Smaller banks and building societies across Europe face the prospect of implementing a strict bonus deferral regime from January next year under proposed new guidelines on pay from the European Banking Authority (EBA). UK regulators will have to implement the new guidelines if they are adopted by the EBA later this year. The Financial Conduct Authority (FCA), which regulates approximately 1,000 UK banks, building societies, and other financial institutions, has urged smaller banks and building societies to respond to the EBA’s consultation before it closes in June 2015.
So should smaller financial services companies be concerned about the EBA’s proposals? The key changes cover how and when any variable pay (typically bonuses and long-term incentives) can be paid to identified staff (employees who can have a material impact on the risk profile of their employer through their day-to-day activities). Currently only the largest banks and building societies are restricted by the relevant provisions of the remuneration code. Under the EBA proposals, all firms would have to adopt the rules on variable pay, regardless of size.
What are the rules on deferral and payment of variable pay for identified staff?
At least 40% of all variable pay must be deferred, and ‘vest’ (become payable) over a period of at least three years. Vesting must not happen more quickly than on a pro-rata basis across the deferral period. So for example, if a bonus of £10,000 is awarded, a maximum of £6,000 can be paid upfront, and the remaining £4,000 can be paid in equal tranches on the first, second and third anniversaries of the original bonus payment.
In addition, a maximum of 50% of all variable pay – whether deferred or paid upfront – can be paid in cash. The rest must be paid in shares or certain types of bond that are linked to the organisation’s financial health. The shares or bonds that can be used to satisfy this element of the remuneration code are also tightly regulated.
Why are they changing?
Up to now, European regulators have used a principle known as ‘proportionality’ to shield smaller firms from the more complex aspects of pay regulation. Proportionality means that the larger the firm, the more strictly it must be regulated. National financial services regulators such as the FCA have used the principle of proportionality to exempt smaller banks and building societies from the deferral and variable pay provisions outlined above. Even larger firms have been exempt from these aspects of regulation for employees whose total pay is less than £500,000. The problem is that new legal advice suggests that the underlying European legislation – the Capital Requirements Directive (‘CRD IV’) – does not permit national regulators to disapply the minimum requirements on pay in this way.
What are the regulators doing about this?
In response to the new legal interpretation, the EBA has issued a draft new set of guidelines on financial services pay. The guidelines determine how national regulators must interpret and apply the rules on pay for firms within their jurisdiction. The draft guidelines are currently open for consultation, which means that regulators, firms and individuals may submit views and comments up to the end of the consultation period (4th June 2015).
The EBA is clearly concerned about the practicality of extending the full regulatory regime on pay to all firms, though whether this is out of sympathy for the increased regulatory complexity this would impose on smaller firms, or on the additional burden it would place on the national regulators who have to police the regime, is not clear. In its preamble to the proposed new guidelines, the EBA holds open the possibility of asking the European Commission to make changes to the legislation to accommodate some form of proportionality in the application of the rules on pay. The implication is that the EBA still believes that it may be disproportionate to apply the stricter provisions on payment and deferral of variable pay to smaller firms. The consultation document goes out of its way to invite comment on this aspect of the new guidelines, asking firms that have previously been exempt to provide an estimate of how much it would cost them to implement pay structures that would conform to the guidelines, and to flag any practical obstacles to their doing so.
Nevertheless, as they stand, the proposed guidelines are clear – these provisions would apply to all firms regardless of size, and to all identified staff, regardless of the overall level of pay received. It seems that the EBA will only fight its corner on this issue if it receives sufficient adverse evidence and comment from firms and their regulators on the impact that lifting the proportionality protection would have. The FCA has taken the unusual step of issuing a statement on its website encouraging small firms to review the proposed new guidelines and respond to the consultation questions.
What are the practical implications for firms that will be affected by tighter regulation?
The prospect of having to conform to the remuneration code’s deferral and payment provisions for variable pay is certainly something that firms should take seriously. Below are some of the steps likely to be needed to in order to put compliant remuneration structures in place, each of which will have a cost in terms of time and resource:
- Decide how deferral will work and incorporate new rules into bonus plan documentation – which categories of employees are affected, when deferred elements of the payment will vest, what happens if the employee leaves before payments vest, and the circumstances in which an unvested payment can be reduced before payment, or clawed back after payment (both of which are requirements of the legislation).
- Identify a suitable vehicle for the payment of the 50% of variable pay that cannot be paid in cash. Assuming this is shares, you may need to set up arrangements for the supply of shares, for holding them in trust on the employees’ behalf during the deferral period, and for the subsequent transfer of ownership to the employee (or sale at the point of transfer). You will also need to specify the period of time for which employees are required to hold shares after ownership has transferred to the employee (a ‘retention period’ – the regulations specify a minimum of one year).
- You may need to make changes to employment contracts to ensure that variable pay can be clawed back in certain circumstances after it has been awarded.
You may not, of course, believe that the requirement to implement deferral and clawback, nor payment of a portion of awards in shares, is a bad thing. The regulations are after all designed to protect firms from the payment of excessive pay awards. You may already have deferral or share plans in place that you can build on relatively easily to meet the new requirements. And even if you don’t, you may feel that once the appropriate structures are put in place, the additional ongoing burden of managing them for a limited number of individuals will be relatively modest, and worth the element of security they bring for the employer. So the EBA’s proposals need not be all bad news for reward and HR professionals in smaller financial services firms. Either way though, now is definitely the time to consider their implications, and to respond to the EBA’s consultation document.