EBA final guidelines on sound remuneration policies and opinion on the proportionality principle

On 21 December 2015, the EBA published the final version of its guidelines on sound remuneration policies (Guidelines). On the same day, it published an opinion addressed to the European Commission containing proposals for legislative amendments to CRD IV (CRD) to clarify the scope of the proportionality principle (Opinion).

These papers set out the EBA's final position following the publication of draft guidelines in March 2015 (which we covered in our Ashurst briefing here). They outline the requirements for remuneration policies, the accompanying corporate governance requirements and the processes which should be applied when remuneration policies are implemented.

The implementation date for the EBA guidelines is 1 January 2017. The FCA has confirmed in its statement here that the rules will first apply to the 2017 performance year i.e. firms will not need to change their existing pay practices for the 2016 performance year. Interestingly, it is not clear that this position is shared by the EBA but firms should gain comfort from the fact that the FCA has confirmed this expressly.

Importantly, the final Guidelines and Opinion provide detail on the proportionate application of some CRD requirements which was the most contentious aspect of the draft guidelines when they were first published.

Key message – Bonus cap will not be subject to the proportionality principle

The headline from the March draft of the Guidelines was that smaller and non-complex firms would no longer be able to use the principle of proportionality to dis apply the application of certain remuneration rules (including the bonus cap), but would be required to comply in a similar way to systemically important firms. This signaled a potential change to business practices for investment managers and broker dealers, for example, and how they structure the incentives packages for their staff.

The final Guidelines and Opinion change this position, but only slightly. The EBA has announced in its Opinion that it intends to amend CRD so that small, non-complex firms would not be required to apply the rules regarding the deferral of variable remuneration and the requirement for bonuses to be paid in instruments. However, the EBA maintains that all firms, regardless of size, should be subject to the bonus cap and there are no proposals to amend CRD in this respect. This signals a significant change for smaller and non-complex firms from the current position.

The Guidelines also deal with the allocation of remuneration between fixed and variable components. They differentiate between requirements applicable to all staff and requirements applicable to identified staff, with the latter being subject to more stringent remuneration policies owing to their higher impact on the risk profile of firms.

Some of the key points to note in relation to the Guidelines and Opinion are set out below.

Proportionality

The proportionality principle enshrined in CRD aims to match remuneration policies and practices consistently with the individual risk profile, risk appetite and strategy of an institution. Some respondents to the EBA's consultation launched in March argued that the EBA should retain the approach taken within the earlier Guidelines issued by CEBS (the predecessor to the EBA) regarding proportionality and the ‘neutralization’ of certain requirements as, otherwise, institutions would have to bear significant implementation and on-going costs relating to the administration of remuneration policies, deferred payments and payment in instruments.

The EBA has taken this on board to some extent by proposing legislative amendments to CRD to allow small, non-complex firms to apply proportionality in relation to deferral and payment in instruments as well as in relation to staff who receive low levels of variable remuneration (although whether "low" has the same meaning as under the current rules is not set out). However, proportionality will not apply to the bonus cap. This is a significant change from the current position.

Identification of staff

The Guidelines provide that institutions should conduct an annual self-assessment in order to identify all staff whose professional activities have or may have a material impact on the institution’s risk profile. The identification process should be part of the overall remuneration policy of the institution.

The Guidelines state that the self-assessment should be based on the qualitative and quantitative criteria set out at European level (in Commission Delegated Regulation (EU) No 604/2014) and should include, where necessary to ensure the complete identification of all staff whose professional activities have a material impact on the institution’s risk profile, additional criteria set out by the institution that reflect the levels of risk of different activities within the institution and the impact of staff members on the risk profile. Records of how the institution conducted the assessment process must also be kept. This is a slight change to the current position and firms should pay particular attention to the nuanced change that will require them to make their assessment more subjective than the simple objective application of the "material risk taker" definition in the European regulation.

Capital base

The EBA notes that institutions must maintain a sound capital base. Remuneration represents an important cost factor for institutions, with remuneration payments directly influencing the institution’s capital base and liquidity (oddly, the fact that the bonus cap changes will likely force fixed costs up is a point not commented on!). There is also an indirect influence on the capital base (i.e. the impact of the remuneration policy on the risks taken for which capital is required). If an institution falls short of its capital targets, priority is to be given to building up the necessary capital or solvency buffer and a conservative remuneration policy needs to be pursued, particularly regarding variable remuneration. To ensure that remuneration does not endanger the financial stability of the institution, remuneration must also be taken into account for capital and liquidity planning purposes.

Long-term incentive plans

The draft version of the Guidelines had set out the timing for when the value of awards granted under long-term incentive plans (LTIPs) should be taken into account when calculating the ratio between variable and fixed remuneration. The EBA had suggested that firms must value LTIP awards in the year they vest, rather than when they are awarded (as is currently the practice). The approach to the valuation of LTIPs has sensibly been revised, with the valuation of LTIP awards at grant rather than at vesting.

Categories of remuneration

The Guidelines provide that fixed remuneration should primarily reflect the relevant professional experience and organizational responsibility of staff and provide a stable source of income.

The Guidelines outline the criteria for determining whether the remuneration is fixed. These include whether the conditions for its award are: (i) based on predetermined criteria; (ii) non-discretionary, reflecting the level of professional experience and seniority of staff; (iii) transparent with respect to the individual amount awarded to the individual staff member; and (iv) permanent, i.e. maintained over a period tied to the specific role and organizational responsibilities. The Guidelines outline the approach an institution should take to the categorization of components of remuneration such as severance pay.

Carried interest payments

The final Guidelines maintain the position on the treatment of fund manager carried interest as was proposed in the draft Guidelines. Paragraph 2 of Annex I of the AIFM Directive specifically includes carried interest in the definition of remuneration. The ESMA guidelines on sound remuneration policies under the AIFMD apply. For the purposes of the Guidelines, and in particular, for calculating the ratio between the variable and fixed components of remuneration for staff the following should apply: (i) all payments made by the alternative investment fund to staff members through carried interest vehicles which are not representing a pro-rata return on the investment made by those staff members should be considered as variable remuneration and be valued at the time of their award; and (ii) all payments made by the alternative investment fund to staff members through carried interest vehicles which represent a pro-rata return on any investment by those staff members (through the carried interest vehicle) to the alternative investment fund should not be included in the calculation.

Timing and next steps

The Guidelines apply from 1 January 2017 to competent authorities across the EU, as well as to institutions on a solo and consolidated basis, including all subsidiaries which are not subject to the CRD IV framework. They repeal, with effect from 31 December 2016, the guidelines on remuneration policies and practices published by CEBS in December 2010.

As the Guidelines operate on a "comply or explain" principle, national competent authorities will have two months to express their intention to comply with them and in case of non-compliance, they will need to explain their intention not to comply. A compliance table will be published on the EBA website after the expiry of the two-month period. In its statement on the Guidelines, the FCA confirmed that it would, in conjunction with the PRA and HM Treasury, review the changes proposed by the Guidelines and their application to the UK market, and will consult on any necessary changes to our domestic rules and guidance. We expect further comment, especially in relation to the bonus cap issue.