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FSA Adopts Rules to Address Compensation Policies that Promote Risky Behaviors

by Ron Diel on August 15, 2009

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Earlier this week, the FSA provided a solid example of rules that address risks created by poorly structured remuneration programs. The FSA rules demonstrate an alternative to pending US legislation and highlight the importance of acting quickly to control 2010 compensation. Under the rules, firms are required to adopt remuneration policies reflecting an included list of principles, have them approved by board compensation committees, file them with the FSA by the end of October, and put them into practice by January 1st. The rules also provide guidance on addressing pre-existing contracts like the questions being raised concerning Andrew Hall’s employment agreement with Citibank.

The FSA focused on risks from badly structured compensation agreements, specifically not attempting to address perceived compensation excesses (which are in any case less prevalent than in the US):

The aim of the Remuneration Code is to ensure that firms have risk focused remuneration policies, which are consistent with and promote effective risk management and do not expose them to excessive risk.

The code specifies that compensation programs should be based on risk-adjusted long-term profits not revenues, reflect adherence to risk and compliance policies, individual, division, business unit, and firm performance, and Include a base component sufficient to allow the firm to choose not to pay a bonus in a given year. It also calls for limiting guaranteed bonuses to the first year of employment, and spreading payment of at least two-thirds of any senior employee bonuses over a three-year period.

Firms with inconsistent contract obligations are called upon to amend such obligations within set time frames.

Our detailed analysis of the FSA rules and a comparison with USA proposals are available here.

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InDepth: New FSA Regulations Address Risks from Compensation Practices

by Ron Diel on August 14, 2009

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Summary: Detailed analysis of new FSA rules designed to prevent UK financial services firms from adopting remuneration programs that could encourage key staff to take excessive risks; includes a comparison to US proposals. A briefer entry is available here.

Earlier this week, the FSA provided a workable example of rules that address the risks that can result from poorly structured remuneration programs at financial firms.  Given the uncertain and politically charged debate now underway in the US, this example deserves our attention.  The new FSA rules also highlight the importance of acting quickly enough to affect the upcoming 2010 compensation year – something that will be difficult here where pending legislation provides regulators with a nine-month period to in effect assess the need for action.

By already putting its requirements into effect, the FSA pulled ahead of its counterparts in the US.  The changes go into practice quickly to address the 2010 compensation cycle: firms must adopt remuneration policy statements reflecting the new principles, have them approved by board compensation committees, file them with the FSA by the end of October, and put them into practice by January 1st.  The rules also provide guidance on addressing pre-existing contracts like the questions being raised concerning Andrew Hall’s employment agreement with Citibank.

To act quickly, the FSA focused specifically on the risks created by badly structured compensation agreements, rather than getting caught up in a debate about popular outrage over perceived excesses as has happened in US.  In balancing its reform efforts, the FSA noted that “inappropriate remuneration policies, practices and procedures were a contributory factor rather than a dominant factor behind the market crisis.”  As such, the UK code provides an interesting example of regulations more in tune with traditional financial regulation – mandating formal policies and procedures, internal oversight roles, and specific practices – than the US approach, summarized in another posting on this site, which attempts to limit risk by ceding more compensation authority to shareholders and regulators.

In its newsletter, the FSA describes the intent of the code as getting boards and firms to adopt compensation incentives that more strongly promote good risk management practices:

The aim of the Remuneration Code is to ensure that firms have risk focused remuneration policies, which are consistent with and promote effective risk management and do not expose them to excessive risk.

In keeping with the results focus at the heart of policy-based regulation, the provision anticipates efforts to engineer around any rules-based limits, extending coverage to “all aspects of remuneration that could have a bearing on effective risk management including wages, bonus, long term-incentive plans, options, hiring bonuses, severance packages and pension arrangements.”

Content of the FSA Rules

Structurally, the code modifies existing provisions to require firms to have board-level compensation committees and adopt written compensation policies and procedures.  The procedures must include performance appraisal processes and must allow for the risk and compliance areas to have “significant input” if they are concerned that a decision could encourage risky behavior or include a potential conflict of interest.  The code also extends the definition of regulated business risk to include risks arising from remuneration policies.

The code amends the Senior Management Arrangements, Systems and Controls Sourcebook to include a series of new principles to be applied when setting remuneration for individuals who could significantly impact the performance or risk exposure of the firm.  Under these principles, their compensation should:

  • Be based on risk-adjusted profits not revenues
  • Reflect long term profits, potentially through the use of moving averages, deferred payouts, or risk adjustments
  • Be significantly affected by an individual’s non-financial performance, including adherence with the firm’s risk and compliance policies
  • Tie bonus levels to individual, division, business unit, and firm performance (their emphasis)
  • Include vesting periods and dependencies on future firm performance for deferred bonuses
  • Include a base component sufficient to allow the firm to choose not to pay a bonus in a given year
  • Be set using appropriate, accurate management reports for the relevant areas of the business

Beyond these principles, the code calls for two specific compensation practices: first, guaranteed bonuses should be limited to the first year of employment, and second, payment of at least two-thirds of any senior employee bonuses should be spread over a three-year period.  Special considerations also apply to determining compensation of risk and compliance staff whose compensation is expected to be adequate to attract the required talent but “significantly” less variable or performance based than other positions.

Firms unable to comply with the new provisions because of existing obligations will not be considered in violation provided they amend such obligations to be compliant at the earliest opportunity prior to the end of March 2010.  Firms unable to do so by that date must take reasonable steps to amend or terminate the obligations at the earliest opportunity (and in no case later than the end of December 2010) and must adopt specific, effective procedures to manage any risks raised by such obligations while they remain in effect.

Comparison with Proposed US Regulations

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Regulating the Rating Agencies

by Ron Diel on August 2, 2009

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On July 21st Treasury proposed legislation to strengthen regulatory oversight of national credit rating agencies by amending Section 15E of the 34 Act to require agencies to (1) register with the SEC as “nationally recognized statistical rating organizations” (NRSROs), (2) create internal compliance organizations under a CCO, (3) implement written policies, procedures and codes of ethics, (4) include greatly increased risk and reliability related disclosures in their ratings reports, and (5) file annual regulatory reports, including compliance certifications.  Among other topics, the mandated policies and procedures must address conflicts of interest in the rating process.

The proposal directs the SEC to create an office dedicated to overseeing NRSROs and to adopt rules to change industry business pricing and business practices. This would amend the Credit Rating Agency Reform Act of 2006 and its associated regulations, which provided for optional registration.

Our detailed analysis of the proposal is available here.

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Hedge Funds Take Advantage of Bank Pullback

by Ron Diel on August 1, 2009

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A recent WSJ article reported that hedge funds are experiencing their best performance in a decade due, at least in part, to declining competition for market opportunities from proprietary trading by the major banks which have become more conservative.  This provides an explanation for a Morningstar report on July 21st that during the second quarter their index of 1,000 hedge funds had posted its best quarterly return at 9.25% since the inception of the index in 2003.  The prior best was just 7.40% in 2003.

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InDepth: Regulating The Rating Agencies

by Ron Diel on July 31, 2009

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Summary: Detailed analysis of the Treasury’s proposal to require Credit Rating Agencies to register with the SEC and implement enhanced compliance organizations, practices and disclosures.  Includes analysis of the actions the SEC is directed to take to implement the proposal.  A briefer entry is available here.

Last week the Department of the Treasury proposed legislation to strengthen regulatory oversight of national credit rating agencies, one of the groups that has been pointed to as contributing to the current financial crisis. The proposal would amend Section 15E of the 34 Act to require agencies to (1) register with the SEC as “nationally recognized statistical rating organizations” (NRSROs), (2) create internal compliance organizations under a CCO, (3) implement written policies, procedures and codes of ethics, (4) include increased risk-related disclosures in ratings reports, and (5) file annual regulatory reports, including compliance certifications.  The proposal also requires the SEC to create an office dedicated to overseeing NRSROs and to adopt rules to change industry business practices thought to compromise the efficacy of the rating practice, as well as to detail the rules required to implement the Act.

This legislation builds upon the Credit Rating Agency Reform Act of 2006 and its associated regulations, which provided for optional registration and were themselves extensions of earlier Commission efforts to increase the reliability of the ratings process through a series of no action letters.  The approach taken in the proposal to improve the conduct of the NRSROs mirrors regulatory provisions adopted over the past several years to tighten the governance and compliance environments in regulated broker/dealers, investment advisers and investment companies, including the development of written policies and procedures, the adoption of codes of ethics, the designation of Chief Compliance Officers, and the institution of systems of internal controls.  The specific concerns targeted in the proposal also reflect the increased focus that governance experts, like Professor Coffee at Columbia, have placed on dealing with conflicts of interest between the “gatekeepers” like the auditors and rating agencies and their clients, as the basis for structuring statutory and regulatory requirements.

On August 5th Professor Coffee testified before the Senate Committee on Banking, Housing and Urban Affairs concerning this proposal. In his opening statement, a clip from which is included at left, Professor Coffee points to two shortfalls in the Treasury proposal relative to legislation proposed in April by Senator Reed, which he believes would make the measure ineffective in remedying the problems it targets. First, the proposal fails to address the lack of due diligence reviews by the agencies of the inputs used in their models. Second, rating agencies don’t face the same risks of potential legal liability that motivates most other gatekeepers to adopt rigorous measures to verify the accuracy of their work products.

Concern with the reliability of credit ratings has been voiced by a number of firms and organizations in the investment industry, especially by those managing money market funds which are required to apply NRSRO ratings when selecting certain investments.  In April representatives from some of the leading investment firms, the industry groups, the NRSROs, and academia participated in an SEC roundtable on this issue.  While much of the discussion called either for a more dramatic restructuring of the industry at one extreme, or for much less change than the proposal includes at the other, depending mostly on the affiliation of the participant, there was clear agreement that change is required because the markets have lost confidence in the ratings being issued.  In his statement, Richard Baker (the President and CEO of the Managed Funds Association) noted the concerns of the alternative investment industry, described the agencies as playing a fiduciary role,  and called for regulators to require increased disclosure, greater transparency, and some form of accountability.

NRSRO Requirements

The Act directs the SEC to promulgate rules specifying how NRSROs are to manage conflicts that arise from business relationships, affiliations or board overlaps with the issuers they rate, from any affiliations among their staff and the issuers or underwriters of rated securities, and from any any other sources of conflict they identify.  Based on these rules, each NRSRO will be required to establish and enforce compliant written policies and procedures, reasonably tailored to their activities to identify, address and disclose conflicts of interest involving the agency or its staff, and to strengthen their governance procedures for managing such conflicts as may arise.

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Looking into hedges

Background: OK, So What Exactly is a Hedge Fund?

by Ron Diel on July 6, 2009

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Over time I’ve found there’s a lot to be learned by exploring those questions that seem simple but require complicated answers, and defining a “hedge fund” falls squarely in that category. Therefore, I hope you’ll bear with me for an overly long post exploring this particular question.

Beyond the simplistic, and not entirely accurate, explanation that the name reflects the fact that hedge fund advisers use hedging to increase returns and decrease volatility, an analysis of the definition of a hedge fund can provide insights into what is really distinctive about these advisers both individually and as an industry. I believe this effort is timely because these distinctions will play a major role in determining the real impact (intended or otherwise) of the upcoming regulatory changes.

According to some histories, the term “hedge fund” was originally applied to A.W. Jones & Co, a general partnership started by Alfred Winslow Jones in 1949 and subsequently changed to a limited partnership in 1952 (others, including Warren Buffett, point to earlier investors like Benjamin Graham). The term fit well because Jones’ fund was distinctive in that besides buying securities viewed as under-valued, he hedged by short-selling securities believed to be over-valued. Because the short positions provided some protection against a drop in the market, he felt safe in borrowing to increase the leverage of the fund – without hedging “I would not have been able to sleep so well at night.”

Articles about Jones in Fortune, Institutional Investor, and New York Magazine during the 1960’s provided some early insights into the hedge fund industry, highlighting a number of hedge fund characteristics that remain typical of the industry today:

  • Shorted securities seen as over-valued to hedge market risk and benefit from relative underperformance
  • Used leverage (about 50% at A.W. Jones at that time) to increase returns
  • Insiders contributed a significant portion (40% originally) of hedge fund assets
  • Restrictions applied to fund additions and withdrawals (annual only)
  • Funds had high trading volumes
  • Managers received a 20% performance fee
  • Funds operated under a limited partnership legal structure
  • Funds and advisers were exempt from Adviser Act and 40 Act registration
  • Advisers limited disclosure of business and client information
  • There was a tendency for staff to leave to form competing hedge funds after learning the ropes

And, again showing the breadth of continuity, the New York Magazine article noted a couple of the industry’s concerns in 1968 with potential regulatory changes that are at least as timely today:

  • Being subjected to registration with the SEC and increased regulation
  • Losing the carried interest treatment of performance fees

Much, however, has changed in the hedge fund industry during the past forty years.

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