Bonuses in the New Financial World – Has Anything Really Changed?

Paul Quain and Jon Gilligan 8 June 2010

Bonuses in the New World

• Is there a consensus on how bonuses should be treated?

• What is the position of the FSA?• What are the legal implications of clawback and

deferral on bonuses?• What does the latest round up of cases tell us about

the current legal position on bonuses?

Introduction

• The credit crunch led to the greatest financial crisis since the 1929 Wall Street Crash and resulted in unprecedented state support for the financial services sector.

• Many institutions have merged, been broken up or disappeared altogether.

• There has been a huge public and political backlash against the bonus culture in the financial services sector.

• But has anything really changed and what is the current position in relation to bonuses?

Is there Consensus between Governments?

• There was significant international co-operation and consensus in bailing out the banks, but what about bonuses?

• Consensus in expressing opposition to the existing bonus culture in the financial services sector, but not really on how best to change the current approach.

Is there Consensus between Governments - Regulation

• In 2009, the G20 agreed a number of principles to regulate bonuses. The key recommendations were: At least 40-50% of the bonus amount should be in

non-cash. Bonuses should be deferred for at least three

years and be subject to potential claw-back in the event of future poor performance.

Multi-year guaranteed bonuses should be banned.

Is there Consensus between Governments - Regulation

• In the UK, the FSA has introduced bonus guidelines.• In the US, the Federal Reserve introduced

compensation guidance. • In France, a series of measures were introduced,

including deferring traders’ bonuses over three years, paying one-third of awards in shares and imposing strict long-term performance criteria in order to receive full payment. Bonus watchdogs were also appointed at banks that have received state aid.

• In Germany, the G20 recommendations were broadly implemented.

Is there Consensus between Governments - Tax

• The UK introduced a ‘one-off’ payroll tax for banks in 2009 to try to deter excessive bonus payments. A tax rate of 50% was applied to all bonuses exceeding £25,000.

• President Nicolas Sarkozy of France decided to follow the UK in imposing one-off penalties on bonuses over €27,000.

• General tax increases were not introduced in the US or Germany.

Is there Consensus between Banks?• Prior to 2009 a number of banks already operated

bonus schemes that included payment in shares and deferral over a period of time.

• A key concern of the banks is to balance the pressure to make changes in relation to bonuses with remaining competitive with their rivals. As conditions get tougher the fight for top talent is crucial.

• The financial institutions that have received state aid have come under more pressure to operate schemes that are less generous for employees, e.g. RBS in the UK, AIG in the US and Société Générale in France.

Is there Consensus between Banks?

• There are some general trends that most banks are following:Increasing basic salary to reduce the amount paid

in the form of discretionary bonuses.Paying bonuses over a period of time.Paying an element of the bonus in non-cash.Introducing the ability to ‘claw-back’ some of the

bonus in certain situations.Ceasing to offer multi-year guaranteed bonuses.

FSA Policy Statement 09/15

• Reforming remuneration practices in financial services.

• This includes the Remuneration Code.

• Applies to Banks and Building Societies.

• Key general requirement that remuneration policies must be consistent with effective risk management.

FSA Remuneration Code• The Remuneration Code covers all aspects of

remuneration that could have a bearing on effective risk management including wages, bonuses, long term incentive plans, options, hiring bonuses, severance packages and pension arrangements.

• Under Principle 1, the FSA may ask remuneration committees to provide evidence of how well a firm's remuneration policies meet the Remuneration Code’s principles, together with plans for improvement where there is a shortfall.

FSA Remuneration Code – Principles 4 & 5

• Assessments of financial performance used to calculate bonus pools should be based principally on profits rather than revenue.

• A bonus pool calculation should include an adjustment for current and future risk and take into account the cost of capital employed and liquidity required.

• The assessment process for the performance-related component of an employee’s remuneration should be designed to ensure assessment is based on longer-term performance.

FSA Remuneration Code - Principle 6• Non-financial performance metrics should form a

significant part of the performance assessment.

• Non-financial performance metrics should include adherence to effective risk management and compliance with the regulatory system and with relevant overseas regulatory requirements.

• In conjunction with Principle 2, this means that support functions such as Risk, Compliance and Finance should have input into bonus assessments.

FSA Remuneration Code - Principle 8

• The remuneration structures for senior employees and risk-takers must promote effective risk management.

• This applies to: employees who perform a significant influence

function; and employees whose activities have, or could have, a

material impact on a firm’s risk profile.

FSA Remuneration Code – Principle 8

• Makes clear that multi-year guarantees are unlikely to comply.

• The fixed component of remuneration should be a sufficient proportion of total remuneration to allow a firm to operate a full flexible bonus policy.

This means that a firm would have the ability not to pay a bonus in a year in which the firm (or part of it) makes a loss.

FSA Remuneration Code – Principle 8

• A significant proportion of any bonus should be deferred with a minimum vesting period:

The vesting period of the deferred element should be at least 3 years.

If the bonus is significant when compared with the fixed remuneration, at least two thirds of the bonus should be deferred.

• NB also Principle 7 - the measurement of performance for long-term incentive plans, including those based on the performance of shares, should be risk- adjusted.

Deferral and Clawback• Two key concepts that have been stressed by regulators

and politicians:Bonuses should be deferred over a period of time.Some or all of bonuses should be able to be clawed-

back to ensure bonuses reflect longer-term performance.

• NB - Deferral is nothing new and was a key part of the bonus structure at Lehman Brothers.

• What are the legal issues that can arise when introducing or amending deferral or clawback arrangements?

Deferral

If an employer is introducing deferral arrangements, there are four key factors to consider:

1. the period over which the bonus will be paid;2. the form of the payment (e.g. cash, shares); 3. whether the deferral will be mandatory or

voluntary; and4. what happens if the employment terminates

during the deferral period.

Deferral• If deferral is not currently part of the bonus scheme, the

employer will need to consider what the employment contracts and any bonus policy provides for. In particular:

Does the contract/policy specify that a bonus, if awarded, will be paid in full and/or at a particular time or does it allow for deferral?

Does the contract/policy state that the bonus will be paid in cash or does it allow for payment in other forms?

Does the contract/policy allow for changes to be made to the bonus scheme?

• In addition, what approvals are needed to change the bonus scheme, e.g. Board, Shareholders?

Deferral• Assuming that an employer does have the ability to make

changes to its bonus scheme from time to time, there are still important issues to consider, e.g.:

Can the employer make changes to the scheme during the bonus year to apply to that bonus year?

Are there limits on the form in which the bonus is paid? Can deferral be applied in some cases but not others? What happens if the employment terminates?

• NB - If an employer already has a deferral plan in place, but wants to make changes to it, the same considerations will apply, with the ultimate test being whether the exercise of discretion is rational or not.

Clawback• Clawback can cover the reduction of unvested parts of a

bonus during a deferral period and requiring an employee to actually repay part of a bonus that has already been paid.

• Potentially more problematic than deferral.

• Introducing clawback will require a change to the existing bonus scheme and the same issues that are discussed in relation to deferral above will apply.

• Unless the applicable rules are unreasonably punitive, the introduction of clawback in the current market should not constitute an unreasonable exercise of discretion.

Clawback• Key issues to consider:

How much of the bonus can be clawed-back?

Can clawback be applied in some cases, but not others?

Can some/all of bonus amounts that have actually been paid to an employee be clawed back?

Can unvested instalments of the bonus be forfeited?

Who should decide whether to apply clawback and on what criteria?

Recent Cases

• Did Keen –v- Commerzbank “kill” bonus claims?

• Malcolm Rutherford -v- Seymour Pierce Limited (11 February 2010)

• Saleem Khatri -v- Cooperatieve Centrale Raiffeisen-Boerenleenbank BA (23 April 2010)

• Anar & others -v- Dresdner Kleinwort Limited (1) and Commerzbank AG (2) (28 May 2010)

Rutherford

• Employed as Head of Institutional Sales.• Summary Dismissal on 28 November 2007 conceded

to be unfair.• Payment of bonus for last quarter of financial year

ending on 13 September 2007.• Bonus Pool made up of 40% of employee’s

commission and was retrospective. Half was distributed during 1st 3 quarters and the remainder following completion of Q4.

Rutherford

• Can a term be implied that, in order to be considered for an award, an eligible participant must be in employment and not under notice as at the date of payment of the award?

• Need for evidence of poor performance.• Approach the Court takes to quantum – look at

upper and lower limits and what other senior employees were paid.

Khatri

• Unsuccessful application by Claimant for summary Judgment at first instance.

• Appeal to the Court of Appeal.• Claimant employed as a derivatives trader from June

1998 to January 2009.• Salary plus “any future applicable bonuses made

entirely at the discretion of the bank on the basis of your financial and managerial performance viewed across Rabobank International”.

Khatri

• Khatri signed new contract on 18 March 2008 providing for a guaranteed bonus and a performance related bonus according to a formula.

• The formula was “applicable to the 2008 bonus. The Bank maintains the right to review or remove the formula linked bonus arrangement at any time”.

• Heavy losses sustained on the Claimant’s “book”.

Khatri

• Possibility of redundancy, but the Claimant was successfully redeployed as Trader within Global Financial Markets, Interest Rate Derivatives Desk.

• Bank sent letter amending his original contract stating he was eligible for a discretionary bonus, but the formula driven bonus relating to his previous desk “will cease with immediate effect”.

• The letter asked for a signature to indicate acceptance. The letter was not signed and the Claimant was not pressed to sign it.

Khatri• The Claimant continued to work in the London Office, doing

exactly the same work, with the same budget and sat the same desk, but reported to a different person.

• On 28 October 2008 the Claimant was dismissed for redundancy which took effect on 12 January 2009.

• If the formula applied, the value of the Claimant’s bonus was €1,601,767.92.

• Test for bonuses is essentially one of Wednesbury unreasonableness.

• The employer must act in a rational and fair manner.

Dresdner/Commerzbank• A Town Hall announcement was made in August 2008

by the CEO guaranteeing a minimum bonus pool of €400 million for employees of the investment bank.

• The announcement was made in London, broadcast to staff in Frankfurt, Moscow and New York and placed on the intranet.

• At the end of August 2008, it was announced that Commerzbank was taking over Dresdner – completed 12 January 2009.

Dresdner/Commerzbank• 2 weeks after the takeover was announced, Lehman

Brothers collapsed and in November 2008 Commerzbank announced that it would receive billions of Euros from the German government.

• On 19 December 2008 “provisional” bonus letters were sent to employees awarding an amount from the 400 million bonus pool, but subject to a Material Adverse Change clause.

• February 2009 the bank decided the MAC clause had been triggered and reduced the bonus awards by 90%.

Dresdner/Commerzbank

• Did the town hall announcement in August 2009 constitute a legally enforceable agreement?

• Did the bank have the right to add provisos to provisional bonus awards?

• Was acceptance or consideration necessary?

• Do claims based on estoppel or misrepresentation work in relation to communications on pay?

Dresdner/Commerzbank• Announcement itself lacked sufficient certainty to

constitute legally enforceable agreement.

• Court allowed the argument that provisos may be legally impermissible to go forward but had serious reservations.

• Acceptance and consideration were considered, but the conclusion will need further hearing.

• Arguments based on estoppel may succeed if there is sufficient clarity.

Conclusions• Issue of acceptance and consideration still open.

Should future bonus award letters (or indeed communications making significant changes to contracts) be signed as deeds?

• Informal announcements seem to be safer.• Estoppel and reliance based on change of position

seem to be possible arguments where there is a clear indication of a promise unsupported by acceptance or consideration

• Bonus claims are perhaps not dead after all!• Plus ça change, plus c’est la meme chose!