Regulatory updates regarding CRD V and a new UK prudential regime for investment firms

Our latest executive briefing covers two recent regulatory announcements, as follows:

• Part I outlines the recent publication by the EBA of final draft regulatory technical standards on the identification of ‘material risk takers’ under CRD V.
• Part II covers the discussion paper published by the FCA relating to the new UK prudential regime for MiFID investment firms.

Part I - EBA publishes final draft regulatory technical standards on the identification of ‘material risk takers’ under CRD V

The EBA has published its final draft Regulatory Technical Standards (RTS) on the criteria to identify all categories of staff whose professional activities have a material impact on the institution’s risk profile (often referred to as ‘material risk takers’ or ‘MRTs’). The primary objective of the draft RTS is to harmonise the criteria for the identification of material risk takers “in order to ensure a consistent approach to the identification of such staff across the EU”.

Once finalised, the new RTS will replace the existing standards (adopted in relation to CRD IV) and will apply for performance periods beginning on or after 28 December 2020 (but please note our comments below regarding UK implementation in the context of Brexit).

Consistent with the approach that was taken for CRD IV, the new standards apply a combination of quantitative and qualitative criteria in order establish whether an individual is a material risk taker.

The criteria are broadly consistent with those set out in the current RTS (as applied under CRD IV). However, there are a number of nuances and amendments which mean that firms will need to carefully review the new standards, once confirmed. We have summarised below the main changes.

Qualitative criteria

- New definitions: The updated standards introduce a number of new or updated definitions which will enable firms to more readily identify whether individuals are MRTs or not. These include:

• “managerial responsibility”: This definition has been revised, taking into account that institutions of different sizes may have different numbers of hierarchical levels. Broadly, the definition covers the head of a material business unit, a function head (see below) and, in large systemically important institutions, the heads of subordinated business units or functions. Accordingly, this makes clearer that some entities may well have fewer MRTs.
• “material business units”: Although defined under the current RTS, the definition has been expanded to include a unit that has a “material impact on the institution’s internal capital”. It also includes a ‘core business line’, as defined in the Bank Recovery & Resolution Directives; this will, therefore, capture units which “represent material sources of revenue, profit or franchise value for an institution”. No guidance has yet been provided on how materiality should be determined, but the accompanying notes make clear that it will not be relevant whether an institution allocates internal capital to the business unit. This will potentially expand the number of individuals that fall within scope of the standards.
• “control functions”: The definition remains consistent with the common understanding of a control function, but has been expanded to explicitly include the risk management, compliance and internal audit functions. Given that most organisations already interpreted the guidance this way, this is unlikely to result in any material change.

- Function heads: The list of function heads (that are deemed MRTs) has been expanded to include functions relating to the prevention of money laundering and terrorist financing, information security and outsourcing for critical or important functions.

Quantitative criteria

- Amended €500,000 threshold: As was noted in our briefing last year, the text of the directive has incorporated the €500,000 threshold, albeit it has been amended to only capture an individual if their total remuneration is equal to or higher than €500,000 and the average remuneration awarded to the management body and senior management. This will potentially raise the quantitative threshold for identified staff as currently applied under CRD IV (although it would still remain subject to an assessment against the qualitative criteria).

-  €750,000 threshold: Staff who receive total remuneration equal to or greater than €750,000 will also be identified (this is an absolute measure with no comparison to the pay of other individuals). The EBA has also confirmed that this criterion has to be applied on an individual level by institutions, as well as on a sub-consolidated and consolidated basis.

-  Proportionality applied to 0.3% criterion: The standards have retained the criterion that identifies staff by reference to the 0.3% of staff with the highest remuneration. However, in order to “reduce the burden for small institutions”, the measure will only apply to institutions that have more than 1,000 staff members.

-      Exclusion process: If an individual is identified under the quantitative criteria (e.g. the €750,000 or 0.3% criteria) the institution will be able to apply to exclude that individual. The process set out in the standards is similar to the current process, except that it will now require prior approval by the relevant regulator. It remains to be seen whether the UK regulator will also adopt a prior approval process (at least one respondent to the consultation suggested an ex post checking process could be applied, with sanctions where an exclusion was found not to be appropriate).

-  Removed quantitative criteria: As expected, the EBA has removed the criterion (included in the CRD IV standards) that identified staff if they earned more than the lowest paid MRT.

-  Calculation methodology: Institutions will be required to set out the reference year for which they calculate variable remuneration, being either the preceding financial year in which the variable remuneration is awarded or the preceding financial year for which the variable remuneration is awarded. This will give firms flexibility as to how they calculate total remuneration for the purpose of the quantitative criteria (noting that the chosen approach must be applied consistently).

Next steps and Brexit

CRD V will come into force on 28 December 2020, but it still remains to be seen when the new standards will apply from. A number of respondents to the RTS consultation noted the complicating factor of the application date of the Investment Firms Directive (into June 2021). The EBA acknowledged the issue and has said it will take it into account in discussion with the European Commission.

It also remains to be seen how the UK will choose to implement CRD V, following Brexit. The directive will come into force (28 December 2020) before the end of the transition period. HM Treasury provided a policy update last week and confirmed that it intends to consult on the implementation of CRD V during this summer (as part of its update of prudential standards and implementation of the latest ‘Basel 3.1’ revisions).

Part II - Discussion paper regarding new UK prudential regime for MiFID investment firms

Introduction

As we anticipated in our recent briefing, the FCA has published a discussion paper in order to gather views on a new prudential regime for UK investment firms. The paper sets out the details of the EU’s new prudential regime for investment firms (IFD/IFR) and identifies specific areas of the EU regime upon which it is looking for feedback.

The foreword (by the current interim CEO of the FCA) succinctly sets out the approach the UK intends to take for the new regime:

“We supported the overall goals of the EU prudential regime for investment firms (IFD/IFR), and welcome the Chancellor’s statement in the budget that the Government intends to legislate for a UK regime. We propose to introduce a UK regime that will achieve similar intended outcomes as the IFD/IFR whilst taking into consideration the specifics of the UK market.”

The paper seeks feedback from interested parties by 25 September 2020. It also notes that the FCA will consider the feedback it receives and publish a further consultation document later in 2020. 

Although the paper does not set out a definitive approach for the future UK regime, it does provide some early indications regarding where the UK regulator might take a different approach from current practice (e.g. under IFPRU or BIPRU) and the default provisions of IFD/ IFR. We, therefore, consider it a ‘must read’ for anyone with responsibility for, or advising on, reward issues at any UK investment firm.

Main remuneration points to note

The paper anticipates that a new remuneration code would be adopted for solo-regulated firms, based on the substance of the IFD/IFR regime, but adapted for the UK market, where necessary. The new remuneration code would replace the existing IFPRU and BIPRU remuneration codes.

The timetable for implementation of the new regime is vague. The paper notes that firms are expected to comply with the existing IFPRU and BIPRU remuneration codes until the new code comes into effect. The date of application for the new UK regime will become clearer when the follow-up consultation is issued later this year.

The key remuneration-related amendments in the discussion paper are as follows:

Application: The paper does not attempt to cover those investment firms which would still remain subject to the CRD/CRR regime, i.e. firms considered to be of systemic importance by virtue of their size and complexity. The FCA plans to consult “in the coming weeks” on how the existing remuneration rules will be adapted for those firms.

At the other end of the spectrum, a small and non-interconnected investment firm (SNI) will not normally be subject to the remuneration requirements of IFD (although it can be caught if it is part of a group which includes a larger non-SNI firm). It appears that the UK will follow the same approach, although it remains to be seen precisely how the FCA will calibrate the classification system which would, in turn, determine which firms will be in/out of scope for the remuneration requirements.

Proportionality: The text of the IFD envisages that some firms and/or individuals will be exempt from some of the provisions regarding variable remuneration (the provisions on pay-out, deferral and pensions holding/retention periods), either by way of specific firm/individual exemptions or application of a general principle of proportionality.

Under IFD, a firm level exemption is potentially available for firms with average on-and off-balance sheet assets of EUR 100 million or less over a 4-year period. The FCA has suggested that it, if it is given the relevant powers by the government, then it would increase this threshold for UK firms to a level of EUR 300 million (as is provided for within the text of IFD). Either way, this will be a significant reduction from the current approach, e.g. the IFPRU/BIPRU firms with relevant total assets up to GBP 15 billion are able to disapply equivalent provisions regarding variable remuneration.

An individual level exemption is also available under the IFD regime for individuals whose annual variable remuneration is EUR 50,000 or less and represents 25% or less of that individual’s total annual remuneration. Again, this is significantly lower than the current thresholds set out in the IFPRU/BIPRU remuneration codes, i.e. total remuneration no more than GBP 500,000 of which no more than 33% is variable remuneration. The FCA has simply invited feedback on the effect of this change but it acknowledges that if an IFD-compliant approach were implemented, “it is likely that individuals would be brought into scope of the provisions on pay-out and deferral who do not currently apply our rules on these matters”.

The paper also notes that the wording of the IFD allows for a ‘general proportionality principle’ which would potentially replace the existing ‘remuneration principles proportionality rule’ which forms part of the IFPRU and BIPRU remuneration codes. In the view of the FCA, the new principle is narrower than the existing rule and, therefore, “investment firms may not disapply any of the remuneration principles in whole or in part on the basis of the general proportionality principle alone”.

Material risk takers (MRTs): The FCA intends to develop technical standards for the identification of MRTs and build upon the EBA’s draft technical standards. Indeed, the EBA has recently developed final technical standards on identifying MRTs for the purposes of CRD V (as  explained above). We anticipate that the PRA will issue guidance for identification of MRTs at credit institutions in the coming months (this is likely to be indicative of the approach which UK regulators will also take towards investment firms).

Remuneration principles: It appears that the FCA will replicate the key remuneration principles of IFD in the UK regime, including the following:

• Policies must be consistent with, and promote, sound and effective risk management, take into account the long-term effects of investment decisions, and encourage responsible conduct and prudent risk-taking.
• Firms will be required to establish a remuneration committee (note that the FCA has interpreted this requirement as being subject to the modified threshold which they are considering increasing to firms with average on-and off-balance sheet assets of EUR 300 million).
• Set an appropriate ratio between variable and fixed remuneration (the FCA does not intend to provide further guidance on what it considers an ‘appropriate ratio’ to be).

Performance criteria for variable remuneration: The FCA expects to clarify in guidance that:

• a 50/50 split between financial and non-financial criteria “will be appropriate for some investment firms, while a different split may better suit others”;
• non-financial performance criteria should, where appropriate, override financial criteria;
• conduct metrics should make up a “substantial portion of” non-financial performance criteria; and
• non-financial performance criteria should assess how an individual adheres to effective risk management and regulatory requirements.

Risk adjustment: The text of the IFD requires that risk adjustment is part of the process when measuring performance to calculate variable remuneration. The new UK regime will also include a requirement to apply risk adjustment and the FCA intends to consult on guidance to clarify its expectation of firms. It also notes that, in its view, risks will include both financial and non-financial risks, “such as reputation, conduct and client outcomes”.

Pay-out in shares or other instruments: The IFD requires that at least 50% of an individual’s remuneration be paid in shares or other non-cash instruments. However, some firms do not issue any instruments which meet the requirements set out in the text of the directive. The IFD therefore allows member states to provide for the use of ‘alternative arrangements’ and the FCA has indicated it would also be willing to operate a similar mechanism. It plans to issue guidance based on the approach taken by the EBA in its technical standards (see our previous briefing), subject to amendment for the UK market.

Deferral: The FCA has indicated that it intends to include IFD-compliant deferral terms in the new UK  remuneration code (e.g. at least 40% of the variable remuneration deferred for 3 to 5 years, at least 60% deferred where variable remuneration is ‘a particularly high amount’, deferred variable remuneration must not vest faster than on a pro-rata basis).

Early indications from the FCA are that it:

• expects that firms will have a group or firm-wide policy on deferral;
• currently considers variable remuneration of £500,000 as being a ‘particularly high amount’ for the purpose of deferral; and
• is aware of the potential tax complications for partnerships and LLPs as a result of deferral (hinting that there may be scope to introduce a similar tax mechanism that currently applies to AIFMs).

Ex post risk adjustment: The IFD requires firms to be able to make ex-post risk adjustments to variable remuneration (including malus and clawback). However, it is for each investment firm to determine the criteria for when these would apply (the IFD specifies situations such as individual misconduct leading to significant losses). The FCA acknowledges that those firms which do not currently have malus/ clawback provisions in their incentive plans will require guidance and intends to consult on new guidance on ex-post risk adjustment (including triggers, scope of application, clawback periods, etc.).

Non-performance-related variable remuneration: The IFD also includes requirements for variable remuneration which is not linked to performance (e.g. a prohibition on the award of guaranteed bonuses other than for newly recruited staff). The paper acknowledges those requirements will “likely” be included in the new remuneration code, “and clarify our expectations of firms in accompanying guidance”.

Disclosure and reporting: The IFD requires competent authorities to collect certain information from firms (e.g. senior management/ MRT remuneration, gender pay gap). The FCA is considering whether to collect this information by requiring firms to complete templates and plans to issue a consultation on reporting requirements.

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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