authors
Christopher Hitchins | Partner, London
Ashley Brown | Associate, London

The big-bonus culture associated with financial services institutions worldwide has been heavily criticised in the media as being one of the main contributory factors to the recent economic crisis by incentivising employees to take excessive short-term risks.

In order to sustain market confidence and promote financial stability by removing the incentives for inappropriate risk-taking by firms regulated by the Financial Services Authority (FSA), earlier this year the FSA carried out extensive consultation with relevant financial institutions about executive remuneration.

Although the FSA has conceded that “inappropriate remuneration policies” contributed to the recent economic crisis, in its findings it stated that this was not the “dominant factor.” Nonetheless, the FSA has proposed introducing the Code of Practice on Remuneration Practices (Code) as an attempt to move away from the unique culture prevalent in the financial services sector, where incentives are primarily linked to short-term results, which many view as an incentive for risk-taking. At the very least, the FSA hopes this will provide shareholders with some reassurance that risk management is being observed.

The final version of the Code was published by the FSA on 12 August 2009¹ together with a policy statement on reforming remuneration practices in financial services (CP09/15) summarising the feedback on the consultation that took place earlier this year.

The Code is to be incorporated into the FSA Handbook from 1 January 2010 (rather than 6 November 2009 as originally proposed) so that the FSA can directly enforce it.

Hector Sants, chief executive of the FSA, stated that at its heart, the Code has two aims, namely (1) to ensure that boards and remuneration committees focus more closely on the link between compensation, risk appetite and sustainability, and (2) to ensure that individual compensation practices provide the right incentives.

To Whom Does the Code Apply?
At least initially, the Code will only apply to around 26 of the largest banks, building societies, and broker-dealer firms (in contrast to the 47 firms that the consultation paper anticipated it would apply to). At the time of writing, the FSA had not yet publicly issued a list of those firms affected, although the organisations themselves should know who they are by now, as the FSA would have contacted them.

Most overseas banks with UK subsidiaries will not be affected by the Code unless they are part of a group that contains UK banks or building societies that meet one of the following criteria:

1. Have total regulatory capital in the UK banking entities exceeding £1 billion or are part of a finance group (UK or international) with regulatory capital in excess of £20 billion or the equivalent amount in another currency
   
   
2. FSA-regulated BIPRU 730k firms (i.e., a bank, building society or investment house that is subject to Directive 2006/49/EC (Capital Requirements Directive) and to minimised capital requirements of €730,000) that have a total regulatory capital in the UK-authorised entity exceeding £750 million or the equivalent amount in another currency or, alternatively, are part of a finance group (UK or international) with regulatory capital in excess of £5 billion or the equivalent in another currency

What Are the Main Recommendations of the Code?
The Code is intended to target senior employees and those employees with a “significant influence function,” as opposed to the wider employee population. It is intended to apply to all remuneration-related issues including wages, bonuses, long-term incentive plans, stock options, sign-on bonuses, severance packages, pensions, and the thorny issue of rewards associated with failure.

The general requirement of the Code states that affected financial institutions must establish, implement, and maintain remuneration policies, procedures, and practices that are consistent with and promote effective risk management.

To ensure compliance with the aforementioned general requirement of the Code, affected firms are generally expected to comply with the following eight evidential principles (the principles are also accompanied by additional guidance contained in the Code itself, which has also been summarised below):

1. Role of bodies responsible for remuneration policies and their members: an independent remuneration committee should be set up with a specific focus on risks associated with employee recruitment and management (with a further focus on remuneration policies).
   
   
2. Procedures and risk and compliance function input: risk management and compliance should be involved in establishing remuneration policies.
   
   
3. Remuneration of employees in risk and compliance functions: remuneration of employees in risk management should be considered separately from other business areas; any variable element to compensation for those in risk and compliance should be significantly less than risk-takers themselves.
   
   
4. Profit-based measurement and risk adjustment: profit levels (as opposed to revenue or turnover) should be the performance indicator used to calculate bonus pools.
   
   
5. Long-term performance measurement: where a substantial element of an employee’s salary is linked to performance, the assessment process for the performance-related component of an employee’s remuneration should be designed to ensure assessment is based on longer-term performance.
   
   
6. Nonfinancial performance metrics: nonfinancial performance metrics should form a significant part of the performance assessment process, and nonfinancial performance metrics should include adherence to effective risk management and compliance with the regulatory system and with relevant overseas regulatory requirements.
   
   
7. Measurement of performance for long-term incentive plans: the measurement of performance for long-term incentive plans, including those based on the performance of shares, should be risk-adjusted.
   
   
8. Remuneration structures: remuneration should be linked to safe risk management. Good practice is:
   
   
   1. To have a fixed component of remuneration that is a sufficient proportion of total remuneration, to allow a firm to operate a fully flexible bonus policy (so that it does not have to pay a bonus if the firm suffers a loss)
      
      
   2. To defer a significant part of an annual bonus with a vesting period of at least three years and if, when compared with the fixed component of an employee’s remuneration, the bonus is a significant proportion, then a reasonable starting point would be to defer two-thirds of the bonus
      
      
   3. To ensure that any deferred element of the variable component of remuneration is linked to the future performance of the firm (as well as the employee’s division or business unit). It is unlikely that a guaranteed minimum bonus for more than one year is consistent with the Code.

Whilst compliance with the eight evidential principles is likely to indicate compliance with the overriding general principle of effective risk management (and vice versa), compliance with the evidential principles is not compulsory per se. Firms may be able to demonstrate good risk management without compliance with the evidential provisions. Indeed, there may be circumstances where it would not be appropriate for firms to comply with specific evidential provisions.

During the consultation period many financial institutions argued that the draft Code was too prescriptive and imposed many draconian provisions that went significantly further than proposals made by regulatory bodies overseas. It was even suggested that the strict provisions of the draft Code would encourage a brain drain or, even worse, that financial institutions would relocate outside the UK to avoid compliance with the new rules.

Largely as a result of these criticisms, and to retain London’s competitiveness, the final version of the Code has been significantly narrowed in scope. However, the FSA does not seem to be able to escape criticism, as commentators in the media have now condemned the final version of the Code by saying that it has been too watered down from the draft Code that was circulated for consultation earlier this year, particularly the stringent proposals in relation to the payment of bonuses.

The draft Code was made up of 10 separate principles (as mentioned above, in the final Code this has now been reduced to eight), one of which controversially required deferral of at least two-thirds of bonuses over three years.

This principle, together with that of tying incentives to the performance of the entire financial institution and not just the particular division (and therefore not paying out where the financial institution has incurred a loss) has now been relegated to guidance, and whilst compliance is seen as best practice, noncompliance with the guidance will not automatically result in noncompliance with the Code.

The FSA does not intend to restrict the amount of individual bonuses, but expects banks to move away from guaranteed bonuses and short-term, cash-based remuneration for highly paid employees in favour of the type of deferral and longer-term performance incentives more commonly seen in other major UK companies.

Although limited to guidance only, the Code also discourages guaranteed bonuses that run for a period of more than one year (which the FSA refers to as “multiyear” bonuses), as it is unlikely that such practices are consistent with the general requirement of the Code and unlikely to accord with good risk-management practices.

That the FSA has left institutions with the freedom to tailor remuneration procedures to their specific needs can only be welcomed by financial institutions, as in certain circumstances it may be appropriate to allow guaranteed bonuses, perhaps to entice a new recruit to join the organisation or to develop a particular business team.

What Happens to Financial Institutions That Do Not Comply with the Code?
Banks will have to prove that they have enough capital to pay bonuses, and if this requirement is not met, then the FSA will have the ability to step in and force them to hold more capital where it feels that they have risky bonus structures, which in turn will decrease profitability and thus the end pool available for distribution. If necessary, the FSA may resort to taking enforcement action or impose a fine.

In this respect, the FSA has confirmed that it is already carrying out “spot checks” on individual bankers’ bonus agreements to ensure that they are consistent with the provisions of the Code.

Main Criticisms of the Code
It is clear that the issue of bankers’ bonuses has been at the forefront of the media both in the UK and on an international level, and political parties very much have this topic at the top of their political agenda. The European Commission has confirmed its intention to publish regulations relating to remuneration in the financial services sector by the end of 2010, whilst the Basel Committee on Banking Supervision plans to introduce remuneration practices on a global basis, and regulations have been proposed in the Netherlands to cap bonuses in that jurisdiction.

Whilst there is an international consensus on the need to change the structure of executive remuneration in the financial services industry, there are proposals for multiple strands of legislation—at a national, continental, and international level—and undoubtedly with these various layers of regulations will come inconsistencies. Banks that operate in multiple jurisdictions will have to grapple with different rules coming into force in various places and at various times. The UK Government is clearly hoping that because the FSA is bringing in changes sooner rather than later, the other financial centres will look to introduce something similar in line with the UK’s rules, safeguarding London’s status as one of the world’s major financial centres.

The FSA is the first regulatory body to implement regulations on executive remuneration and, as noted above, to a large extent these new rules have to be implemented by January 2010. This job is not to be underestimated and there will be many complex employment issues that need to be addressed (see below).

By pressing ahead with implementing the Code for January 2010, it could ultimately result in affected UK financial institutions having to amend their remuneration policies, contracts of employment, and bonus structures now and again in the future, if the Code is subsequently amended in light of domestic, continental or international legislation.

One of the main criticisms of the Code is that in restricting the nature of bonuses that are paid, it may encourage firms to increase the base salary of its employees to maintain the same level of total compensation. In fact, many firms are already doing this as a reaction to the recent backlash against bankers’ bonuses.

Employment Law Implications Arising from the Code
From an employment perspective, there is clearly a considerable amount of work to be carried out by affected firms in the months ahead as they will be required to review and, where appropriate, amend remuneration polices, bonus structures, and employment contracts.

The Code provides some degree of latitude for affected firms as they will have a transitional period to amend existing noncompliant contractual remuneration packages.

Subject, of course, to the terms of such agreements relating to remuneration, those agreements entered into on or before 18 March 2009 are exempt from the provisions of the Code for a limited period of time as follows:

• If the noncompliant agreement can be amended or terminated unilaterally, affected firms must do so by no later than 31 March 2010
  
  
• If the noncompliant agreement cannot be amended unilaterally then it must, in any event, be amended or terminated by no later than 31 December 2010

For those contractual agreements entered into after 18 March 2009 (which was the date the consultation paper was issued), all remuneration practices must be compliant with the Code by no later than 1 January 2010.

Accordingly, those firms subject to the Code will need to review and identify any agreements that may potentially be noncompliant without delay. Where there is concern as to whether an agreement or practice is compliant, the FSA has advised that affected firms should, in the first instance, seek guidance from it on how to proceed.

Those firms affected by the Code with noncompliant agreements that cannot be amended unilaterally are left in a very difficult position. We would advise that they seek employment advice on the legal implications and options available.

It is a classic catch-22: on the one hand, the Code provides that affected firms have to ensure compliance with the new Code, but on the other hand, where contracts of employment cannot be amended unilaterally (and therefore the employer is forced to terminate the relevant agreement to ensure compliance), employers are opening up to potential claims from the affected employee(s) for breach of contract.

It remains to be seen whether the reason for termination of the agreement (i.e., to avoid noncompliance of the Code and possible sanctions imposed as a result) is sufficient legal protection against a claim brought by the affected employee(s) for breach of contract.

In such situations, affected firms are strongly advised to get written confirmation from the FSA that the agreement is noncompliant and that they will suffer penalties from the FSA unless it is terminated.

If a claim was brought by an affected employee on this basis, it is likely to be high profile and high value and would attract unwanted publicity to the banking industry at a time when it is trying to regain popularity with the public. It would seem ironic that the forced termination of a highly generous bonus scheme (because of the risk level it posed to the bank) could result in the affected firm potentially having to pay out a comparable amount in damages for breach of contract.

Link Between the Code and Other Proposals
Whilst the FSA acknowledges that the Code is not going to change the "bonus culture" overnight, it also recognises the vital importance of the role of shareholders in monitoring and controlling remuneration risks. There have been recent proposals made in respect of executive remuneration in the financial services industry (the Walker review) and the FSA has confirmed that it will work closely with the Walker review team on such corporate governance issues.

What Happens Next?
Although the FSA has not published a list of the 26 firms that it anticipates will be affected by the Code, we understand that it has written to them inviting them to complete a remuneration policy statement on their compliance with the Code by the end of October.

Separately, it is anticipated that the FSA will issue further guidance in November on the extent to which remuneration-related rules, including, inter alia, the Code, should apply to other financial institutions operating in the UK (i.e., those firms not currently affected by the Code).

Conclusion
As recent reports indicate that financial institutions have returned to pre-credit-crunch profits and bank bonuses are predicted to reach £4 billion this coming year, it is certain that the issue is going to remain a political hot potato.

In September, Alistair Darling, the UK Chancellor of the Exchequer, led efforts to reach a global consensus on a crackdown on bankers’ bonuses at the meeting of G20 finance ministers in London ahead of the G20 summit in Pittsburgh, on 24 and 25 September 2009.

In addition, Gordon Brown, French President Nicholas Sarkozy, and German Chancellor Angela Merkel wrote an open letter to fellow EU leaders urging a united EU position on bankers’ compensation at the Pittsburgh summit.

At the G20 summit in Pittsburgh, an economic charter was agreed upon, outlining a framework for governments to work together to strengthen international economic coordination. Implementation of the framework is to be left to each country’s regulator (in the UK this will be the FSA) but it is to be closely monitored on a global level by the Financial Stability Board, which has been tasked with developing policies and practices around the world.

In response, Gordon Brown has confirmed that he intends to introduce new legislation this year incorporating some of the recommendations made at the G20 summit. It is suspected that this is, however, a political issue and an attempt to create an electoral divide with the Conservative party in the UK.

Whilst the introduction of the Code is, of course, a step towards balancing risk and reward, any controls executive remuneration undoubtedly need to be implemented on a global basis to achieve any real success. As a result of the announcement made at the G20 summit in Pittsburgh, the FSA has confirmed it will renew the Code prior to its implementation. We await the implementation of the Code and further international developments with anticipation, as the months ahead will undoubtedly provide interesting debate and comment.

¹ The Code can be accessed online at http://www.fsa.gov.uk/pubs/policy/ps09_15.pdf.