Executive briefing – August 2021

FCA IFPR policy statement: remuneration requirements

In April 2021, the FCA issued a consultation document setting out the proposed remuneration requirements for the new UK Investment Firm Prudential Regime (IFPR) (please see our previous briefing here regarding that consultation). It has now considered the feedback received and has issued a policy statement which includes near-final rules, as well an explanation of what changes have been made following the consultation.

The proposed rules are substantially the same as those issued with the April consultation document, but the FCA have made a number of adjustments and useful clarifications. We have summarised the notable remuneration related sections from the policy statement, below, and recommend that remuneration committees and management teams at investment firms consider the policy statement carefully.

Recap

IFPR is a UK-specific version of a new prudential framework for investment firms which mimics much of the new regime that is being introduced by the European Union (which the UK helped to design prior to Brexit). UK firms that also have operations in one or more EU member states will need to consider both regimes.

The new prudential regime for UK investment firms will be brought into a single rulebook known as MIFIDPRU. This will replace the existing IFPRU and BIPRU rulebooks, including the associated guidance, which will be deleted.

Although the new rulebook will apply to all FCA investment firms, the remuneration requirements provide for a proportionality framework that distinguishes between 3 different classes of investment firm. The following diagram (taken from the consultation document) provides an overview of the three levels of remuneration requirements that will apply to UK investment firms:

The FCA has confirmed that UK firms will need to apply the new rules from the start of their next performance year beginning on or after 1 January 2022 (as previously indicated).

Scope and application

• Transitional provisions: The FCA has confirmed that it is the performance period, rather than the date on which the remuneration is awarded or paid out, which is relevant to determining which regime applies. This means that firms should continue to apply existing remuneration codes (e.g. IFPRU, BIPRU) in respect of remuneration paid in respect of a performance period which started before 1 January 2022.
• Extended requirement threshold: Some respondents complained about the thresholds used to determine application of the ‘extended’ requirements. They argued that non-SNI (smaller and non-interconnected firms) firms subject to the standard remuneration requirements would have a competitive advantage over those subject to the extended requirements. Although the FCA has acknowledged the metrics used to determine the thresholds are not “perfect”, it does feel that they represent a proportionate approach. Further detail has been provided regarding the calculation of on/off balance sheet assets/ items and the averaging methodology, e.g. confirming that values should not be amended retrospectively to take account of later events, such as acquisitions.
• Group consolidation: The FCA has confirmed that the extended remuneration requirements do not apply on a consolidated basis. This means that an entity within a consolidation group is subject to the extended remuneration requirements (pay-out in instruments, deferral, retention, etc.) only if that entity exceeds the thresholds, and not solely because another entity in the group exceeds the thresholds.
• Identification of MRTs: There is no change to the criteria to be used to establish the MRT population of a firm. However, the policy statement does provide some useful clarifications regarding the identification process, e.g. the substance of a role rather than its title is determinative; the identification process should focus on managerial not operational roles.
• Individual proportionality: The FCA proposes to exempt those MRTs who earn below a certain amount from the extended remuneration requirements (if they are working at a firm that would otherwise be caught by those requirements). In order to qualify for the exemption, the MRT would need to have: (i) variable remuneration of no more than £167,000; and (ii) variable remuneration which makes up no more than one-third of their total annual remuneration. A number of respondents argued that those thresholds should be increased. Although the FCA has not decided to alter the thresholds, it has provided some clarifications, including a reminder that the exemption is calculated using the amount of actual variable remuneration awarded.
• Subsidiaries established in third countries: The FCA has confirmed that the remuneration rules only apply to those MRTs who oversee or are responsible for business activities that take place in the UK.

Basic requirements

• Application: FCA has confirmed that the basic remuneration requirements will apply to all FCA investment firms, including SNI firms. The FCA noted that the “principles-based nature of these requirements provides firms with a high degree of discretion in how they comply with them”. It considers that this will mitigate the risk of any competitive disadvantage with EU firms that are not subject to the same principles (which was the argument of at least one respondent).
• Carried interest and co-investment arrangements: The FCA has provided amended guidance regarding the treatment of these types of arrangements. In particular:
  • some of the extended requirements (pay-out in instruments, deferral, retention and ex-post risk adjustment) will not apply to carried interest, as long as it fulfils certain requirements (carried interest determined by reference to related fund, period between award and payment at least 4 years, minimum provisions for forfeiture and cancellation); and
  • the returns on a co-investment arrangement will be considered to be remuneration only where the investment was made using a loan provided by the firm that was not provided to the individual on commercial terms, or had not been repaid in full by the time the return on the investment was paid.

Standard requirements

• Fixed to variable ratio: Firms will be required to set an “appropriate ratio” between variable and fixed remuneration as part of the remuneration policy. Although the FCA does not intend to define any boundaries for this ratio (such as the ‘bankers bonus cap’ that applies to CRD firms), it has added additional guidance to the draft rulebook. The new guidance encourages firms to consider all potential scenarios and the ratio should “reflect the highest amount of variable remuneration that can be awarded in the most positive scenario”. This may present a practical challenge for some firms that operate uncapped profit pools. A number of firms also expressed concern about the potential consequences of being required to publicly disclose their ratios, noting that it could lead to pressure to increase variable remuneration if employees are able to compare ratios across firms. The FCA has noted these concerns and flagged that it will issue a further consultation paper (expected Q3 2021) containing proposals on remuneration disclosure requirements. It is hoped that this will take into account these concerns. 
• Malus and clawback: The new rulebook will require mechanisms be in place to potentially apply ex-ante and ex-post risk adjustment, including minimum clawback periods and triggers for the application of malus/clawback. Some firms requested clarity on appropriate clawback periods in situations where deferral is not used (the initial guidance suggested that the clawback period should span at least the combined length of any deferral period and retention period). In response, the FCA has added new guidance that indicates a period of 3 years would be “an appropriate starting point” when setting the clawback period. 
• Annual review: Firms will be required, at least annually, to conduct a central and independent internal review of whether the implementation of its remuneration policies and practices comply with the remuneration policy and practices adopted. Further guidance has been provided by the FCA, regarding the scope of the review and noting that it may be outsourced to external consultants, e.g. if the firm does not have an internal audit function.
• Buy-out awards: The initial consultation indicated that buy-out awards should be subject to the “same pay-out terms” required by the individual’s previous employer. The FCA has clarified that the policy intention is simply to require the duration of the retention, deferral, vesting and ex-post risk adjustment arrangements to be ‘no shorter’ than the duration applied, and remaining, under the previous employer. The non-duration aspects of the pay-out, malus and clawback arrangements must only be aligned with the ‘long-term interests of the firm’.

Extended requirements

• Pay-out in shares or other instruments: At least 50% of the deferred portion of variable remuneration should be paid out in shares or similar instruments. Following a query from a trade body, the FCA has confirmed that firms may use “notional units which track the performance of units in the underlying portfolio and are settled in cash”. It has agreed that this form of instrument will achieve the objective of reflecting the credit quality of the firm or fund managed (consistent with the policy intention).
• Interest and dividends: The initial consultation proposal did not permit interest or dividends on shares or instruments during the deferral period to be paid out to the individual. This elicited strong feedback from respondents. For example, some argued that it creates a misalignment of the interests of the individual and the firm’s key stakeholders, such as shareholders and clients. As a result, the FCA has changed its approach. MRTs will now be permitted to “accrue interest and dividends during the deferral period, but firms will not be permitted to pay them to MRTs until the point of vesting”. In addition, the interest rate or level of dividends paid should not be higher than that which would have been paid to an ordinary holder of the instrument. Moreover, any interest or dividends do not need to be counted for ratio purposes.

Governance

• Remuneration committee: Several respondents disagreed with the original proposal for remuneration committees to be established at individual entity level. Having considered this feedback, the FCA has stated that it is possible for the objectives of remuneration committees to be fulfilled at group level. This mean that a non-SNI firm can rely on a group level remuneration committee (without needing to apply to the FCA) where the firm is part of an FCA investment firm group to which prudential consolidation applies and where the UK parent entity has a remuneration committee.

FIT comment: The main elements of the IFPR remuneration rules proposed under the original consultation have not changed materially. In particular, the architecture of the regime (basic/ standard/ extended), substantive requirements (deferral, pay-out process rules, etc) and proportionality thresholds (for firms and individuals) all remain broadly in the same form as proposed by the FCA. That said, there are some useful clarifications and limited amendments to the rules that firms should take note of. We think that the concession on the payment of interest and dividends will be welcomed by firms, as will the clarification that cash-settled units can be used to satisfy the pay-out in instruments requirement. 

As always, it will pay to work through the detail and consider how the rules apply to the specific circumstances of each firm.

EBA report on management of ESG risks for credit institutions and investment firms

The European Banking Authority (EBA) recently published a report on management and supervision of ESG risks for credit institutions and investment firms. The report includes a number of observations and recommendations regarding the adaptation of remuneration policies to deal with ESG risks. 

Observations:

• In the view of the EBA, remuneration policies of institutions are not sufficiently integrated into business strategies, core values and long-term interests to account for ESG risks (to ensure sound risk management and mitigate excessive risk taking in this area).
• Remuneration policies that give the right incentives to staff members to favour decisions in line with the institution’s ESG risk-related strategy would facilitate the implementation of ESG risk-related objectives and/or limits.

Recommendations:

• The EBA sees the need for institutions to proportionately incorporate ESG risks into their internal governance arrangements (including remuneration aspects).
• Institutions should evaluate how to account for ESG risks in their remuneration policies, especially in the case of staff whose professional activities have a material impact on the institution’s risk profile (MRTs).
• Firms should consider ESG indicators and ESG risk-related objectives and/or limits when taking into account the long-term interests of the firm in the design of remuneration policies and their application.
• Institutions should consider the implementation of a remuneration policy that links the variable remuneration of MRTs (taking into account their respective roles and responsibilities) to the successful achievement of those ESG risk-related objectives, while ensuring that green-washing and excessive risk-taking practices are avoided.

FIT comment: Consideration of ESG risks is only the rise for all businesses, not just credit institutions and investment firms. Indeed, the EBA report is consistent with the general direction of travel globally, including for UK listed companies and non-FS businesses.

Whilst the recommendations contained in the EBA report will not result in immediate change to EU legislation or guidance, they provide a good indication of the likely content of any future legislation and/or guidance. We anticipate that new EU legislation and guidance on this subject is likely in the short to medium term. Moreover,

If you would like to read further regarding the integration of ESG risks into remuneration arrangements, then please see our earlier briefings here and here. 

If you wish to discuss anything arising from this briefing, please ask your usual contact at FIT or call us on 020 7034 1111 or email us at Info@fit-rem.com. 

This paper is intended to be a summary of key issues but is not comprehensive and does not constitute advice. No legal responsibility is accepted as a result of reliance on the contents of this paper.

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