AREAS DE ESPECIAL SIGNIFICANCIA AMBIENTAL

4.3.2.3.2.1 The Code’s general requirements

The general rule has not been changed in the new Code, which states that “[a] firm must establish, implement and maintain remuneration policies, procedures and practices that are consistent with and promote effective risk management”,109 as this represents the central tenet of the Remuneration Code. The Code wants firms to avoid remuneration structures that could create incentives for employees to take excessive risk to increase bonuses and endanger the firm’s sustainable growth. A firm’s remuneration proposals would be measured against this rule and firms are expected to use the general rule as the first point of consideration and apply it to all staff in the firm.110 Firms are also advised to have regard for the guidelines on remuneration and corporate governance published by other bodies, such as the ABI and the NAPF.111 Despite the fact that the regulators asserted that the ABI and NAPF guidelines are valuable, they are not binding and are limited to the remuneration of executive directors.112 This did not support the regulators’ aim to extend the remit of remuneration committees to cover remuneration practices on a company-wide basis.

The general rule is supplemented with principles to assist firms to comply with this. These principles are mainly intended to prevent remuneration structures that encourage decision making on a short-term basis or without due regard to risk, and to encourage those that take

107 _{FCA, “General guidance on proportionality” (n 104) para 29.}

108 _{Financial Services Authority, “General guidance on proportionality: the remuneration code (SYSC19A) and}

pillar 3 disclosures on remuneration (BIPRU 11)” September 2012.

109 _{FSA, CP 09/10 (n 53) para 5.8.} 110 _{ibid para 3.29.}

111 _{SYSC, 19A.2.2.G(2).} 112

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into account long-term effects on the business.113 The principles have rules and sometimes evidential provisions which can show whether a firm is applying the general rule or not. However, the principles under the FSA updated Code are more prescriptive and intrusive than those of the previous Code, and they rely more heavily on rules rather than evidential provisions. In other words, the principles will be used to assess the quality of a firm’s remuneration policies and whether they encourage excessive risk-taking as the means of determining their compliance with the general rule. The principles are also supplemented with guidance to help firms with implementation.

The principles deal with risk management, governance, capital, government intervention, risk adjustment, pensions, hedging and avoidance, remuneration structures, and the effects of breaching the principles.

4.3.2.3.2.2 Risk management and control function

Firms must ensure that their remuneration policy is consistent and promotes effective risk management, aligns with business strategy, objectives and long-term corporate value and does not lead to conflicts of interest at any level, encourage excessive risk-taking, or exceed the firm’s tolerated level of risk.114

To ensure effective risk management overseeing, the Code urges firms to separate the remuneration of those employees in a control function from the remuneration of the business area they oversee to allow them to be independent and focus on long-term growth.115

Moreover, the Code obliges firms to ensure that the remuneration of senior officers in risk management and compliance functions is overseen by the remuneration committee or the governing body directly.116 However, achieving the right balance between risk-taking and risk management will represent a difficulty for firms, especially with the separation of the remuneration between front and back offices. More risk-taking translates to more financial growth in the short-term but this may or may not be the same case in the long term. Judging

113 _{Y Hausmann and E Bechtold-Orth, “Changing remuneration system in Europe and the United States: a legal}

analysis of recent developments in the wake of the financial crisis” (2010) 11(2) European Business Organization Law Review 195, 203 & 204.

114 _{SYSC, 19A.3.7-19A.3.9.} 115 _{SYSC, 19A.3.14.} 116

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precisely what leads to long-term growth in the absence of an accurate long-term measure117 is a very challenging task; adopting a very conservative risk management policy will result in less financial growth in the short term but not necessarily encourage greater growth in the long term. Therefore, this separation should be re-examined in more detail to ensure objectivity and involvement, as the proposed separation and increase in base pay might serve to ensure the detachment of risk management and compliance officers from the business. 4.3.2.3.2.3 The governing body

The principles are also concerned with aspects of governance. The Code only requires significant firms to have remuneration committees. The remuneration committee or governing body in smaller firms is responsible for adopting and periodically reviewing the general principles of the remuneration policy. The members of the remuneration committee must be members of the board who do not perform executive functions. They must be independent, skilled and experienced enough to exercise competent and independent judgement in preparing the decision for the board, taking account of the implications for risk management, capital, and liquidity as well as the long-term interests of shareholders, investors, and other stakeholders in the firm and in the public interest.

However, the Code states this rule without suggesting any solutions in the case of a conflict of interests between these interests.118 For example, what might be in the interests of shareholders might not be in the interests of other stakeholders and since the Code does not suggest any hierarchy, firms may not be able to give proper consideration to other interests, especially when common law favours shareholder primacy.119 Concerns were also raised that there might be a shortage of non-executive directors with the relevant experience to sit on remuneration committees given this increased responsibility, which would make it difficult for firms to comply with this principle.120 The Code also urged firms to allow risk management and compliance functions to have appropriate input into the setting of

117

Note that share price is suggested as an indicator of long-term growth. However, share prices are affected by a number of factors, some of which are beyond a firm’s control, especially in inefficient markets.

118 _{SYSC, 19A.3.10-19A.3.12.}

119 _{The Companies Act 2006, section 172.} 120

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remuneration policies to help the remuneration committee or the governing body to align the remuneration policy with effective risk management.

4.3.2.3.2.4 The relationship between the firm’s capital and variable remuneration

The Remuneration Code tries to restrict the effect of variable remuneration on the ability of a firm to build its capital. The Code also has some rules which relate to institutions receiving government aid. The Code requires institutions which receive exceptional government intervention to limit variable remuneration as a percentage of net revenues and to stop paying variable remuneration to any members of senior management who were in office at the time of the intervention unless it is justified.121 This rule can be seen as a way of terminating the existing contracts of the existing senior management of a firm which has received exceptional government intervention, as they are more likely to transfer to another firm where they can have variable remuneration; however it does not prevent firms which have received government intervention from hiring new talented managers and paying them a variable remuneration. However, the principle did not differentiate between managers as all of the existing managers will be precluded from receiving variable remuneration when their firm receives government aid while some may be in some departments which did not cause the loss to the firm and they will be precluded from variable remuneration due to errors made by other people.

4.3.2.3.2.5 Risk adjustment of remuneration

The updated Code focuses not only on the ex-post measure of aligning remuneration outcome with risk outcome, but also pays attention to the ex-ante measure. This means that when measuring performance for the purpose of determining the variable remuneration to adjust the remuneration to those risks, firms need to take account of all types of current and future risks, especially the cost and quantity of capital, and the liquidity required.122 The Code leaves firms to decide which risk adjustment measure is appropriate to use depending on the firm’s risk profile. However, firms will be asked to provide the regulators with details of all adjustments that are used by the firm under a formulaic approach as well as applying

121 _{SYSC, 19A.3.20.} 122

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qualitative judgements in the final decision about performance-related components of variable remuneration.

4.3.2.3.2.6 Discretionary pensions and avoidance

The Code has also introduced a rule for discretionary pensions. A discretionary pension is different from a standard pension entitlement and a firm’s financial contribution schedule, being a non-standard one-off payment on an individual basis that is deemed to be of a variable nature.123 The Code obliges firms which grant discretionary pensions to leaver or retired employees to be paid in specified instruments124 and held by the firm for five years.125 The updated Code has introduced provisions to cover avoidance and hedging. Hedging and insuring the risk of deferred remuneration or using it as collateral for a non-recourse loan could undermine the effect of deferral. The Code urges firms to ensure that their employees do not take out an insurance contract on their remuneration to transfer the risk to a third party in exchange for payment. However, the Code has simply placed the onus on firms to ensure that they have effective arrangements to ensure compliance, which can be very difficult to implement.

4.3.2.3.2.7 The structure of remuneration

Principle 12 is concerned with the structure of remuneration and covers a range of issues related to performance assessment and adjustment, deferral, guarantees, retention, leverage, and payment related to early termination. The Code restates the main objective that the structure of remuneration must be consistent and promote effective risk management.126 However, rules covering guaranteed variable remuneration, payment of remuneration in shares or other capital instruments, deferral and performance adjustment do not apply to Code Staff who fulfil two conditions. The first is that his or her variable remuneration is less than 33 per cent of total remuneration and the second is that his or her total remuneration does not exceed £500,000.127 As part of introducing the new remuneration provisions of CRD IV into 123 _{FSA, CP10/19 (n 20) para 3.53.} 124 SYSC, 19A.3.47. 125 _{SYSC,19A.3.29.} 126 _{SYSC, 19A.} 127 _{SYSC, 19A.3.34.}

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the Code the regulators have required firms to make a clear distinction between criteria for determining fixed and variable pay.

The Code wants a departure from using revenue to measure performance to using profit for a number of reasons. The most important is to force employees to pay sufficient regard to the quality of business undertaken and services provided and their appropriateness for clients.128 The Code urges that when calculating the bonus pool current and future risk adjustment should be included. In addition, the cost of capital employed and liquidity required should be taken into account. Moreover, long-term performance should be a significant part of the performance assessment process, based not solely on financial measures but also non- financial measures (especially those related to risk management and compliance). The Code emphasises that long-term performance should be assessed using a moving average of results or by using a deferral technique. It also stresses that some measures of performance, such as EPS and TSR, have a short-term focus and are risky, even if they are based on a two- to four- year period as firms tend to increase leverage to ensure a higher return.

The Code wants firms to move away from only using financial measures to assess performance. Assessment of performance in the Code’s view must be based on the performance of the individual, the business unit and the overall results of a firm in a multi- year framework, and should include non-financial criteria related to the adherence to effective risk management and compliance with the regulatory system.129 However, this provision might be challenged by shareholders who are granted a binding vote regarding remuneration policy. Shareholders, especially those with short-term prospects, are more likely to vote against a policy which favours such non-financial criteria.

Another important issue is that the Remuneration Code instructs firms to stop payment of variable remuneration when financial performance is poor. However, the payment of such variable remuneration is unlikely to be justified by non-financial performance because Principle 12(h) asks firms to reduce unvested remuneration in the case of a downturn in the financial performance of a business unit.130 The relationship between determining employee

128 _{FSA, CP 09/10 (n 53) 32.} 129 _{SYSC, 19A.3.36-3.39.} 130

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remuneration and the use of non-financial measures is not completely clear in the Code even it has recommended the use of balanced scorecard. Moreover, despite the importance of using non-financial measures to assess performance, it is unclear how it can be verified if firms overuse these.

The use of surveys or the benchmarking of other firms is based on current financial performance or, in other words, it is a short-term comparison between firms which will be more likely to put a firm with more effective risk management at the bottom of the table but the same company might be at the top after a few years as a result of taking a longer-term perspective. However, shareholders are generally short-sighted and will demand more change in a firm, which will put pressure on directors to meet shareholder demands to avoid being removed from office. The Code did not place any responsibility on shareholders to adhere to the Code’s principles when exercising their voting power. For example, Carpenter, Cooley and Walter argue that the solution to the remuneration problem in financial institutions should be based on solving the agency problem of risk-shifting between shareholders and society, rather than the traditional view of solving the agency problem between shareholders and management; the Code fails to address this issue.131 However, the PCBS has raised this point, recommending that the Government consult on a proposal to amend section 172 of the Companies Act 2006 to remove shareholder primacy in respect of banks, requiring directors of banks to ensure the financial safety and soundness of the company ahead of the interests of its members.132

The Code prohibits firms from awarding Code Staff a guaranteed variable remuneration unless the company has a sound and strong capital base and the award is consistent with the Code requirement that this is exceptional in the case of hiring new remuneration Code Staff, is limited to the first year only, is not more generous than the award made by the previous employer, and is subject to performance adjustment and deferral.133 Firms are also required to maintain a balance between the variable and fixed components of remuneration, which will be achieved through raising the fixed component of remuneration. However, as part of

131_{J Carpenter, T Cooley and I Walter, “Reforming Compensation and Corporate Governance” in: V Acharya, T}

Cooley, M Richardson and I Walter (eds), Regulating Wall Street, (John Wiley & Sons, New Jersey 2011).

132 _{Joint Committee on Banking Standards, Changing banking for good (2013-14, HL27-I, HC175-I) 42.} 133

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introducing the CRD IV the regulators have incorporated the rules on the ratio between fixed and variable payment by inserting the relevant sections from the CRD IV into the Code and making them applicable to level-one and level-two firms.134

These two rules regarding guaranteed variable remuneration and the balance or maximum ratio contradict each other, as the Code requires firms to stop paying guaranteed variable remuneration but allows them to raise employee salaries which can be a form of guaranteed remuneration or, even worse, may lead to an increase in salary for everyone without the need for a corresponding rise in performance. Having a flexible defined guaranteed variable remuneration is better than having a guaranteed fixed component. The reason given by firms is that the rise in salary increases the fixed cost of running the business whereas variable remuneration can be reduced or increased. So, this will not give firms the flexibility to implement a remuneration policy which rewards success and punishes failure even if the punishment were solely a reduction in the expected variable remuneration. Thus, the rules on balance and guaranteed variable remuneration need to be revised in order to give firms more flexibility to implement their remuneration policy and reduce their fixed costs. Firms should not be asked to have a balance but to provide a rationale for any payment, ensuring this is determined on financial and non-financial performance.

These rules, together with the deferral rule, will have the effect of raising the hiring bonus, which is not prohibited but is limited to the first year, as the firm hoping to attract employees needs to compensate them for the forfeiture of the deferred part of their remuneration. In addition to this, the current employer will not be able to counter an offer if it is made to a key member of staff, despite the regulators’ assertion that they would consider retention bonuses, as there are no clear rules and guidelines about their application in the Code, meaning employers who offer a retention bonus will be in breach of the rules.135 Therefore, this rule will increase the mobility of talented staff as well as making it very expensive and as a result firms facing failure will not have the ability to attract new staff because they would not be able to offer them more than they could expect from their previous employers and they would not be likely to find talented employees who will take such risks to move to a new firm.

134 _{Prudential Regulation Authority, Strengthening capital standards: implementing CRD IV, feedback and final}

rules (PS7/13, December, 2013), (PRA, PS7/13).

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Principle 12(e) obliges firms to ensure that payment for early termination reflects performance achieved over time. This area is also controlled by section 215 of the Companies Act 2006 for directors. This raises the following issue: given that the regulators have no power to amend the Companies Act and this rule contains an indirect amendment of the Companies Act, if the payment was approved by a member of the company or is consistent with the Companies Act 2006, will the firm be considered as being in breach of the rules or will it be exempt given that it had met the Companies Act requirement? If the answer is that