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Remuneration in financial services - new rules on deferral and clawback

29 June 2015

New rules on deferral and clawback of variable remuneration are set out in a joint policy statement issued by the Prudential Regulation Authority (“PRA”) and the Financial Conduct Authority (“FCA”). They will apply to variable remuneration awarded for performance periods beginning on or after 1 January 2016.

New rules on deferral and clawback of variable remuneration are set out in a joint policy statement issued by the Prudential Regulation Authority (“PRA”) and the Financial Conduct Authority (“FCA”). They will apply to variable remuneration awarded for performance periods beginning on or after 1 January 2016.

The rules are intended to discourage excessive risk-taking and short-termism and encourage more effective risk management. They represent the outcome of last summer’s joint PRA/FCA consultation in response to the recommendations made by the Parliamentary Commission on Banking Standards (“PCBS”) in its report Changing banking for good.

The PRA has also issued a supervisory statement on remuneration, setting out its expectations on how firms should comply with the relevant section of the PRA rulebook, and the FCA has issued guidance on the adjustment of variable pay to take account of ex-post risks or adverse performance.

Background

The financial services industry has been the focus of wide-ranging reform over the past few years as a result of both government and European initiatives. In January 2014, a package of reforms implementing the fourth set of amendments to the EU Capital Requirements Directive (“CRD”) took effect.

CRD includes the infamous bonus cap, which requires that the amount of bonuses and other variable remuneration awarded for performance by material risk takers (“MRTs”) on or after 1 January 2014 should not exceed 100% of fixed remuneration (or 200% if shareholders approve).

MRTs include individuals identified by reference to:

  • qualitative criteria - relating to the role and decision-making power of the staff member (e.g. a member of the firm's management body or senior management); and/or
  • internal criteria - developed by each firm to identify MRTs based on the firm’s specific risk profile; and/or
  • quantitative criteria - based on the individual's remuneration, unless it can be demonstrated that he or she is not in a fact a MRT.

Until recently, it was considered that compliance with CRD was subject to the principle of proportionality. This allows a firm to comply with CRD according to its size and internal organisation and the nature, scale and complexity of its activities. In implementing this principle, the PRA and FCA categorise firms into three levels with differing minimum expectations for each level.

Deferral

Under the current rules, at least 40% of variable pay awarded to MRTs must be deferred over a period of at least three to five years. Where the award of variable pay is particularly high or where it is paid to an executive director of a proportionality level one firm, at least 60% must be deferred.

For performance periods beginning on or after 1 January 2016, PRA-regulated firms must defer variable pay as follows:

  • senior managers who are subject to the Senior Managers Regime (“SMR”) (i.e. individuals who have the greatest influence over the strategic direction of the business) – deferral for a minimum seven-year period with no vesting until three years after award and vesting no faster than on a pro-rata basis thereafter;
  • risk managers (excluding those covered by the SMR) - deferral for a minimum five-year period with vesting no faster than on a pro-rata basis. (This includes members of the management body, risk managers and their direct reports, heads of material business units and their direct reports, heads of function and managers of MRTs);
  • all other material risk takers – deferral for a minimum three-year period with vesting no faster than on a pro-rata basis. (This includes individuals exposing the firm to credit risk or trading book/market risk, individuals approving the introduction of new products, individuals who are members of the local risk committee and MRTs identified solely under the quantitative criteria if subject to managerial oversight.)

The FCA will retain the three to five-year deferral period for all MRTs who are not senior managers under the SMR. Senior managers under the SMR will be subject to the same minimum seven-year deferral rule set out above.

Firms that are dual-regulated by both the PRA and FCA will be required to comply with the rules for PRA-regulated firms.

Clawback

For performance periods beginning on or after 1 January 2015, PRA-regulated firms in proportionality levels one and two have been required to apply clawback to variable pay awarded to MRTs in situations of misconduct or failures of risk management up to seven years from the date of award. You can read more about this here.

The FCA has confirmed that for variable remuneration in respect of performance periods beginning on or after 1 January 2016, it will also introduce a seven-year clawback rule for MRTs.

In addition, the clawback period will be extended to ten years for senior managers under the SMR where at the end of the seven-year period there are outstanding internal or regulatory investigations which could potentially lead to the application of clawback.

Possible future developments

Buy-outs

Guaranteed bonuses are generally prohibited under the present rules unless the bonus is exceptional and certain conditions are satisfied, but there is currently no need to demonstrate that a “buy-out” award is exceptional. This is an award to buy out rights that the staff member will forfeit on leaving his former employment (in contrast to an incentive sign-on bonus). The buy-out bonus should not, however, be more generous - either in terms of amount or vesting - than the awards the staff member will forfeit.

In its report, the PCBS objected to buy-outs on the basis that they had the effect of "wiping the slate clean" for individuals who change employment, since they are then no longer at risk of malus adjustments in respect of their former employment. The PRA and FCA have confirmed that they will explore further whether it will be possible to require buy outs to be held in a form that permits them to be subject to malus by the previous employer.

Proportionality

In March 2015, the European Banking Authority (“EBA”) issued a consultation paper on guidelines for sound remuneration policies, proposing that the principle of proportionality would effectively be removed. The EBA’s proposal is highly controversial and has been the subject of detailed comments as part of the consultation process. Interestingly, the PRA and FCA have simply reconfirmed in their statements and guidance that the proportionality principle applies.

General

Changes relating to the regulation of remuneration within the financial services sector continue apace and the new deferral and clawback rules go much further than the CRD’s existing requirements. If the principle of proportionality is also withdrawn, more firms will be subject to increasingly stringent requirements – not least the bonus cap.

The combination of these circumstances increases the likelihood that affected staff will push for higher fixed salaries. While the PRA and FCA have said that higher fixed salaries would be unwelcome, they seem almost inevitable.

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