The remuneration code requirements will cover matters such as ratios for fixed and variable pay (no hard numerical cap is contemplated), remuneration governance and policies, remuneration committee oversight, disclosure and regulatory reporting. Whilst many of the remuneration rules’ concepts, requirements and principles will be familiar to investment firms, the biggest impact is likely to be felt by (a) adviser-arranger firms, which are not currently subject to the rules in the existing remuneration codes, and (b) those firms that are currently able to disapply the more onerous structural requirements.
Although the IFR/IFD will apply from 26 June 2021, the new remuneration rules will likely apply to the remuneration payments for the year commencing January 2022.
The application of the rules depends on how the investment firm is classified under the IFR/IFD.
Class 1 firms
These firms include certain proprietary trading firms, securities underwriters and placing agents. They will continue to be subject to the remuneration requirements in the CRR/CRD.
Class 2 firms
Class 2 investment firms will be subject to the remuneration rules under the IFR/IFD. This class of firms includes firms which are not large and systemic (so not in class 1) and which do not qualify for the small firm treatment of class 3. Managers of collateralised loan obligations who need a placing licence to qualify as a sponsor under the European Securitisation Regulation will likely fall within scope.
In general, the remuneration rules will apply to class 2 firms on an individual and consolidated basis. However, local regulators are able to provide a waiver for the regime to apply on an individual basis for, broadly, investment firms within group structures that are considered to be sufficiently simple.
Class 3 firms
Class 3 investment firms will continue to be subject to the remuneration rules in MiFID II, unless they are included in a group subject to consolidated supervision under the IFR/IFD, in which case they will be subject to the remuneration rules in the IFR/IFD.
Both class 2 firms and class 3 firms that are included in a group subject to consolidation under the CRR/CRD will remain subject to that regime.
Please see our previous alert for further details on investment firm classification.
The prescriptive pay rules will apply to senior management, risk takers, staff engaged in a control function and any employees receiving overall remuneration equal to senior management or risk takers, whose professional activities have a material impact on the firm’s risk profile or the assets that it manages.
The concept of a ‘risk taker’ is currently used in the CRR/CRD and, broadly, covers senior management, heads of business units, heads of various control functions, and staff who are able to commit their firm to transactions above a certain amount, as well as those staff who are identified by reference to their remuneration exceeding certain thresholds, such as €500,000 per year. As a result, ‘risk takers’ should be fairly familiar to many investment firms. Whilst the EBA will consult with the ESMA to develop regulatory technical standards that will specify the criteria to identify risk takers, the IFD requires the standards to take account of existing remuneration guidelines in this area in order to minimise divergence.
Governance and pay policies
Class 2 investment firms will be required to establish, implement and maintain remuneration policies, procedures and practices that are consistent with and promote sound and effective risk management, and are gender neutral (i.e., that are based on equal pay for men and women for equal work or work of equal value). The EBA, in consultation with the ESMA, will issue guidelines on gender neutral pay policies, and will issue a report on how firms have applied gender neutral remuneration policies two years following the issuance of those guidelines.
Furthermore, remuneration policies should not encourage risk-taking that exceeds the tolerated risk level set by the firm and, if relevant, should take into account the long-term effects of investment decisions taken. The rationale behind this is that if the pay policy is not aligned with effective risk management, employees may have incentives to act in ways that could undermine the firm’s approach to risk.
In formulating its remuneration policy, as well as complying with the pay rules, a firm will also need to take into account any applicable good practice guidelines on remuneration and corporate governance issued by industry bodies, as well as its statutory duties in relation to equal pay and non-discrimination.
Remuneration policies, procedures and practices are required to be comprehensive and proportionate to the size, internal organisation, nature, scale and complexity of the firm’s activities, so what one firm must do to comply may be quite different from another.
The remuneration rules place responsibility on firms’ management to ensure that remuneration policies are appropriate and that they are implemented in practice. The firm’s management body is required to adopt and periodically review the general principles of the firm’s remuneration policy, and is responsible for overseeing its implementation.
Further, a firm must carry out an independent internal review on at least an annual basis to ensure that the remuneration policy is being implemented correctly.
The remuneration policy itself must be in line with the business strategy, objectives, values and long-term interests of the firm.
A firm’s remuneration policy should make a clear distinction in the criteria applied to determine an individual’s basic fixed remuneration and their variable remuneration.
Variable remuneration (e.g., bonuses, discretionary pension benefits, early termination payments and buy-out payments) will be subject to all of the principles listed in article 32 of the IFD, including a restriction on guaranteed bonuses, save for new staff in their first year only and subject to the firm having a strong capital base. Whilst the IFD will not apply a bonus cap, investment firms will be required to set appropriate ratios between the fixed and variable component of total remuneration, with the ability to pay no variable remuneration in certain cases.
Many of the principles are similar to those set out in the CRR/CRD, such as those relating to malus and clawback, composition of the variable remuneration, and deferrals; these will therefore be familiar to many investment firms.
Notably, the principles on the composition of the variable remuneration element and deferral can be disapplied for investment firms (a) whose average on- and off-balance sheet assets over the preceding four year period are less than or equal to €100 million, and (b) where the maximum amount of variable remuneration for the individual in question (i) does not exceed €50,000 and (ii) does not account for more than a quarter of that individual’s total yearly remuneration. EU Member States are able to define the application of these thresholds in limited, prescribed circumstances.
This is a marked contrast to the BIPRU and IFPRU remuneration codes, which have a much wider scope to disapply these important provisions. Under these codes, firms are permitted to disapply the rules on guaranteed bonuses, composition of the variable remuneration element, deferral and performance adjustment, in circumstances where an individual’s variable remuneration is no more than 33 per cent of their total remuneration and their total remuneration is no more than £500,000.
Oversight – remuneration committees
The IFR/IFD require investment firms to establish a remuneration committee except that investment firms with on- and off-balance sheet assets of less than or equal to €100 million over the preceding four-year period will not be required to establish a remuneration committee. The remuneration committee can be established at the group rather than individual level. Where a class 2 investment firm has a remuneration committee, it will be required to establish a gender balanced remuneration committee formed of non-executive directors who are able to exercise competent and independent judgement.
Notably, the IFR/IFD sets a lower quantitative threshold to be met for a remuneration committee to be established. This contrasts with the position under the IFPRU and BIPRU remuneration codes, where only ‘significant’ firms must maintain a remuneration committee. For instance, under IFPRU, firms that have total annual assets exceeding £530 million would be classified as ‘significant’ and therefore required to establish a remuneration committee.
Decisions taken by the remuneration committee in relation to the firm’s remuneration policies and procedures will be required to take into account the public interest and the long-term interests of shareholders, investors and other stakeholders.
The remuneration committee will be directly responsible for overseeing the remuneration of senior managers in the risk management and compliance functions. Staff performing these and other controlled functions must be remunerated in accordance with the achievement of objectives linked to their function and should not take into account the performance of the business.
Disclosure and regulatory reporting
To assist the EBA and local regulators in benchmarking remuneration trends and practices, investment firms will be required to publicly disclose and report certain detailed information relating to the remuneration of senior management and risk takers, covering the gender pay gap, the ratio and composition of fixed-to-variable remuneration, deferrals and severance payments.
Further information should be reported on the number of individuals who receive remuneration equal to €1 million or more, as well as information on their job responsibilities, the business area they are involved in and the main elements of their salary, bonus, long-term award and pension contribution.
Although the IFR/IFD will come into force after the UK leaves the European Union on 31 December 2020 (i.e., the end of the proposed transitional period, with no extension), HM Treasury intends to take powers to enable the introduction of an updated prudential regime for investment firms in the UK. Public consultations are expected in Q3 2020, subject to any further deferral by the FCA due to the COVID-19 pandemic.
While the full details of the new regime are yet to emerge, there is enough information in the published level 1 text to start planning and modelling for the new regime. Firms should plan to take the following actions:
- Identify which group entities will be affected and whether consolidated supervision may be imposed.
- Determine the relevant class for each firm.
- Identify staff members that are in scope of the remuneration principles.
- Consider how to meet the composition of variable remuneration requirements.
- Determine whether, and for whom, employment terms must be amended.
- Consider whether any disapplications will apply and document the basis of their disapplication.
- Review employee compensation schemes that are currently in place, and which are due to be put into place for any deferred compensation mechanics.
- Review bonus arrangements.
- Determine whether a remuneration committee is required and the extent to which any existing remuneration committee practices, composition and terms of reference must be amended.
Client Alert 2020-325