Further regulatory proposals on pay

United Kingdom

The Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA) have issued a joint paper consulting on possible further changes to employee remuneration arrangements. These would take effect for performance periods beginning on or after 1 January 2015 (meaning that changes should impact 2016 and subsequent pay-outs).

Many of these changes are in direct response to the UK Parliamentary Commission on Banking Standards’ recommendations for various pay reforms in the sector (click here to view the relevant law-now). They go beyond what is required and are still being developed under existing pay restrictions derived from European banking and other directives. Accordingly, while in due course other countries may adopt similar measures, pay rules will in many cases be tougher in the UK than elsewhere if these proposals are implemented on a UK-alone basis.

Proposals include:

Longer deferral: over 5 years rather than 3 years – it is currently possible for deferred remuneration for Code Staff who are employed by firms in Levels 1 and 2 to be fully received within 3 years of it being awarded (though no more than a third may be received each year).

It is proposed that this deferral period is increased to 5 years (with no more than a fifth vesting each year). Senior managers would have a 7 year deferral period and would not be able to receive any remuneration before year 3 (and so would receive up to a quarter each year between years 3 and 7). No express powers to impose even longer vesting terms in individual cases are proposed because the PRA and FCA consider that they have these powers already.

Clawback for up to ten years for senior managers – after a period of consultation the PRA last week decided that clawback should apply to variable remuneration paid to Code Staff in Level 1 and 2 firms (to the extent that remuneration is not subject to malus) for up to 7 years after being awarded (see our separate Law-Now on this), and that this would apply to all variable remuneration awarded on or after 1 January 2015 (one year before the implementation date of the proposals the subject of this consultation paper).

The PRA is also separately consulting on whether senior managers should have a still tougher regime. A proposal is that their variable remuneration should be at risk of clawback for a further 3 years (ie 10 years in total) either where at the 7 year point the firm is itself conducting an internal investigation which could result in clawback otherwise applying under normal rules or the firm has been notified that a regulatory authority (including an overseas one) has commenced an investigation which could result in clawback otherwise applying under normal rules.

The FCA is also consulting on bringing in a clawback proposal in line with the PRA’s plans.

Buy-outs – when employees leave for a new firm, it is common for their unvested remuneration from the old employer to lapse and to be replaced with an equivalent opportunity from the new employer, often practically on more favourable terms. This is a commercial feature of arrangements which firms choose to impose: it is not a regulatory requirement, indeed many regulatory problems arise from this because the employee benefits without reference to the fortunes of the former employer. The PRA and FCA are not putting forward any firm proposals here, but are seeking views on the advantages and disadvantages of the following:

  • banning buy-outs altogether,
  • requiring departing employees to keep their awards (thus removing any need for buy-outs) and apply malus to those awards,
  • applying malus to the new employer’s award (which would involve the regulator reducing a new award and somehow transferring the benefit of the reduction to the old employer), and
  • not making any changes to the use of buy-outs, but instead relying on the extended clawback arrangements being implemented and which the old employer could use to obtain financial redress.

Risk adjustment to variable pay pools – creating a risk-adjusted bonus pool from which variable remuneration is paid has been a key part of the regulator’s aims over the last few years. Merely taking profits or revenues as the basis for bonus is no longer acceptable, but quite how the pool should be adjusted has been left flexible for firms to agree with the regulator. The PRA is proposing a more rigid approach in future in that profit for remuneration purposes should be calculated by deducting a prudential valuation adjustment from the fair value accounting profit.

Another proposed change is that simple revenue-based measures, such as return on equity, earnings per share and total shareholder return, may not be relied upon to determine variable remuneration at aggregate or individual levels, except as part of a balance and risk-adjusted scorecard. This was becoming more common anyway, but an express provision would codify the point.

Non-executive director pay – nowhere has there been an express prohibition on non-executive directors receiving variable pay from a firm. While the UK’s Corporate Governance Code frowns on this, this is a comply or explain provision, not an outright ban. The PRA and FCA now propose preventing non-executive directors from receiving variable pay, but this change is in many respects formalising what is already occurring. This would be a feature across all the various regulatory Remuneration Codes.

Areas where no developments will occur in the short term - there are two areas where the PRA and FCA say that they do not intend to take any further action, at least for the moment:

  • No extra public disclosure on prospective pay levels and amounts is being proposed, but the PRA will privately ask firms for more on projections for future pay, and
  • While sales-based incentives were heavily criticised as part of the Parliamentary Commission's proposals, the FCA has been encouraged by early responses to its 2013 guidance in this area and so no immediate action is proposed although this issue will be kept under review.

As the PRA and FCA independently develop their regulatory material on remuneration and their separate approaches, the consultation paper also sets out proposals to develop separate remuneration regimes. Although currently largely overlapping in terms of form and substance and with shared proportionality regimes, these clearly have the potential to diverge over time as the two bodies push forward separate objectives.

Comments are invited on all proposals by 31 October 2014. Drafting for proposals has not been provided at this stage.

To read the consultation paper, please click here.