PrintSummary: 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
In contrast to the FSA rules, the pending legislation in the US relies on added control from shareholders, through non-binding say-on-pay votes, and from regulators through oversight to moderate the risk created by poorly designed compensation programs. In the author’s opinion, these mechanisms will prove to be significantly less effective than the FSA framework.
One of the persistent criticisms of shareholders in the our markets has been their focus on quarterly (or shorter-term) performance. The now out-of-favor growth in options-based compensation, which increased the risk appetite of many senior executives, was instigated to make management more responsive to such shareholders who supported management during the upside of the bubble. As noted in the clip at left of John Coates – a professor of law and economics at Harvard – testifying before a Senate hearing on Improving Corporate Governance, shareholders of financial service firms with implicit and explicit guarantees are likely to have a larger risk appetite than we would have as citizens providing those guarantees. Moreover, shareholder democracy will mix a wide variety of other factors into these votes and be restricted to a binary (and non-binding) yes or no vote. While say-on-pay may be effective in allowing corporate critics to attack compensation packages that are “too large,” it is far less likely to provide the information or opportunity for the analysis needed to establish a societally-appropriate risk appetite and determine whether compensation is aligned with that appetite.
On the other hand, regulators will have more flexibility to evaluate the impact of proposed compensation structures as a part of their prudential supervision. Given the wide scope allowed for prudential supervision, this of course was already within their purview for federally regulated banks while the current crisis was brewing. In the case of the largest banks, which contributed disproportionately to the crisis, the FRB provided continuous, engaged risk oversight under the Large and Complex Banking Organization program. This did little to reduce the exposure: unlike a determination that an individual’s compensation is simply sizable, close engagement with the content and practice of the business is required to determine whether it creates undue risk, and regulators generally do not have that level of engagement.
In contrast, the FSA framework closely parallels the reliance placed on internal compliance and risk professionals in the Institution-Based Regulatory approach that is widely applied to the US securities industry (and recently proposed for the credit rating agencies). By creating explicit policies and procedures for establishing executive compensation, and placing dedicated risk and compliance professionals in a position to apply those procedures to review and approve potentially risky compensation packages, that framework applies a model that has generally worked well in the US. Moreover, by leveraging the CCOs and procedures already in place, it can be applied more rapidly while leaving regulators the opportunity to review their findings and verify that the framework is being appropriately applied, tasks at which they have proved to be effective.
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