Planning ahead for EU bonus caps (May 2013)
14 May 2013
Given longstanding demands from the European Parliament to limit EU bankers' pay and unhelpful survey data from the European Banking Authority showing that CRD3 had not done its job in tackling pay levels, the arrival of a cap in some shape or form was inevitable. British opposition to the proposals was unlikely ever to prompt a U-turn in negotiations.
The reality that bonus cap rules will apply from 2014 onwards – assuming that CRD4 legislation is finally approved – has instilled an understandable sense of urgency into the need for firms to review and amend their remuneration arrangements. So what do we know and are there any clear solutions yet?
Detail and timing
At this stage we only have the bare bones of the proposals. The detail will be fleshed out in the coming months in EBA guidelines and in local implementing rules. So, to that extent, firms will have to play their planning process by ear.
Major question marks remain over how different elements of variable pay will be valued for the purpose of the cap, how this will tie in with the existing rules on the structure of variable remuneration contained in CRD3, and what anti-avoidance provisions will apply. These questions will be answered by the EBA and local regulators in due course.
One concession on the timing front is that, whilst the rules will apply from 1 January 2014, they will apply to bonuses awarded for 2014 performance so that the first bonuses to be affected will be those payable in 2015. Firms therefore have some time to adjust, but have a busy time ahead in order to have plans in place (together with necessary contractual amendments and shareholder approvals) for the 2014 bonus year. Aside from the bonus cap, these will also need to address other aspects of new CRD4 remuneration rules, such as stricter clawback requirements.
Who is caught?
Consistent with the scope of CRD3 rules, CRD4 rules will have wide cross-border application. EEA-based "firms" (credit institutions and investment firms) must apply them across their group operations, including to non-EEA branches and subsidiaries. Non-EEA based firms must apply them to EEA subsidiaries (and potentially to EEA branches if required by local rules).
Only categories of staff whose professional activities have a material impact on firms' risk profile such as senior management, risk takers, control function staff and high-earners will be affected. The EBA will issue regulatory standards with criteria to identify these staff in response to concerns that some countries such as the UK have been taking a minimalist view.
How the cap works
"Variable pay" of affected staff will be capped at 100% of their fixed pay, but can be higher – up to 200% of fixed pay – if the firm's shareholders explicitly agree. This would require a "yes" vote from 66% of shareholders holding at least 50% of shares or, if no 50% quorum, from 75% of shareholders present. Firms that seek shareholder approval will need to make a detailed recommendation justifying their request and its impact. National rules can set lower variable pay caps.
Up to 25% of "variable pay" (or any lower maximum percentage specified by national rules) can consist of long-term deferred instruments which must be delivered in the form of equity or debt. Such long-term instruments must be deferred for at least five years and must be subject to clawback. However, the face value ofthe instruments may be appropriately discounted for the purpose of applying the cap.
Aside from seeking shareholder approval to utilise the 200% limit, increasing fixed pay or introducing "fixed-pay allowances" are possible solutions to mitigate the impact of the cap. The definition of "fixed pay" in CRD4 is potentially broad, but understanding how local regulators interpret this will be key before proceeding with structures such as temporary fixed pay allowances. Considering the impact of any (temporary or permanent) fixed pay increase on salary-related benefits and pension provision will also be important.
Further flexibility could be achieved by benefitting from the discount to be applied on long-term deferred instruments, thereby allowing headroom to award other forms of variable pay. This could yield a further increase in the cap (though EU negotiators indicate that this would be closer to 200% than to 300% of base salary). The EBA will confirm in future technical guidance how the discount should be calculated for the purposes of the cap – clarification that will obviously be keenly awaited by firms.
Consistent with CRD3, firms are likely to grapple with generic anti-avoidance provisions for CRD4's remuneration rules that give them no comfort on whether specific remuneration structures are permitted. Whilst this does allow some discretion, they should be aware of the risk that more innovative or unusual structures could be scrutinised by local regulators.
The ripple effect
The reality of life with bonus caps is also hitting other parts of the financial sector. Joining the fray are UCITS investment funds after the announcement of EU proposals that their fund managers should be subject to the same pay curbs as bankers. Their bonus cap rules will be contained in the proposed UCITS 5 directive which we expect will mirror those applicable under CRD4.