Final EBA Guidelines on sound remuneration policies - … … · · 2016-01-11proportionality to the remuneration provisions of the 4th Capital Requirements Directive ... Final

www.pwc.co.uk

Final EBA Guidelines on sound remuneration policies

December 2015

http://www.pwc.co.uk/


PwC 1

On 21 December 2015 the European Banking Authority (‘EBA’) published its final guidelines on sound remuneration policies (the ‘Guidelines’). These Guidelines are the finalised version of a draft originally published for consultation in 4 March 2015. They will replace a previous set of guidelines prepared by the EBA’s predecessor, the Committee of European Banking Supervisors (‘CEBS’), originally published in December 2010. At the same time the EBA published an opinion (‘the Opinion’) on the application of proportionality to the remuneration provisions of the 4th Capital Requirements Directive (‘CRD4’).

The full text of the Guidelines and Opinion can be found here.

Executive summary Proportionality and the Opinion

Without question, the biggest new development is in relation to the EBA's view on proportionality. To date, most of the European Economic Area (‘EEA’) competent authorities (the ‘National Regulators’) have permitted some key remuneration rules in CRD4 to be ‘neutralised’ through waivers for certain firms or categories of staff, as explicitly permitted under the previous CEBS Guidelines. In the draft Guidelines, the EBA stated that the way National Regulators have enforced the proportionality provisions in the Directive was not, in their view, permitted under the Directive. To address this issue, the Guidelines are accompanied by an Opinion written by the EBA and addressed to the European Commission, Parliament and Council. In this Opinion, the EBA maintains their previous position that neutralisation of rules is not permitted, but recommends that a legislative process is undertaken to amend the Directive. This amendment would make it clear that certain firms are able to apply proportionality in a manner that allows them to disapply rules on minimum deferral and use of instruments (that is to continue to apply proportionality in the manner currently operated in the UK and most other Member States). However, the EBA is explicit in its Opinion that this should allow for the disapplication of the rules on deferral and payments in instruments, but not to the cap on variable pay (the ‘bonus cap’). This will mean that all firms who are subject to CRD4, regardless of size or licence, will be required to apply the bonus cap for their Material Risk Taker (‘MRT’) population. There are further concerns for the asset management community - the drafting of the Opinion strongly implies that the expectation would be that firms could not apply proportionality purely due to the nature of the business that they undertake. This could potentially mean that larger investment firms would no longer be able to rely on the application of proportionality in respect of the CRD4 remuneration requirements. The Guidelines are also explicit that a subsidiary of a significant institution could not apply proportionality, which would essentially remove the re-tiered status of a number of asset and wealth management businesses of large banks in the UK. At the same time, the EBA and ESMA report last week proposed a new approach to the prudential supervision of investment firms, which could potentially increase the number of investment firms subject to the remuneration requirements of CRD4.

Implementation process

Perhaps reflecting the delay in publication, and also the controversial nature of the recommendations on proportionality, the effective date of the Guidelines has been moved from 1 January 2016 to 1 January 2017.


https://www.eba.europa.eu/-/eba-publishes-final-guidelines-on-sound-remuneration-policies-and-its-opinion-on-the-application-of-proportionality


PwC 2

Once the process of translating the Guidelines into the official European languages has been completed, Member State regulators (the Prudential Regulation Authority (‘PRA’) and Financial Conduct Authority (‘FCA’) in the UK) will have a two month period in with they are required to confirm whether they will comply with all or parts of the Guidelines. This period will probably conclude at some point in late spring or early summer of 2016. After this, it would be expected that any required changes to local regulation will be made (which in the UK would likely be operated through a consultation process on changes to both the PRA Rulebook and SYSC 19A and 19D). The "comply or explain" process only applies to the Guidelines. The EBA’s proposed changes to proportionality would be a change to the Directive itself. This means that the timing remains uncertain - changes will need to go through the full legislative process in Europe with agreement from the Commission, Council and Parliament. It is clear that the EBA intend to provide support to ensure that this change is made as soon as possible, presumably so that it can be enforced by 1 January 2017. However, it is distinctly possible that the legislative process to amend the Directive could take longer than the EBA desires and may not be complete by the end of 2016. It is worth noting that the EBA’s position, supported by the European Commission, is that neutralisation of rules is currently impermissible under CRD4, and that, therefore, National Regulators who currently allow it are not applying CRD4 correctly. The proposed legislative changes would somewhat relax this position by allowing neutralisation in certain limited circumstances. In practice, given the extent of current practice in contravention of the EBA’s view, it seems unlikely that the EBA will seek to force National Regulators to change their position on proportionality until a change to the Directive is made to render the position unambiguous. Once this legislative change is made, unlike the Guidelines, there will be no ability for National Regulators to choose not to comply unless they choose to legally challenge the Directive itself. Clearly the final requirements remain uncertain and will likely be subject to significant debate in Europe. However, it seems likely that, once agreed, there will be little flexibility for National Regulators to take a different approach. As a result, those impacted should begin planning now how they will manage the commercial impact of these changes.

Although the proposed changes to proportionality rules as set out in the Opinion are a matter for legislative process, there is a requirement in the Guidelines that the bonus cap should apply to all MRTs. If the PRA and FCA wish to continue with their current proportionality regime they would need to indicate their intended non-compliance with that part of the Guidelines pending legal clarification. Given the timing of this decision (probably late spring or early summer) it is likely to be a matter of political sensitivity.

Key features of the Guidelines

The Guidelines themselves are long (at 172 pages) and contain a number of changes from the draft published earlier in 2015 that will be welcome to many firms, including changes to the treatment of long-term incentives and the use of share-linked instruments. However, other areas, including prohibition on the payment of dividends during deferral periods and tougher language on the use of allowances, remain. The table below provides a high level summary of the main aspects of the Guidelines. Further details on areas likely to be of particular interest to impacted firms have been provided later in this document, as indicated in the table.

Topics Overview Guidelines

reference

Proportionality The Opinion recommends that proportionality should be permitted for deferral

and payment in instruments, but be removed for the bonus cap. See Section 1

4

Deferral and retention Five year deferral for senior managers in significant institutions confirmed and

retention periods extended to one year except in limited circumstances. See

Section 2

15.1 –15.6

Capital instruments Additional clarity and the ability for listed firms to continue to use share-linked

instruments. See Section 3

15.4


PwC 3


reference

Dividends or interest

payments

Restriction on payment of dividends or interest to MRTs during deferral periods

remains. See Section 4

15.4

Definitions of pay and

allowances

Definition of fixed pay broadly in line with the earlier EBA Opinion on

allowances is retained, with some minor additions. See Section 5

7, 8.1

Long term incentives Changes will allow long-term incentives to be included in the cap calculation at

grant, but subject to certain conditions. See Section 6

8.2

Material Risk Takers Considerable additional detail has been included on the process and governance

for identifying MRTs and excluding them under quantitative criteria. In

addition, the requirement to identify at both a consolidated and solo basis has

been confirmed. See Section 7

5

Malus and clawback No significant changes, but intention for certain firms to adopt the use of

clawback. See Section 8

15.7.1

Risk adjustment Significant additional detail (mostly unchanged from the draft) suggest a

significant increase in expectations in this area. See Section 9

15.7

Buy outs, guarantees

and retention awards

Ambiguity in the wording in this area remains, with new requirements on buy

outs adding further complexity. See Section 10

8.4, 9.1 –

9.2

Shareholder

involvement

Final wording unchanged from the draft Guidelines, suggesting a requirement

for ultimate shareholder approval may be required. However, this is not certain,

due to additional wording accompanying the Guidelines that suggests that non-

EEA headquartered banks may not need a vote from their ultimate

shareholders. See Section 11

2.2

Remuneration of

control functions

Wording implying an effective cap of 1:1 on control function pay remains. Some

relaxing of the requirements on performance conditions will allow at least part

of control function pay to be driven by firm-wide performance. See Section 12

14.1.3

Capital base Largely unchanged from the draft Guidelines, with the principles of this area

remaining unchanged, but expanded granular requirements to demonstrate

compliance.

6

Governance The EBA position that all significant firms (including significant subsidiaries)

must establish an independent local Remuneration Committee remains.

Formalised increase in the roles and responsibilities of these Remuneration

Committees applies to all significant firms (including non-EEA headquartered

firms). A requirement for internal audit to formally review compliance with

remuneration regulations has been confirmed and applies to all firms.

2

Remuneration policies Few changes from the draft Guidelines, with more specific requirements on the

content of remuneration policies, which should also be differentiated for

different categories of MRTs.

2.5, 3, 13

Severance Changes to the final Guidelines in this area which should result in the

requirements being easier to practically comply with in some Member States,

although general principles remain unchanged.

9.3

Personal hedging Onerous requirements for HR to conduct spot checks for compliance remain,

albeit with some concessions to reflect the restrictions of national law in the UK

and elsewhere.

10.1


PwC 4


reference

Circumvention Specificity on non-compliant behaviours remain and will be particularly

important for firms newly required to comply with the cap to consider.

10.2

Pay ratio Requirements on the ratio itself largely unchanged, but amended wording on

the calculation of fixed pay suggests UK approach of annualisation of salary for

new hires would not be permitted.

13.2

Disclosure Broadly unchanged from the draft Guidelines, but significant increase in the

disclosure obligations for most firms.

17, 18

Non CRD4 firms in

EEA consolidation

groups

Confirmation that non-CRD4 firms in CRD4 consolidated groups are subject to

pay requirements on a consolidated basis is in line with UK approach, but may

be challenging in other Member States.

3

Interaction with

AIFMD/UCITS

Confirmation that all MRTs of the consolidated banking group should be subject

to the bonus cap, irrespective of whether additional sectoral regulation also

applies. See Scope of Guidelines

3


PwC 5

Background The Guidelines replace a previous set of guidelines prepared by the EBA’s predecessor, CEBS, originally published in December 2010 to provide guidance on the implementation of CRD3. CRD4, which came into effect in January 2014, instructed the EBA to update the CEBS guidelines for the additional requirements of CRD4. These CRD4 provisions authorised the EBA to make changes to the original guidelines, in addition to updating them for the additional requirements of CRD4. A draft of the Guidelines was first published for consultation purposes by the EBA on 4 March 2015. The considerable delay in the publication of the final version of these Guidelines mainly reflects the extent of response from the industry on this consultation, in particular on the question of proportionality, and the EBA’s decision to rethink its approach on this.

Each of the National Regulators must confirm whether they will or will not comply with the Guidelines. They must do this within two months after the translation of the Guidelines into the official EU languages and their publication on the EBA website. The translation of the Guidelines will likely take a number of months, so the deadline for the National Regulators to comply or explain will probably be in late spring or early summer of 2016. If a National Regulator chooses not to comply with some or all of the Guidelines, they must provide the EBA with reasons for this. The EBA must then publish a list of those National Regulators that do not intend to comply. The EBA may also choose to publish the reasons given by each National Regulator for this in its annual report to the Council and Parliament, along with details of how the EBA intends to ensure that any listed National Regulators comply in the future.

The exception to this process is the content of the EBA Opinion that was published in conjunction with the final Guidelines. This Opinion is addressed jointly to the European Commission, Parliament and Council and recommends a change to the text of the Directive itself in order to allow some proportionality to be applied to smaller and non-complex firms and those individuals with low variable pay for the rules on deferral and payment in instruments as well as to allow the use of share-linked instruments by listed firms. As this recommendation requires a change to the European legislation itself, it will need to follow the full European legislative process, beginning with a formal recommendation of this change by the European Commission. This will likely be published in the summer of 2016 as part of the Commission’s findings of the separate review of the remuneration requirements of CRD4 that they are conducting.

Approval from the Council and Parliament will then be required in order to formalise this change. It is clear from the EBA’s statements within the Opinion (and the unusual decision to include suggested changes to the Directive) that they are keen to expedite this process. It remains to be seen if this can practically be done before 1 January 2017. The EBA has not suggested how key phrases such as ‘non-complex’ or ‘relatively low levels of remuneration’ should be defined, and agreement on such concepts could take some time. However, regardless of timing, it is clear that once the changes are enshrined in the Directive there will be no flexibility for National Regulators to choose not to comply with the requirements of proportionality without breaching EU law.

Scope of guidelines The overall scope of the Guidelines is the same as that of CRD4. As such, the Guidelines apply to all firms within a CRD consolidation group, as well as to CRD firms on a solo basis. Branches and subsidiaries of firms within the CRD consolidation group are therefore included on a worldwide basis. The National Regulators are expected to ensure that CRD branches of non-EEA firms are subject to the Guidelines.

The Guidelines make it clear that the CRD consolidation groups will also include subsidiaries that are also subject to other specific sectoral directives (e.g. AIFMD and UCITS V). This is in line with the existing position taken by the UK and a number of other Member States.

Timing of implementation The Guidelines state an effective date of 1 January 2017. This is a revision from the draft Guidelines, which stated an effective date of 1 January 2016, which likely reflects the late publication of the Guidelines and significant changes in some areas. The Guidelines do not specify if this refers to any awards made after this date, or awards made in respect of performance after this date. Precedents from CRD4 would suggest that the latter (performance from 1 January 2017) is more likely. However, firms should be aware that some National Regulators may take a different position or voluntarily choose to comply earlier. Provided that National


PwC 6

Regulators state that they will comply with it, the new Guidelines on the application of the bonus cap without consideration of proportionality will therefore apply for the 2017 performance year to all MRTs in all firms subject to CRD4.

The timing of the enforcement of the Opinion is more uncertain. While the EBA has been clear that they wish to expedite the process (presumably to allow the 1 January 2017 deadline to be met) it is far from certain that this will be possible. This reflects the complexity of the EU legislative process, with the need for agreement between the European Commission, Council and Parliament on any changes to the Directive text.

PwC Comment

The status of current proportionality arrangements operated by National Regulators is uncertain. The EBA has stated that approaches involving waivers to neutralise rules are not in line with the regulatory requirements in CRD4. However, it is difficult to envisage National Regulators changing their approach until the legislative process suggested by the EBA to amend CRD4 is complete. This said, the final Guidelines do set out that the bonus cap is not subject to proportionality and it is likely that National Regulators will be expected to apply this requirement to all CRD4 firms when the Guidelines come into effect on 1 January 2017. The time required to effect this legislative change is likely to give firms that stand to lose the ability to apply proportionality more time to prepare for the change, but the relief will only be temporary if National Regulators comply in full with the Guidelines. Therefore, any delay caused by the legislative process will only be relevant in Member States where the National Regulators have chosen not to comply with this aspect of the Guidelines. One of the other key aspects of the Opinion, the application of proportionality for deferral and payment in instruments, is not explicitly addressed in the Guidelines. Therefore, National Regulators will likely continue with the status quo in these areas, especially since the EBA is seeking to preserve the current approach through changes to the Directive. The status for share-linked plans in listed firms is less clear cut. The Opinion is clear that the Directive should be changed to allow this. However, the final Guidelines explicitly prohibit this. Uncertainty therefore remains on how National Regulators will tackle this issue in the short term. It is possible that the UK regulators may choose not to comply with the new Guidelines on the application of the bonus cap in relation to proportionality. In 2013, the UK government tried unsuccessfully to remove the bonus cap from CRD4 with an appeal to the European Court. Senior officials in the Bank of England (including the PRA) have also publically criticised the cap on the basis that it will not improve the alignment of remuneration incentives with prudent risk taking, and may work against it, since it reduces the proportion of total remuneration which is aligned to performance and capable of being reduced through malus or clawback requirements. However, the position of the UK authorities on this question is not known at this stage and inevitably any decision on this will be affected by political considerations and may, ultimately, only allow a short delay in the application of this requirement. It is undoubtedly the case that potentially affected firms need to actively scenario plan during 2016 for implementation of the bonus cap from 1 January 2017.


PwC 7

Key changes set out in the Guidelines 1. Proportionality

As expected, the EBA has chosen to recommend changes to the Directive itself in order to address the issue of applying proportionality raised in the draft Guidelines. However, their end position is not as flexible as many firms were hoping for following the extensive consultation period.

The draft Guidelines published in March stated that, in the view of the EBA, the approach adopted to applying proportionality was not consistent with CRD. In particular, the EBA stated that the Directive does not permit certain provisions of CRD to be disapplied or ‘neutralised’ for particular groups of firms or individuals. During the consultation period for the draft Guidelines, this position was challenged on both legal and commercial grounds by firms and representative bodies across Europe. The result is the EBA Opinion, which recommends that the European Commission, Council and Parliament change the Directive to allow an approach to proportionality in which requirements on deferral and payment in instruments can be neutralised for certain firms or individuals within firms.

However, while the EBA recommends the application of proportionality for deferral and payments in instruments they are explicit that proportionality should not be applied in respect of the bonus cap. In the UK, this will mean that banks and IFPRU investment firms currently within only Level 3 will now be subject to the bonus cap for their MRTs for the first time. This will be a particular concern and challenge for those firms with relatively high and volatile levels of variable pay. For investment firms there is also the additional uncertainty created by the EBA and ESMA’s joint input into the review of the prudential regime for investment firms, which could further impact the extent to which these types of firms are subject to remuneration requirements. Most notable is the suggested change to the definition of investment firm under CRD that would potentially include BIPRU firms in the scope of CRD remuneration regulation.

More generally, the Guidelines include a considerably expanded list of factors which National Regulators should use when considering whether a proportionate application of the remuneration rules is appropriate. This includes factors such as size, geographical presence, types of activity, business strategy, client types and complexity (amongst others). The size and scope of this list, as well as the suggested amendments made by the EBA to the Directive in their Opinion, imply that the current approach used by the PRA and FCA may need to be revised. This could mean that, in the future, the PRA and FCA will need to relook at the criteria used to determine which firms should be allowed to apply proportionality and make adjustments to this approach. In particular, the Opinion seems to suggest that application of proportionality based solely on the nature of activities undertaken may not be permissible. This could be a particular challenge for large and/or complex limited licence and activity firms who are permitted to apply proportionality under the current PRA and FCA “levelling” system.

At the same time, draft wording proposed for changes to the Directive text would exclude subsidiaries of significant institutions from applying proportionality. This would effectively end the “re-tiered” status of some asset managers and wealth managers of large banks.

An amendment to the Directive text will take a considerable amount of time, both due to the legislative process involved and the need for consensus to be reached amongst the EU legislative authorities. In the meantime, and in the absence of statements in the Guidelines to the contrary, it is reasonable to assume that proportionality can continue to be applied to neutralise requirements on deferral and payments in instruments, in line with the approach currently adopted by National Regulators.

However, it is less clear that this will apply to the current use of proportionality for the bonus cap. This is because the requirement for all CRD4 firms to apply the cap is explicitly included in the Guidelines themselves (which are effective from 1 January 2017) and is not one of the proposed amendments set out in the Opinion. This means National Regulators will have to decide whether to comply with the requirement in the first half of 2016 or explain why they will not. Attention will therefore now turn to the likely response of the PRA and FCA and other National Regulators on this point.


PwC 8

PwC Comment

The EBA’s final position on proportionality is somewhat unexpected, given the volume and strength of the legal and commercial opposition expressed in responses to the consultation on the original draft. Firms will be relieved that proportionality can continue to apply for at least the medium term in respect of deferral and payment in instruments. However, the decision explicitly to exclude the bonus cap from any application of proportionality will undoubtedly pose a significant challenge for many smaller firms. It will also raise serious commercial concerns for those operating in global markets or in sub-sectors where some competitors may not be subject to the requirements of CRD. The EBA has remained silent on the extent to which proportionality can be applied to the performance adjustment requirements. While technically speaking, malus would not be relevant where a firm was not required to defer, it is unclear what the implications would be with regards to clawback, which is encouraged in any case by the final Guidelines. This is likely to be an area that National Regulator’s interpretation will be required in order to provide clarity.

Impact for Level 1 and 2 firms

For UK Level 1 and 2 firms, the confirmed position on proportionality should not represent a significant change. However, the suggested Directive wording in the Opinion could effectively remove the ability for significant banks to ‘re-tier’ their subsidiaries. This will place some entities, for example asset management businesses of large banks, at a significant commercial disadvantage. Overall, though, Level 1 and 2 firms are likely to consider an extension of capping requirements to smaller competitors to be a levelling of the playing field.

Impact for Level 3 firms

In the UK, the changes to the proportionality principle set out in the Guidelines will present the most significant change and challenge for Level 3 firms.

These firms may no longer be able to apply proportionality in order to disapply the bonus cap for their MRT population. This will place investment firms that are within the scope of CRD4 at a significant commercial disadvantage, particularly when compared to competitors currently outside of the scope of CRD4. However, joint recommendations from the EBA and ESMA last week imply that, in the longer term, the prudential regime for investment firms could change with, in particular, changes to the definition of investment firms under CRD4. If this were to happen, it is uncertain how the remuneration provisions would apply to BIPRU firms currently outside of the scope of CRD4.

More generally, changes to the Guidelines when read in conjunction with the suggested changes to the Directive may lead the PRA and FCA to conclude that their current proportionality approach is not in line with the requirements of the Directive and Guidelines. This may therefore change the status of some firms within the PRA’s proportionality framework. In particular, there is some concern that large and/or complex investment firms within the scope of CRD4 may be required to apply deferral and payment in instruments.

Attention will now turn to the PRA and FCA who must decide in 2016 whether to comply with these requirements. Regardless of the outcome of this, once changes to the Directive are agreed, the UK will have no choice but to comply. As such, Level 3 firms should begin to prepare for complying with the bonus cap now, with a focus on identifying key areas of concern and reviewing their approach to identifying MRTs.

2. Deferral and retention

The final Guidelines increase both the length of the period over which variable remuneration should be deferred and also the time period over which instruments used to deliver variable remuneration should be retained for some populations of MRT.

The Guidelines clarify that the period considered appropriate to meet requirements for the retention of variable remuneration paid in instruments should be 1 year, an increase from the 6 months currently applied in the UK.


PwC 9

However, they do allow for an exemption to this rule if deferral is for a period of 5 years and the MRT is not a member of senior management. In this scenario, a retention period of 6 months can operate. For significant firms the Guidelines require that deferral should be for 5 years for senior management, vesting no faster than pro-rata. There is also an additional requirement for this population that a significantly higher portion of this deferral should be in instruments (although this amount is not defined).

PwC Comment

The increased deferral requirements would bring closer alignment between the UK and other EEA Member States following the UK extension of deferral periods (to between 5 and 7 years for members of senior management in Level 1 and 2 firms). Whilst the increased deferral requirements could create a level playing field in Europe, global competitiveness could be weakened.

Although the increase of the retention period to 1 year may not in itself appear significant, it will add to the overall impact on variable remuneration awarded to UK PRA Senior Managers in Level 1 and 2 banks who will now have to wait for up to 8 years before all of their deferred variable pay is delivered in full (by virtue of 7 years of deferral requirements for PRA Senior Managers plus a further 1 year of retention on amounts delivered in instruments). The Guidelines also suggest that it would be required that a greater proportion than 50% of this deferral would need to be in instruments and therefore subject to the further retention period.

The combination of this 8 year period and the risk and liability introduced by the new Senior Manager Regime in the UK is likely to put additional strain on the ability of firms to attract and retain Senior Managers. It will also further reduce the perceived value of variable pay awards for this population.

Conversely, for Risk Managers, the required 5 year deferral means that a retention period of 6 months can in theory be retained, unlike the treatment for Senior Managers and other MRTs. This does however assume that firms will be able to use the definition of PRA identified Senior Manager under the Senior Manager Regime to meet the EBA terminology of senior management, which is not explicitly defined within the Guidelines.

3. Capital instruments

CRD4 requires that a substantial portion (at least 50%) of variable remuneration consists of a balance between: shares (or share equivalent instruments); and, where possible, other instruments which are eligible to count towards capital requirements (as defined by the EBA in a separate Regulatory Technical Standard). The Guidelines reiterate the proposals of the draft Guidelines and make it clear that the use of instruments should contribute to the alignment of variable remuneration with the performance and risk of the institution. Particular requirements include the following:

Where there are no specific factors or national laws preventing the use of other instruments, then such instruments should be used for remuneration purposes where they are available; and

Where more than 50% of variable remuneration is paid in instruments, firms should prioritise a higher share of instruments in the deferred portion of remuneration.

The most significant change from the draft Guidelines is the proposal in the Opinion to amend the text of the Directive to remove the requirement for listed companies to use only actual shares (and not share-linked instruments). However, it should be noted that at this time the wording in the final Guidelines continues to prohibit the use of share equivalent instruments in public companies.

PwC Comment


PwC 10

Firms will welcome the EBA's decision not to include prescriptive requirements on the use of alternative capital and debt instruments. Instead, firms are only required to use such instruments where they have already issued them in sufficient amounts to make awards practical.

The EBA’s decision to request a change to the wording of the Directive to explicitly allow listed firms to make use of simple phantom share arrangements will also be very welcome to many firms who would have struggled with a number of practical and administrative issues in this area. As in the case of proportionality, it would seem reasonable to assume that National Regulators will continue to allow firms to use phantom share arrangements while they await legislative changes to the Directive. However, the EBA decision to maintain current wording in the Guidelines that prohibits the usage of share equivalent instruments in companies with access to public shares adds confusion to this issue. National Regulators will need to decide how to take a practical, but compliant, approach to this issue while they await the outcome of any change to the Directive text.

If a firm has suitable other instruments available, it will need to use them to deliver part of variable remuneration alongside the use of shares. Depending on the form of the instruments, their use to deliver remuneration is likely to create some challenges – for example, providing liquidity to employees once retention periods end and the associated need to value the instruments. There is also the challenge that the use of instruments is likely to further reduce the perceived value of deferred remuneration for senior management.

4. Dividends or interest payments

The Guidelines confirm the position set out in the draft Guidelines that no interest or dividends should be paid during the deferral period on instruments awarded as deferred variable remuneration. This applies both during the deferral period and to any payment at vesting in respect of the deferral period. Dividend payments on any shares wholly and legally owned by an employee are permitted.

PwC Comment

The prohibition of the payment of interest and dividends on deferred remuneration will be, in our view, a significant challenge for many firms and is a source of concern to shareholders, who feel that it lessens alignment with their interests. While the intention of the EBA is to prevent excessive dividend equivalent payments, this added restriction may create unintended consequences such as increases to fixed pay to compensate individuals for the perceived dividend equivalents lost. Given that the market price of an instrument will incorporate an element representing expected dividend flows, firms will need to consider how to address this shortfall, which, depending on the dividend policy of the firm, could be material. It is also worth noting that the new restriction on dividends together with the increased deferral and retention period would trigger a further discount to the perceived value of variable remuneration unless steps are taken to deal with this gap. It is disappointing that the EBA did not make an exemption for normal dividends on listed shares, and it remains to be seen how National Regulators will deal with this issue.

5. Definitions of fixed and variable pay and allowances

As expected, the final Guidelines incorporate the content of the October 2014 EBA Opinion on allowances, and add some further explanatory comments. The Guidelines confirm that remuneration is fixed where:

The conditions for the award are predetermined, non-discretionary, transparent to staff, permanent (i.e. maintained over a period tied to the specific role and organisational responsibilities) and non-revocable;

The permanent amount is only changed via collective bargaining or following renegotiation in line with national criteria on wage setting; and

The payments cannot be reduced, suspended or cancelled by the institution, do not provide incentives for risk assumption and do not depend on performance.

In addition, the final Guidelines confirm that allowances can only be permitted if they are paid to any other staff member fulfilling the same role and who is in a ‘comparable situation’, whether or not that person is an MRT.


PwC 11

Some uncertainty existed as to whether the EBA definitions of fixed pay and allowances permit payment in instruments. The final Guidelines have provided helpful clarification on this point in both the Guidelines themselves and the notes accompanying the Guidelines at the back of the published document. Our understanding of the Guidelines, is that payment in instruments can be considered as fixed, but in order to meet the definition of fixed pay the payment would have to be contractually determined in advance by the value of the instruments to be awarded, not their number. In addition any deferral associated with the award would not be permitted.

There is also a requirement that any firm making payments in instruments would need to be prepared to justify the rationale for treating any payment in instruments as fixed, with reference to the definitions of fixed pay contained within the Guidelines. Similar provisions also exist in respect of any allowance only paid to MRTs, or only paid to those who would otherwise be in excess of the cap.

The Guidelines follow the approach set out in AIFMD in relation to carried-interest plans, which do not form part of variable remuneration where payments simply represent a pro-rata return on the investment, but otherwise must be counted towards the cap.

PwC Comment

The precise definitions of the different types of remuneration do raise a number of questions, most notably around how to classify certain types of pay elements that are currently considered as fixed pay such as pension and expatriate pay arrangements. The final Guidelines provide further helpful clarification on the treatment of expatriate allowances (including tax equalisation payments which are referenced in the accompanying EBA commentary to the Guidelines). However, firms will need to continue to take care when making any non-standard or out of policy payments to ensure that they meet the definitions of fixed pay. This is a particularly important area for small firms, now brought into the scope of the bonus cap, who may historically have focused less on this question and have fewer standard policies and procedures in place. On the specific definition of allowances, the final outcome is unsurprising and many firms will already have carried out considerable work to identify the processes for becoming compliant in this area. However, some areas of the Guidelines, such as the ‘consistency’ test are additional to the original EBA Opinion on allowances and may be a challenge to fully implement and evidence. More generally, it is clear that going forward an important part of ensuring that all allowances are treated as fixed will be careful governance around the documentation of compliance in this area.

6. Long-term incentives under the bonus cap

The draft EBA Guidelines published in March 2015 proposed that long-term incentives (‘LTIPs’) subject to performance conditions should be valued at the date of vesting based on the amount vested and that this value should be used when testing variable remuneration against the bonus cap for the year in which the performance is determined (i.e. the end of the performance period). The deferral period would start at this point of award, following the testing of performance. This approach would have made the operation of a ‘UK style’ long-term incentive very difficult, due to the level of uncertainty for both firms and employees caused by the risk that the bonus cap would be breached as a result of factors beyond their control (for example, increases in share price between date of award and vesting of the award), coupled with long total performance and deferral periods.

The EBA appears to have responded to representations from the industry in this area and there have been significant changes to the final Guidelines. Where the LTIP grant is determined based on past performance of at least one year, then the Guidelines confirm that:

Long-term incentives should continue to be valued on the date of award and taken into account in the calculation of the bonus cap for the financial year for which it was awarded; and

The deferral requirements can be measured from the date of grant, although the deferral period cannot end before the first anniversary of the determination of the long-term performance outcome.


PwC 12

Where the LTIP grant is not determined with reference to past performance (for example an award made to a new hire at the start of their first year of employment), then the LTIP is regarded as awarded at the point the performance outcome is determined. This means that it is taken into account for bonus cap purposes in the year that it vests. The deferral requirements apply from this point also. In order to avoid the bonus cap being exceeded because of increases in share price between grant and vesting, where LTIP awards are made over a fixed number of shares in these circumstances, they can be valued for bonus cap purposes based on the share price at grant of the original LTIP award at the start of the performance period.

PwC Comment

Firms and many shareholders, particularly in the UK, will welcome the EBA’s final approach in this area. Long-term incentives are a key form of remuneration for senior management in many firms in the UK and are supported by shareholders as a means to align the interests of management and investors. The original draft proposals would have called into question the feasibility of using long-term incentives as a remuneration instrument for firms. The final Guidelines are likely to mean the survival of UK style LTIPs, though their operation will not be without challenges. In particular, firms that wish to continue to operate LTIPs will need to consider the following:

Most firms will need to review their grant process to ensure that there is a sufficient element of performance assessment (including risk adjustment) and hence variability in award levels to meet the requirements of the EBA for awards to be based on at least one year of prior performance. In particular it should be noted that in order for variable pay to meet the requirements of being fully flexible, it should at least be possible for a zero value LTIP award to be made due to a previous year of particularly poor performance. In practice, it is likely to be possible through a combination of bonus and LTIP in variable pay to meet the EBA requirements and so enable UK LTIPs to be used broadly in their current form;

We expect most firms will seek to avoid granting LTIPs which count against the bonus cap at vesting (notwithstanding the ability to use the grant share price to value these) as they will not wish to measure deferral from this point. This will call into question the process that is used for developing the recruitment package for new hires; and

In the UK, regulators have required LTIPs to be valued at their ‘expected value’ when they are used to meet deferral requirements but at face value for the purposes of the bonus cap. However, there was no requirement for them to be subject to pre-grant performance. Although it is not entirely clear, the wording within the Guidelines and the accompanying explanatory text suggests the possibility that, where LTIPs are subject to prior performance, they may be counted towards both the bonus cap and deferral requirements at face value. However, this will require clarification from the PRA and FCA.

7. Material Risk Takers

The Guidelines clarify the approach for identifying MRTs that should be taken by non-CRD subsidiaries within a CRD consolidation group. The Guidelines call for the ‘consolidating institution’ to apply CRD4 requirements to all staff identified as MRTs across the group and also require all CRD entities within a consolidating institution to conduct an additional identification process on a solo basis.

The final Guidelines also include a number of additional technical confirmations on the process for identifying MRTs, including the treatment for staff in an MRT role for less than three months.

The final Guidelines also retain significant additional detail contained in the draft Guidelines on the governance process for identifying MRTs. Clarity has been provided on the process and governance required around identification, including significant detail on the information that should be presented to the regulator for quantitative exclusions. Details are also given on the timing of these exclusions, both for notification and regulatory approval (which must occur within six months of the end of the preceding financial year) and the governance and sign-off process associated with the identification and exclusion of MRTs.


PwC 13

PwC Comment

The clarification on the application of MRT identification on both a consolidated and solo basis reiterates the requirements of the initial EBA Regulatory Technical Standard on identifying MRTs. However, for many UK firms it will likely lead to an increase to the number of MRTs as a detailed identification process will now need to be undertaken in each CRD subsidiary as well as at the consolidated level, which is an issue that many firms have not addressed in full to date.

Many will welcome the significant additional clarity that the EBA provides on a number of technical issues associated with identification of MRTs. This includes the formal confirmation that those in the role for less than 3 months in the year do not need to be identified as MRTs. This is similar to, but slightly more favourable than, the current approach in the UK which does not allow the bonus cap to be disapplied for this population.

Many will be comforted that the explicit ability to exclude individuals captured by the quantitative criteria remains within the finalised Guidelines. The Guidelines provide significant additional requirements on the reporting and governance of the identification process. Although for larger firms this is likely to be helpful (particularly in setting out the expected content and timing of regulatory notification), for smaller firms the requirements may add significant complexity to their existing process. This will become increasingly important as small firms think through the implications of the removal of proportionality in respect of the bonus cap, which could significantly impact their MRT population.

Saying that, firms should not underestimate the extent of additional activity that is required to meet these requirements. In particular, the formalisation of the notification and approval process for quantitative exclusions considerably increases the amount of documentation firms need to submit to the regulator, as well as constraining the timeframes in which this needs to occur. Getting this process right will be particularly important for smaller firms whose MRTs were not previously impacted by the bonus cap requirements under the application of proportionality.

8. Malus and clawback

The Guidelines indicate that malus (reduction of deferred unvested remuneration in the light of risk outcomes following an award of variable remuneration) and clawback (repayment of variable remuneration that has already vested) should be capable of being applied to 100% of the total variable remuneration received by MRTs. CRD4 introduced a similarly explicit rule in relation to malus, but its references to clawback remain unclear.

The Guidelines state that malus and clawback should apply at least over both deferral and retention periods, which, as noted above (in section 2 - Deferral and retention), could extend for six years based on EBA Guideline requirements. They also expand the list of scenarios in which malus or clawback should operate to now include the conduct of staff where it contributed to regulatory sanction.

The Guidelines acknowledge the difficulty of enforcing clawback in some Member States, and indicate that firms should adopt longer deferral periods in such territories to compensate.

PwC Comment

By specifying that malus and clawback should be applied for up to 6 years, the finalised Guidelines have brought the EU regulatory requirements closer to the position already in place in the UK, where the PRA has published more detailed guidance on the conditions under which malus should be applied, and has also introduced specific requirements in relation to clawback. These UK rules go considerably further than the provisions of CRD4 by specifying that clawback should apply for at least 7 years from the date of award. Moreover, if the requirement of the Guidelines is transposed by the UK as drafted, then it could effectively


PwC 14

lead to a clawback period of 8 years (to cover both the 7 year deferral and 1 year retention period that would now be required).

However, clawback, which is a difficult policy to apply in practice in any event, may be either prevented or discouraged by local laws in a number of Member States. This may well limit the ability of other Member States to align their rules with the UK position. Most banks do not differentiate their deferral periods by Member State, but the Guidelines are now suggesting they do so to reflect the enforceability of clawback.

9. Risk adjustment

The Guidelines are essentially unchanged from the original draft and strongly emphasise the need to adjust for all current and future risks when assessing performance and determining bonus outcomes. Key themes in the guidance include the following:

Risk alignment should be based on an appropriate combination of quantitative and qualitative criteria;

The process should be clear and transparent for both regulators and staff, with a written policy outlining the parameters and key considerations on which judgments will be based;

Risk measurement methods should be consistent with those used for internal risk management purposes (e.g. within the ICAAP), with calculations broken down by business unit and type of risk;

The accrual period for the measurement of performance and application of ex-ante adjustment should be at least one year – variable remuneration should only be paid after the accrual period;

Measures such as profits, revenue, costs and share price will require additional risk adjustment;

Performance measures used for determining bonus pools should take into account long-term indicators of performance and should be based on prudent accounting and valuation methods; and

The need for ex-post risk adjustment (such as the application of malus or clawback) depends on the accuracy of ex-ante risk adjustment.

The Guidelines also make the point that the criteria for establishing individual entitlements should be based on objectives and measures over which the staff member has direct influence – to ensure that variable remuneration has an appropriate impact on staff behaviour. There is an emphasis on the importance of communicating the risk adjustment process to employees.

PwC Comment

In many ways, the Guidelines reinforce the concerns expressed by UK regulators over the last few years in relation to the application of risk adjustment. Whilst there is no prescriptive approach, it is clear that the EBA expects firms to develop a robust and transparent methodology. In fact, the EBA Guidelines in this area go into considerable detail and it is unlikely that most firms are fully compliant with all the requirements as finalised. Firms will therefore need to review their risk adjustment processes with a particular focus on ensuring that they have a well documented and transparent process that is capable of attributing specific adjustments to specific risks – both crystallised risks (‘ex-post adjustment’) and as yet uncrystallised risks (‘ex-ante adjustment’).

Whilst most firms already have significant input from risk functions in making remuneration decisions, this is in many cases focussed on ex-post issues – i.e. identifying and responding to specific risk events. Firms need to extend this to consider all future risks, with a particular challenge being the development of a risk scorecard that measures all types of risks in a multi-year framework, and the integration of that scorecard into remuneration decision making. If LTIPs are used, their award will also need to be considered as part of the risk-adjustment process.

UK regulators have also in recent years emphasised the importance of communicating risk adjustments to employees, although the Guidelines extend this to the whole risk adjustment process.


PwC 15

10. Buy outs, guarantees and retention awards

CRD4 states that guaranteed variable remuneration should be exceptional, should occur only when hiring new staff, where the firm has a strong and sound capital base and should also be limited to the first year of employment.

Some of the unexpected proposals of the draft Guidelines in relation to guaranteed variable remuneration have now been confirmed in the finalised Guidelines. These state that, when awarded prior to the appointment of a new employee, guaranteed variable remuneration need not be included by National Regulators in the calculation of variable pay for the purposes of the bonus cap. This gives National Regulators flexibility to deal with the issue of compensation for bonus relating to the performance period prior to joining, which can be problematic under the bonus cap when there is also a desire to pay a bonus for the first performance period with the new firm. This has not historically been covered by buy-out provisions, as no award has actually been made. The Guidelines then go on to say that in this case the guarantee cannot be subject to malus and clawback and the firm need not (although by implication may) apply deferral or deliver a portion of this in non-cash instruments.

The treatment is less clear with regards to buy-outs. While it is clear that buy-outs should be subject to deferral, payment in instruments and malus and clawback, the final Guidelines do not confirm whether these awards should also be subject to the bonus cap. It is also not entirely clear whether the deferral and retention requirements should simply mimic those on the awards being bought out (as is normal practice) or start afresh in the new firm. Further, while not commented on in its draft proposals, the final Guidelines seem to suggest that buy-outs should be subject to the same tests as guaranteed variable remuneration (i.e. that they should be exceptional).

CRD4 does not refer to retention bonuses, but the Guidelines clarify that where retention bonuses are used they should be subject to the bonus cap (firms are given the choice as to whether they recognise the full value in the year that the retention restriction lapses, or accrue for this over the length of the retention period itself). It is also confirmed that retention bonuses should be subject to requirements relating to deferral, payment in instruments and malus and clawback (firms are only able to apply these rules at the end of the retention period). The Guidelines also state that retention bonuses should only be used to the extent they are consistent with and aligned with effective risk management.

These Guidelines are, in a number of places, less onerous than existing UK remuneration rules that require retention bonuses to only be allowed exceptionally where a firm is undergoing a restructuring and where a case can be made to retain key staff on prudential grounds. The Guidelines are less restrictive on this point, stating that retention bonuses may also be used in other situations where the institution can provide a rationale for its legitimate interest in retaining a relevant staff member.

PwC Comment

Regulators in the UK have discouraged the use of guarantees and retention bonuses because of the weakening of the link between variable remuneration and performance. The Guidelines appear to take a more flexible approach, and it is surprising to see that they have exempted at least certain types of guarantees from the bonus cap and malus and clawback. This contrasts with the approach taken to retention bonuses, which are subject to the bonus cap and other structural requirements in the same way as other types of variable pay received by MRTs. National Regulators are able to apply a more onerous application of the requirements and while the EBA have, overall, adopted a more flexible approach to the rules in this area, it cannot be assumed that this will result in a relaxation of the approach taken in the UK.

To date, the UK has allowed a pragmatic compromise of “annualisation” for new hires, which allows the bonus cap to be applied to annualised fixed pay for new joiners in the first year. It would appear that a combination of the rules on guarantees and the rules on calculation of fixed pay for the purposes of the bonus cap may well render this approach impermissible. This would have the unintended consequence of encouraging greater use of guarantees to buy out part year bonuses, yet these have to meet the exceptional test.


PwC 16

In the UK, firms will be concerned by the apparent tightening of the circumstances in which a buy-out award may be made. This contrasts with current market practice, and commercial reality, where a number of firms have previously understood that these types of award did not need to be ‘exceptional’ in order to be compliant and continue to use these as a way of compensating individuals who will forfeit previous unvested deferred awards. However, the language in this area of the Guidelines is not entirely clear and so it remains to be seen how National Regulators will practically apply these provisions.

11. Shareholder involvement

The Guidelines set out the requirements around obtaining shareholder approval in relation to the remuneration of MRTs. The Guidelines now go further, stating that shareholders should have the ability to vote by simple majority to reduce a higher maximum ratio, although they do also confirm that this permission does not need to be regularly renewed. For firms who have already obtained a vote, it remains to be seen if the changes in this area are significant enough to compel firms to get a new approval.

More significantly, the Guidelines seem to have altered certain aspects of the approval requirement. Currently, the immediate shareholders of the company in which the MRTs operate have been able to approve increases in this ratio. For companies headquartered outside of the EEA, this will typically have been achieved by obtaining approval from an immediate parent company.

The final Guidelines appear to confirm that where such an immediate parent company exercises its right as a shareholder to approve a higher ratio, it must either:

Call for a vote from its own shareholders on how to exercise its voting rights; or

Seek a blanket determination from its shareholders that its subsidiaries may introduce a higher ratio.

However the wording in this section, particularly when read in conjunction with the associated explanation from the EBA at the back of their Guidelines paper, is ambiguous and the final Guidelines do not appear to give certainty on the interpretation of this provision for subsidiaries of non-EEA parent firms.

PwC Comment

The impact of the requirement for a vote by shareholders of an ultimate parent company would be significant for CRD4 firms that are subsidiaries, whether of EEA parents or non-EEA groups. In the past, a subsidiary company bank may have obtained approval for an increase in its pay ratio from its immediate shareholders (i.e. its parent company). The final Guidelines seem to suggest that a subsidiary must seek approval from the shareholders of its ultimate parent company.

However, the drafting of the Guidelines in this area is far from clear and much will therefore also depend on National Regulator interpretation of this requirement. Non-EEA headquartered firms will therefore have a further period of uncertainty as they await final local regulatory clarity on this issue.

12. Remuneration of control functions

The Guidelines contain specific commentary around the remuneration of control functions (the Guidelines clarify that control functions in this context refer to risk, compliance and internal audit functions only). They confirm that remuneration for these individuals must be predominantly independent of the operational business units they oversee, as prescribed by CRD4. However, they do confirm that some portion of pay can relate to assessment of the performance of the institution as a whole. The Guidelines also follow the initial draft by stating that the remuneration of control functions should be predominantly fixed, in order to reflect the nature of their responsibilities.


PwC 17

PwC Comment

It is yet to be seen how National Regulators will require compliance with a requirement around ensuring that control function remuneration should be predominantly fixed. In effect, this requirement should prompt National Regulators to introduce a 1:1 cap on variable pay for control functions.

The change to the draft Guidelines to allow some portion of variable pay for control functions to be based on overall firm performance will be welcome. However, even with this relaxation of the Guidelines, the practicalities of delivering variable pay based predominantly on control objectives, particularly where group-wide long-term incentives are operated for senior control function officers, will need careful consideration.

This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, PricewaterhouseCoopers LLP, its members, employees and agents do not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it. © 2015 PricewaterhouseCoopers LLP. All rights reserved. In this document, “PwC” refers to PricewaterhouseCoopers LLP which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity.

Contacts If you would like to discuss the implications for your organisation, please contact your usual PwC adviser or:

Jon Terry Tom Gosling

T: +44 (0) 20 7212 3973

E: [email protected]

Tim Wright

T: +44 (0) 20 7212 4427

E: [email protected] T: +44 (0) 20 7212 4370


James Coombs

T: +44 (0) 20 7212 4713

E:[email protected]

Katy Bennett

T: +44 (0) 20 7213 5168


David Raikes

T: +44 (0) 20 7774 5889


Documents

Final EBA Guidelines on sound remuneration policies - … … · · 2016-01-11proportionality to the remuneration provisions of the 4th Capital Requirements Directive ... Final