The European Union has had its sights set on regulating executive pay for many years. Following the 2007–2008 global financial crisis, the Financial Stability Board (FSB) published Principles for Sound Compensation Practices in April 2009 and Principles for Sound Compensation Practices – Implementation Standards in September 2009. The EU, as a member of the FSB, quickly asserted that incentive arrangements were a significant factor motivating the excessive risk-taking that allegedly led to the crisis and introduced significant regulatory controls over pay in the financial services sector.
EU-wide regulation is intended to ensure a consistent approach throughout all Member States. The EU believes this is crucial due to competitive pressures in the financial services sector and the fact that many firms have cross-border operations. The initial focus of this regulation was on credit institutions and the largest investment firms. However, the EU has since expanded regulation to other subsectors, including asset managers and insurers.
The EU has also produced legislation that impacts pay for companies outside of the financial services sector. This legislation includes share dealing rules under the Market Abuse Regulation (MAR), securities laws under the EU Prospectus Regulation (EUPR) and corporate governance developments under the Shareholder Rights Directive (SRD), as recently amended by the new Shareholder Rights Directive II (SRD II).
EU requirements are highly detailed and change frequently. This chapter is not intended to be comprehensive but will alert readers to relevant issues and developments that they should be aware of.
II RULES FOR CREDIT INSTITUTIONS AND INVESTMENT FIRMS
In 2010, the EU adopted the Capital Requirements Directive (CRD) III.2 This Directive3 created the bulk of the rules that regulate the remuneration of executives and material risk-takers in EU-regulated credit institutions and certain investment firms. The rules were based on the FSB principles and significantly changed how those firms pay their staff.
Further rules were added in CRD IV.4 One significant addition was a cap on the variable pay of material risk-takers, known as the bonus cap. When CRD IV was introduced, the EU also adopted the Capital Requirements Regulation (CRR) to harmonise remuneration disclosure by CRD-regulated firms.5
CRD and CRR rules must be read in conjunction with the guidelines on sound remuneration policies published by the European Banking Authority (EBA) in June 2016. These guidelines clarify expectations under CRD and CRR and also impose additional rules.
These rules will be subject to significant change over the next few years as a result of the upcoming CRD V and CRR II, and the Investment Firms Directive (IFD) and Investment Firms Regulation (IFR).
CRD and CRR apply to EU-regulated credit institutions and certain investment firms.
Although some of the rules set out under CRD and CRR apply on a firm-wide basis, a number of requirements apply only to staff members 'whose professional activities have a material impact on their employer's risk profile' (identified staff or material risk-takers), that is, senior management, other risk-takers, employees in control functions, and employees in the same remuneration bracket as senior management and risk-takers. In 2014, the EU published regulatory technical standards to clarify the identification of material risk-takers under CRD and CRR. The technical standards use qualitative and quantitative criteria to identify staff.6
A key concept of CRD is the proportionality principle. It is recognised that firms may apply the rules differently according to their size, internal organisation and the nature, scope and complexity of their activities. In practice, this typically results in the disapplication of certain rules. There is currently an inconsistent application of the proportionality principle throughout the EU, but this will change in the future and become more consistent (see subsection iv).
CRD seeks to encourage effective risk management and avoid short-term gain at the expense of long-term results. CRD includes requirements that:
- there is an appropriate ratio between fixed and variable remuneration. This includes the bonus cap, which limits material risk-taker variable pay to 100 per cent or, with shareholder approval, 200 per cent of fixed pay. The shareholder approval is subject to specific conditions and formalities. When calculating the bonus cap, a Member State may allow a discount to be applied up to 25 per cent of total variable remuneration, provided it is paid in instruments deferred for at least five years;
- total variable remuneration cannot limit the ability of a firm to strengthen its capital base;
- where remuneration is performance-related, it must be assessed over a multi-year framework and be based on a combination of the assessment of the performance of an individual, the business unit concerned and the overall results of the firm. When assessing individual performance, financial and non-financial criteria must be taken into account;
- 40 to 60 per cent of variable remuneration must be deferred for at least three to five years and must be aligned with the nature of a business, its risks and the activities of the relevant member of staff;
- at least 50 per cent of each of the deferred and non-deferred portions of variable remuneration must be delivered in shares or equivalent ownership interests, or certain other permitted instruments;
- any instruments awarded must be subject to an appropriate retention policy designed to align incentives with the longer-term interests of a firm;
- variable remuneration must only be paid or vest if it is sustainable according to the financial situation of a firm and is justified on the basis of the performance of the institution, business unit and individual concerned. Firms must set up adjustment mechanisms, including malus (to reduce or forfeit unvested remuneration) and clawback (to recover paid or vested variable remuneration);
- guaranteed bonuses must be exceptional, occur only when hiring new staff and where an institution has a sound and strong capital base, and be limited to the first year of employment;
- termination payments must reflect performance achieved over time, and not reward failure or misconduct;
- staff must not use personal hedging or insurance that undermines the risk alignment effects of the rules; and
- specific rules apply to any discretionary pension benefits paid.
CRD also contains rules relating to remuneration policies and governance, including requirements that the implementation of the remuneration must be subject to an annual independent internal review, that control functions are remunerated independently of the performance of the business areas that they control, and that certain significant firms, in terms of their size, internal organisation and the nature, scope and complexity of their activities, establish a remuneration committee.
The EBA guidance that supplements CRD and CRR also contains clarifications and additional requirements, including a prohibition on the payment of interest or dividends on deferred instruments.
Substantive qualitative and quantitative remuneration disclosure requirements are found in CRR. Firms must publicly disclose remuneration information at least annually, either in a standalone report or in the firm's annual report.
Qualitative disclosures include information about the decision-making process for determining remuneration policy, information about the link between pay and performance, and the most important remuneration design characteristics, including information on deferral policy and vesting criteria.
Quantitative information is broken down by business area and identified staff category and includes:
- amounts of fixed and variable remuneration;
- amounts and forms of variable remuneration, split into cash, shares, share-linked instruments and other types;
- amounts of deferred remuneration awarded during the financial year; and
- amounts of sign-on and severance payments awarded.
Firms must also disclose the numbers of individuals remunerated €1 million or more per financial year. Remuneration between €1 million and €5 million is broken down into pay bands of €500,000 and remuneration of €5 million and above is broken down into pay bands of €1 million.
iv Upcoming changes
The regulation of pay within credit institutions and investment firms will be significantly impacted by two legislative packages.
The first legislative package is the latest revision of CRD and CRR in the form of CRD V and CRR II.7 The revised legislation entered into force on 27 June 2019 and CRD V, as a directive, must be implemented by Member States by 28 December 2020, applying from the following day. In practice, it is expected that the updated remuneration rules will apply to the first performance year beginning on or after 1 January 2021 but, at the time of writing, this is not certain. CRD V and CRR II will continue to apply to credit institutions and certain investment firms. The material changes to the current CRD and CRR regime include the following:
- further clarity has been added, and will continue to be added through further regulatory technical standards, to identify staff who have a material impact on a firm's risk profile;
- listed firms may award share-linked instruments that track the value of shares. This was previously only available to non-listed firms;
- the minimum deferral period has increased from three to four years and, for members of the management body and senior management in significant firms, to five years;
- the concept of proportionality has been amended to remove ambiguity and to increase consistency across the EU. The ability to disapply the requirements to pay a portion of variable remuneration in instruments and to defer a portion of variable remuneration will only be available for:
- a firm that is not a large institution and whose average asset value is equal to or less than €5 billion over the four years preceding the current financial year (although a Member State may change this threshold to up to €15 billion); and
- a staff member whose variable remuneration does not exceed €50,000 and is no more than one-third of total annual remuneration;
- remuneration policies and practices must be gender neutral;
- the quantitative information that must be disclosed will need to be more granular than under the existing rules. For example, separate information on the amounts and forms of each of the upfront and deferred portions of variable remuneration will need to be disclosed instead of aggregating both portions; and
- there are disclosure requirements relating to the application of the new concept of proportionality.
The second legislative package is the new prudential regime for investment firms, comprising the IFD and IFR.8 Although the IFD and IFR were adopted by the European Parliament in April 2019, the timing of entry into force and the implementation deadline was unknown at the time of writing. Clarity should be available in Q4 2019. The IFD and IFR rules will apply to certain investment firms. The material changes to the current CRD and CRR regime include the following:
- investment firms will fall into one of three categories. The category will impact the regulation of pay within a firm. The first category of firms, which consists of the largest and most systemically important investment firms, as determined by reference to set criteria, will be subject to the CRD and CRR remuneration rules instead of the new IFD and IFR requirements. The second category of firms, which consists of small and non-interconnected investment firms, as determined by reference to set criteria, will not be subject to the CRD and CRR or IFD and IFR remuneration rules, and will instead be subject to principles-based remuneration guidelines and certain sales incentives remuneration requirements. The third category, which consists of firms that are not in either of the other categories, will be subject to the new remuneration rules under IFD and IFR;
- there is no set bonus cap, although firms must set their own appropriate ratio between fixed and variable remuneration;
- listed firms can use share-linked instruments and there is also a new ability to use non-cash instruments that reflect the instruments of the portfolios managed;
- similar to CRD V, the concept of proportionality has been amended to remove ambiguity and to increase consistency across the EU. The ability to disapply the requirements to pay a portion of variable remuneration in instruments and to defer a portion of variable remuneration will only be available for:
- a firm where its balance sheet assets are, on average, equal to or less than €100 million over the immediately preceding four-year period; and
- a staff member whose variable remuneration does not exceed €50,000 and is no more than one-fourth of total annual remuneration;
- remuneration policies and practices must be gender neutral and any remuneration committee must be gender balanced; and
- the quantitative, qualitative and derogation disclosure obligations are similar to those under CRR II, but certain requirements are not replicated, meaning that the disclosure burden is reduced. For example, the obligation to publicly disclose numbers of individuals remunerated €1 million or more per financial year, broken into pay bands, is not contained in IFR.
III RULES FOR ASSET MANAGERS
i Alternative Investment Fund Managers Directive
Firms authorised to conduct regulated activities under the Alternative Investment Fund Managers Directive (AIFMD)9 will be subject to the applicable remuneration rules implemented in 2013. The AIFMD remuneration rules have to be read in conjunction with the 'guidelines on sound remuneration policies' published by the European Securities and Markets Authority (ESMA) in February 2013, as amended in March 2016.
The remuneration rules apply to all alternative investment fund managers (AIFMs) authorised under AIFMD, that is, to all EU AIFMs that manage or market alternative investment funds (AIFs) regardless of whether they are EU or non-EU AIFs. This includes managers of hedge, private equity, venture capital, commodity, infrastructure and real estate funds. Like CRD, although some AIFMD remuneration rules apply on a firm-wide basis, a number of requirements apply to the remuneration of those categories of staff whose professional activities have a material impact on the risk profiles of the AIFMs or of the AIFs they manage, including senior management, risk-takers, control functions and employees in the same remuneration bracket as senior management or risk-takers.
As with CRD, the AIFMD rules are based on the FSB principles and are broadly the same, and therefore broadly align with the CRD requirements. There are, however, key exceptions. For example, for AIFMD firms:
- there is no bonus cap;
- the minimum non-cash instrument requirement must be paid in units or shares of the AIF concerned, equivalent ownership interests, or share-linked instruments or equivalent non-cash instruments; and
- the deferral period for deferred remuneration must be linked to the life cycle of the underlying AIF.
Again, as with CRD, certain AIFMs must establish a remuneration committee. In terms of disclosure, any AIFM seeking to obtain authorisation under the AIFMD must disclose details of its remuneration policies and practices to its national regulator, and must also annually disclose specific remuneration information for each EU AIF it manages and each AIF it markets in the EU.
Remuneration requirements under the Undertakings for the Collective Investment in Transferable Securities Directive V (UCITS V)10 mirror corresponding requirements under AIFMD. The UCITS rules were implemented in 2016. UCITS V bridges the regulatory disparity between AIFs and undertakings for the collective investment in transferable securities (UCITS) in the EU. The UCITS V remuneration requirements have to be read in conjunction with the guidelines on sound remuneration policies published by ESMA in October 2016.
UCITS V applies to UCITS and their management companies. Like CRD IV and the AIFMD, although some remuneration rules under UCITS V apply firm-wide, some requirements apply only to the remuneration of those categories of staff whose professional activities have a material impact on the risk profiles of the UCITS management company or of the UCITS that they manage, including senior management, risk-takers, control functions and employees in the same remuneration bracket as senior management or risk-takers.
Like CRD IV and the AIFMD, the UCITS V rules are based on the FSB principles and are broadly the same, and therefore broadly align with the CRD requirements. There are, however, key exceptions. For example, for UCITS firms:
- there is no bonus cap;
- the minimum non-cash instrument requirement must be paid in units of the UCITS concerned, equivalent ownership interests, or share-linked instruments or equivalent non-cash instruments; and
- the deferral period is at least three years (as opposed to three to five years).
As with CRD IV and the AIFMD, certain UCITS management companies must establish a remuneration committee. UCITS V also requires certain disclosures:
- a UCITS prospectus detailing remuneration policy, methods of remuneration calculation and information about those responsible for remuneration;
- an annual report containing information about total remuneration for the financial year and material changes to the remuneration policy; and
- key investor information.
IV RULES FOR INSURERS AND REINSURERS
Remuneration rules for insurance and reinsurance businesses are found in the Solvency II Regulation,11 supplementing the Solvency II Directive.12 The European Insurance and Occupational Pensions Authority has provided guidance on corporate governance under Solvency II, including on the scope of remuneration policy and composition of remuneration committees.
Under the Solvency II Regulation, an insurance or reinsurance undertaking must adopt a written remuneration policy. When establishing and applying that policy, the undertaking must ensure the policy promotes sound and effective risk management and does not encourage risk-taking that exceeds the risk tolerance limits of the undertaking. The policy must apply to the undertaking as a whole and contain specific arrangements that take into account the tasks and performance of the administrative, management and supervisory body, persons who effectively run the undertaking or have other key functions, and other categories of staff whose professional activities have a material impact on the undertaking's risk profile.
The remuneration provisions are not as stringent as under other sets of rules. However, there are wide-ranging requirements, including the requirement to establish an independent remuneration committee, the requirement for an appropriate balance of fixed and variable remuneration, the measurement of performance-related variable remuneration based on the performance of individuals, the relevant business unit and the overall results of the undertaking, and a minimum deferral period of three years.
V RULES FOR SALES INCENTIVES
A recent focus of EU regulation is sales incentives. In December 2016, the EBA published guidelines on remuneration related to the sale and provision of retail banking products and services. In 2017, the EU published a regulation13 supplementing MiFID II.14 The regulation provides remuneration rules in relation to all persons who could impact service provision or firm corporate behaviour within firms providing investment services, including front-office, sales or other staff indirectly involved in providing investment or ancillary services. The MiFID II provisions and EBA guidance cover similar trends.
When providing sales incentives, firms should ensure that they:
- do not remunerate or assess performance in a way that conflicts with duties to act in clients' best interests;
- do not use, inter alia, remuneration structures or sales targets that could provide incentives to recommend a particular financial instrument to a retail client when the firm could offer a different financial instrument that would better meet clients' needs;
- design and implement remuneration policies that have appropriate criteria to be used to assess performance, including qualitative criteria encouraging acting in clients' best interests;
- define and implement remuneration policies and practices under internal procedures that take account of the interests of all clients of a firm, ensuring clients are treated fairly and their interests are not impaired by remuneration practices adopted in the short, medium or long term;
- do not create remuneration policies that create a conflict of interests or incentives that may lead relevant persons to favour their own interests or their firm's interests to the potential detriment of any client; and
- ensure that remuneration and similar incentives are not solely or predominantly based on quantitative commercial criteria, and instead take into account appropriate qualitative criteria reflecting compliance with the applicable regulations, the fair treatment of clients and the quality of services provided to clients.
The MiFID II rules also require that the management body approves the firm's remuneration policy, and that senior management takes responsibility for day-to-day policy implementation and for monitoring compliance risks.
The latest set of rules impacting sales incentives is the Insurance Distribution Directive15 which took effect from 1 October 2018. Under the IDD, insurance distributors must not be remunerated, or remunerate or assess the performance of their employees, in a way that conflicts with their customers' best interests. In particular, remuneration arrangements or sales targets must not provide an incentive to recommend a particular insurance contract where a different insurance contract is available that could better meet a customer's needs.
VI OTHER AREAS OF EU REGULATION IMPACTING EXECUTIVE PAY
i Market abuse
MAR16 came into effect on 3 July 2016 and reformed the EU market abuse regime. Much of MAR focuses on general market abuse provisions, such as insider dealing or market manipulation. However, the rules also impact the operation of incentive plans. MAR includes notification and disclosure requirements for persons discharging managerial responsibilities (PDMRs) working within issuers linked to EU regulated markets and for persons closely associated (PCAs) with a PDMR.
The rules include requirements for PDMRs and PCAs to notify the issuer and the relevant competent authority within three days of every transaction conducted on their own account relating to shares or debt instruments, or linked derivatives, of that issuer. The issuer must notify the market within the same time period. The rules also provide for 'closed periods' during which PDMRs cannot deal in securities of the issuer, subject to limited exemptions.
ii Corporate governance
The EU also has a strong focus on corporate governance. In 2007, the EU published the Shareholder Rights Directive (SRD).17 The SRD aims to improve corporate governance in EU companies traded on regulated markets by enabling shareholders to better exercise voting rights across borders. The rules cover a wide range of formalities for general meetings, including minimum notice periods, information requirements and voting rules.
The SRD was amended in June 2017,18 requiring Member States to implement the amendment into national law by 10 June 2019 (SRD II). SRD II establishes a range of corporate governance rules, including an obligation for companies to publish a directors' remuneration policy subject to a shareholders' vote. Member States may determine whether this vote is binding or advisory, but a vote must be held whenever the policy is amended and at least every four years. Companies must also publish a clear and understandable directors' remuneration report annually, which is subject to an advisory shareholders' vote.
iii Securities laws
The offer of securities to the public within the EU is governed by the EUPR,19 which replaced the EU Prospectus Directive in full on 21 July 2019. Under the EUPR, a prospectus is required for an offer of securities unless an exemption applies.
An offer of securities by a company to its existing or former employees or directors, or to those within its group, will be exempt from the prospectus requirements under an employee exemption contained within the EUPR, provided that a document is made available to individuals containing information on the number and nature of the securities, and the reasons for and details of the offer or allotment. Prior to 21 July 2019, the employee exemption was only available to companies that were headquartered or listed in the EU.
iv General Data Protection Regulation
The General Data Protection Regulation20 (GDPR) came into force on 25 May 2018. GDPR gives individuals greater rights in relation to the processing of their personal data and has widespread application wherever personal data processing takes place. Executive remuneration structures will be caught by GDPR. Companies based in the EU or with employees in the EU should review their remuneration structures to ensure all personal data processing is compliant with GDPR.
VII CONCLUSION AND OUTLOOK
EU regulation of executive remuneration and corporate governance is evolving rapidly. Even though financial services have been the primary target, executive remuneration in all sectors is a sensitive and politically charged issue, as evidenced by the recent corporate governance developments and the upcoming changes for credit institutions and investment firms.
Good governance and robust pay structures can improve accountability and transparency and encourage more open dialogue with shareholders. However, there can be unintended consequences, particularly with regard to prescriptive regulation on financial services pay. Other sectors, such as the technology sector, have flexibility around how they pay their staff, enabling them to attract the most talented people. To compete with these sectors, many banks have significantly increased fixed pay to continue to offer competitive remuneration packages despite the bonus cap, increasing the fixed liabilities of those firms. In addition, some firms have supplemented salaries and bonuses with new forms of remuneration, including role-based or fixed-pay allowances, which the EU has acted to regulate. The upcoming changes may only increase the burden and related issues.
The EU has probably the most prescriptive financial services remuneration rules in the world. Time will tell whether this has the intended impact of reducing risk in the sector, or whether it, along with other regulations affecting the sector, has the impact of making a job in the financial services sector less attractive than it was in the past.
1 Janet Cooper is a partner and Matthew Hunter and Stephen Penfold are associates at Tapestry Compliance Limited.
2 Directive 2010/76/EU, amending Directives 2006/48/EC and 2006/49/EC.
3 Directives direct Member States to implement national law to give effect to objectives set out in the Directive within a set time frame. National implementation can give rise to inconsistent implementation around the EU.
4 Directive 2013/36/EU, amending Directive 2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC.
5 Regulation (EU) No. 575/2013. Regulations directly apply to regulated entities and Member States and do not require transposition into the laws of each Member State.
6 Commission Delegated Regulation (EU) No. 604/2014.
7 Directive (EU) 2019/878 and Regulation (EU) 2019/876, respectively.
8 The final legislation has not yet been formally published at the time of writing.
9 Directive 2011/61/EU.
10 Directive 2009/65/EC, as amended, in particular by Directive 2014/91/EU.
11 Commission Delegated Regulation (EU) 2015/35.
12 Directive 2009/138/EC.
13 Commission Delegated Regulation (EU) 2017/565.
14 Directive 2014/65/EU.
15 Directive (EU) 2016/97.
16 Regulation (EU) 596/2014.
17 Directive 2007/36/EC.
18 Directive 2017/828.
19 Regulation (EU) 2017/1129.
20 Regulation (EU) 2016/679.