ADVISORY Financial Services: Executive Compensation

ADVISORY Financial Services: Executive Compensation FINANCIAL SECTOR PAY GOVERNANCE December 2, 2010 Excessive and imprudent risk-taking in the banking sector has led to the failure of individual financial institutions and systemic problems in Member States and globally. While the causes of such risk-taking are many and complex, there is agreement among supervisors and regulatory bodies, including the G20 and the Committee of European Banking Supervisors, that the inappropriate remuneration structures of some financial institutions have been a contributory factor. (Recital to the proposed amendments to the Capital Requirements Directive (2006/48/EC and 2006/49/EC).) Pay governance in the European financial sector is being overhauled this year with unprecedented vigour. This client bulletin summarises the developments affecting financial institutions operating in the UK and highlights the steps that should be taken by those caught by the new rules. Amendments to the EU Capital Requirements Directive (CRD), known as CRD 3, will impose on a broad range of firms requirements to adopt remuneration policies and practices with effect from 1 January 2011. This is part of a coordinated approach to impose controls on remuneration across the financial sector. Other initiatives, such as the EU Directive on Alternative Investment Fund Managers (AIFMD) will impose similar requirements on fund managers who are not within the scope of the CRD. What are the key developments in 2010? 8 April, 2010 -- the Financial Services Act 2010 gave the UK Financial Services Authority (FSA) new powers to regulate financial services sector pay; 7 July 2010 -- the EU Parliament adopted amendments to the CRD imposing detailed requirements on remuneration policies and practices (CRD 3); 29 July 2010 -- the FSA published its consultation paper (CP10/19) on proposed revisions to its Remuneration Code in order to implement CRD 3 (the consultation closed on 8 October 2010); 8 October 2010 -- the Committee of European Banking Supervisors (CEBS) published a consultation on guidelines on remuneration policies and practices (the consultation closed on 8 November 2010); 10 November 2010 -- the FSA published its consultation paper (CP10/27) on implementation of the CRD 3 requirements on the disclosure of remuneration (the consultation is due to close on 8 December 2010); 11 November 2010 -- the EU Parliament adopted the AIFMD (implementation of the Directive in Members States is expected to be required in Q1 2013); early/mid December 2010 -- final FSA rules amending its Remuneration Code in order to implement CRD 3 expected to be published; early/mid December 2010 -- final CEBS guidelines on remuneration policies and practices expected to be published; and 1 January 2011 -- CRD 3 and amended FSA Remuneration Code come into force. BEIJING BRUSSELS LONDON NEW YORK SAN DIEGO SAN FRANCISCO SILICON VALLEY WASHINGTON www.cov.com

WHICH ORGANISATIONS ARE WITHIN SCOPE? The CRD 3 remuneration requirements apply to all firms that are within the scope of the CRD. That includes all credit institutions, building societies, investment managers, investment advisers, brokers, corporate finance firms and other investment firms which are subject to the markets in financial instruments (MiFID). It does not though include firms which only advise on or arrange investment transactions and which qualify as exempt Capital Adequacy Directive firms. Nor does it include managers of collective investment undertakings, as long as they are not also providing investment services within the scope of MiFID in another capacity. However, such fund managers will, in due course, be subject to the remuneration requirements of the AIFMD. WHAT ARE THE MAIN FEATURES OF THE CRD 3 REMUNERATION PRINCIPLES? The general requirement is that firms must have remuneration policies which are consistent with and promote sound and effective risk management. Firms will also be required, among other things, to: align their remuneration policies with their business strategy and long-term interests; include measures to avoid conflicts of interest; ensure that remuneration for employees in risk and compliance functions is determined independently of the performance of the business areas they control and take account of current and future risks when assessing variable remuneration. CRD 3 remuneration rules are highly prescriptive on pay design: performance-related remuneration must be based on a combination of the assessment of the performance of the individual (taking into account non-financial, as well as financial, criteria), of the relevant business unit and of the firm overall; firms will be required to set appropriate ratios between the fixed and the variable components of total remuneration. CEBS believes it is not possible to decree one optimal relationship between fixed and variable components; the appropriate balance will depend on the quality of performance measurement and associated risk adjustments; the length of deferral periods, degree of risk and legal structures, among other things; at least 40% of bonuses must be deferred over 3-5 years, rising to 60% where a bonus is "particularly high"; at least 50% of bonuses must be paid in an "appropriate balance" of shares or similar instruments. Combined with the deferral requirement, this means that only 20-30% of bonuses will be able to be paid immediately as cash; the unvested deferred portion of any bonus should be subject to reduction in the event of poor performance of the relevant firm, division or individual; and any "discretionary pension benefits" must be delivered in the form of contingent capital and subject to a five year retention period. Significant changes are also being introduced to tighten up corporate governance of pay. In particular, larger firms will be required to establish a remuneration committee to oversee their remuneration policies. Firms will be required to make public disclosures regarding remuneration policy at least annually, including information regarding: the remuneration decision-making process; the link between pay and performance; criteria for performance measurement, risk adjustment, deferral policy and vesting; the main parameters for variable components of remuneration and non-cash benefits; aggregate quantitative information on remuneration broken down by business area; and aggregate quantitative information on remuneration for "in scope" employees. 2

The extension of remuneration rules beyond the banks to investment firms is, in the UK, one of the more controversial aspects of CRD 3. However, CRD 3 requires firms to comply with the prescribed remuneration principles in a way and to the extent that is appropriate to their size, internal organization and the nature, the scope and the complexity of their activities. This proportionality principle is a key aspect of the new requirements and the impact of the remuneration principles imposed by CRD 3 will depend on the degree of flexibility permitted by national regulators in applying this principle. In large part, this will be driven by the CEBS Guidelines. WHICH EMPLOYEES ARE WITHIN SCOPE? The new remuneration rules apply in relation to staff whose professional activities have a material impact on a firm s risk profile. These will include senior management, risk takers and employees receiving a level of total remuneration which takes them into the same remuneration bracket as senior management and risk takers. HOW IS THE UK RESPONDING? The amendments being proposed by the FSA to its current Remuneration Code (which presently applies only to a limited number of large banks and dealers) will fully align the Code with the scope and requirements imposed by CRD 3. The amended Code will apply to all banks, building societies, investment managers, investment advisers, corporate finance firms, brokers and other firms within the scope of the CRD (as described above) which are authorised by the FSA. The Code will not apply to UK branches of EEA firms as such firms will be subject to requirements implementing CRD 3 in their home States. The FSA estimates that the amended Code will apply to over 2,500 FSA-authorised firms from 1 January 2011. The FSA has not yet finalised its approach to the proportionality principle provided for in CRD 3. However, it has indicated that firms are likely to be able to apply certain rules in a proportionate matter and may also be able to adopt a comply or explain approach to other rules. The onus will be on firms not applying the principles fully to justify why it would be disproportionate to do so. However, some principles will need to be complied with in full by all firms. These include the general requirement for remuneration policies to be consistent with and promote sound and effective risk management, to be aligned with firms business strategies and long-term interests, to include measures to avoid conflicts of interest and to set an appropriate balance between fixed and variable components of total remuneration. The FSA has indicated that it would expect staff whose professional activities have a material impact on a firm s risk profile (Code Staff) to include persons performing significant influence functions, senior management, risk takers and other staff receiving the same level of remuneration as senior management and risk takers and whose professional activities could have a material impact on a firm s risk profile. Firms will be expected to compile a list of all Code Staff ahead of the 2010 bonus allocation period. HOW WILL REMUNERATION STRUCTURES FOR FSA AUTHORISED FIRMS BE AFFECTED? The FSA s starting point, already enunciated in its current Remuneration Code and in line with CRD 3, is that firms must ensure that the structure of an individual s remuneration is consistent with and promotes effective risk management. The FSA believes that its current Code is consistent with good industry practice for corporate governance, although changes are necessary to bring it into alignment with CRD 3. 3

Bonus structures will reflect the parameters set in CRD 3: the FSA will publish further guidance on achieving the right balance between fixed and variable elements of remuneration, after further consideration of the CEBS proposed guidelines on implementation of the remuneration requirements of CRD 3 (CEBS Guidelines); at least 40% of any Code Staff s variable remuneration must be deferred for at least 3 years. It is currently proposed that this would increase to 60% where total remuneration exceeds 500,000; at least 50% of any Code Staff s variable remuneration (deferred or non-deferred) must be delivered in shares or share-linked instruments and (where appropriate) capital instruments which reflect the credit quality of the firm. The equity instruments must be subject to a minimum retention policy. The FSA s position on this may change, following review of the CEBS Guidelines; performance adjustments - reflecting actual business outcomes - must in future be possible in respect of all deferred remuneration, consistent with a documented performance adjustment scheme ; guaranteed bonuses can only be offered in exceptional circumstances to new hires for the first year of service. Amounts should not be more generous than the variable remuneration awarded or offered by the previous employer and should be subject to performance adjustment; total variable remuneration must not limit the firm s ability to strengthen its capital base; and staff whose bonus forms less than 33% of their total remuneration, and whose total remuneration is less than or equal to 500,000, will be exempt from the deferral requirement, performance adjustment, and other constraints. It is also proposed that severance payments will now be brought within the Code to ensure that they are not a reward for failure. Likewise the FSA proposes limits on enhanced discretionary pension contributions (i.e. one-off payments, not standard pension plan contributions); these must take the form of shares or share-linked instruments and be held for at least five years. Firms which are significant in terms of size, internal organization and nature, scope and complexity of activities will be required to establish a remuneration committee. In finalising its amended Remuneration Code following the proposals consulted upon in its consultation paper CP10/19, the FSA has had to allow time to absorb the CEBS Guidelines. Once the amended FSA Remuneration Code is published in December, we will provide a further update on the potential impact of the changes, including the way in which the FSA proposes to address the issue of proportional application of the remuneration requirements. WHAT ARE THE FSA S VOIDING POWERS? The Financial Services Act 2010 has given the FSA express powers to prohibit a firm from remunerating its staff in a specified way and to render void any provision of an agreement that contravenes such a prohibition. The FSA proposes to exercise these powers only in relation to Code Staff and only in relation to deferral arrangements and guaranteed payments. Firms will be obliged to recover payments made under non-compliant remuneration arrangements. Employers may therefore be forced to defend breach of contract claims on relatively untested grounds (including frustration of contract). Tax paid in respect of past payments may also be difficult to recover from HMRC. WHEN WILL THESE NEW PROPOSALS TAKE EFFECT? The new FSA Code will be in force from 1 January 2011. It will apply to remuneration awarded on or after that date. It will also apply to remuneration due under contracts concluded before 1 January 2011 but awarded or paid after that date and to remuneration awarded, but not yet paid, before 1 January 2011 in respect of services provided during 2010. The FSA will not expect firms to breach 4

contract or employment law. If obligations arise under an agreement made by a firm before 29 July 2010 (the date of publication of the FSA s consultation paper CP10/19), the firm will be expected to take reasonable steps to amend or terminate the relevant provision in the agreement to enable compliance with the Code as soon as possible and, in the meantime, to adopt effective arrangements to manage the risks raised by the relevant provision. Firms in scope must take reasonable steps to comply as soon as possible. Smaller firms may be able to rely on principles of proportionality to justify deferring the implementation of new remuneration structures until 1 July 2011. What should firms do now? 1. Financial services firms operating in the UK should determine as soon as possible whether they fall within scope of the proposed new rules. 2. If in scope, firms should be planning for implementation of suitable remuneration structures, policies and practices and making necessary adjustments to existing remuneration policies and practices. The FSA recognises that changes to remuneration structures take time to implement and will not expect firms which come in scope for the first time on 1 January 2011 to have the prescribed structures in place until July 2011, although firms will be expected to take steps to comply as soon as possible. If compliance with the revised Code appears very challenging in respect of certain awards, one option is to make payments prior to 1 January 2011. 3. In scope firms should though have appropriate governance arrangements and procedures in place by 1 January 2011. 4. Code staff should be identified. 5. Potential employment legal risks should be identified - for example, where bonus expectations constitute express or implied contractual rights. 6. In scope firms should consider how to begin communicating with Code staff. 7. In scope firms should consider how the proportionality principle may apply to them and whether compliance in full with the remuneration requirements, in particular those relating to bonus structures, is likely to be disproportionate. 8. Firms should ensure that documents are amended to enable the introduction of the required remuneration structures, in particular to enable, where necessary, appropriate deferral and retrospective adjustment to deferred consideration. Employment and service contracts for staff who will be Code Staff entered into prior to 11 January 2011 will need to enable compliance with the new requirements. If you have any questions concerning the material discussed in this client alert, please contact the following members of our financial services and executive compensation practice groups: Simon Currie, Financial Services Regulatory Group +44.(0)20.7067.2011 scurrie@cov.com Christopher Walter, Executive Compensation Group +44.(0)20.7067.2061 cwalter@cov.com This information is not intended as legal advice. Readers should seek specific legal advice before acting with regard to the subjects mentioned herein. Covington & Burling LLP, an international law firm, provides corporate, litigation and regulatory expertise to enable clients to achieve their goals. This communication is intended to bring relevant developments to our clients and other interested colleagues. Please send an email to unsubscribe@cov.com if you do not wish to receive future emails or electronic alerts. 2010 Covington & Burling LLP, 265 Strand, London WC2R 1BH. All rights reserved. 5