information Service. To register for Law-Now, simply visit www.law-now.com and select the 'Register' link in the main navigation.