Bonus of contention

Daniel Stilitz QC explains why the FSA’s new Remuneration Code for the financial services sector is likely to lead to a glut of litigation

In December 2010 the FSA ­published its new Remuneration Code. For the first time this lays down far-reaching, mandatory requirements as to the way ­variable remuneration may be paid.

It applies to banks and building societies, investment banks, investment companies subject to the European Capital Adequacy Directive, most fund and asset managers, some brokers and some corporate finance and venture capital companies, as well as to UK branches of equivalent companies ­headquartered outside the European ­Economic Area – some 2,700 companies in all. Within those organisations the code applies to all staff who may have a material impact on the company’s risk profile.

Stashing the cash

Key features of the code include a ­requirement that at least 40 per cent of any bonus must be deferred for at least three to five years, or 60 per cent for particularly high earners; at least 50 per cent of ­bonuses must be paid in shares, shares-linked ­instruments or other equivalent non-cash instruments; and guaranteed bonuses must be exceptional and limited to new hires in their first year of service.

Bonuses must reflect individual, business unit and company-wide performance, and unvested deferred bonuses must be subject to reduction where there is a material ­downturn in performance, a failure of risk management or where an employee is guilty of misconduct or material error. Termination payments must reflect performance over time and not “reward failure”.

Significantly, the code applies to remuneration awarded or paid from 1 January 2011 onwards, even if pursuant to contracts entered into before the code was introduced, so no time has been allowed to adjust. ­Companies brought within the FSA regime for the first time must comply from 1 July.

Perhaps the most contentious aspect of the code is the requirement that companies must take reasonable steps to amend or ­terminate contractual provisions that are incompatible with the code. On one view, this might be seen as requiring businesses to terminate or vary contractual arrangements, even if doing so places them in breach of contract or exposes them to statutory claims.

This is likely to be a fertile source of ­litigation. Take the case of an employee in the first year of a three-year guaranteed bonus package. On one view, the code requires their employer to breach their ­contract, assuming the employee is not ­prepared to waive their entitlements. If the employee brings proceedings for breach of contract, will the code provide a defence based, for example, on a plea of frustration?

Alternatively, might the employee be obliged to accept a variation by virtue of the implied term of trust and confidence? Some companies may feel they have no option but to dismiss employees and re-engage them on less favourable terms, thus exposing ­themselves to claims of unfair dismissal.

The FSA has exercised its power to render void contractual terms on guaranteed bonuses, lack of deferral and replacement payments that are contrary to the code. However, other terms that contravene the code will prima facie remain binding.

The code is likely to have a significant impact on the operation of the implied term of trust and confidence. For example, it is foreseeable that an employees could argue that their employer has acted in breach of trust and confidence by reducing deferred payments in circumstances where the employee feels that the employer has simply lost commitment to their part of the business.

Might the trust and confidence term ­prevent an employer from shutting down a product line and thereby robbing an ­employee of a deferred bonus? This is not wholly unrealistic, as courts have ­historically been more receptive to challenges to the exercise of employer discretion where they are seeking to claw back entitlements.

The code has a general non-avoidance provision to prevent employers using special vehicles to circumnavigate its provision. Nevertheless, one can see litigation arising from imaginative attempts by businesses to set up creative remuneration structures.

Stable fate?

The deferral and non-cash payment ­provisions are also likely to have a dramatic impact on the law of restraint of trade. The effect of the deferral provisions is to place a substantial premium on continuing service and retention. In the longer run this may dilute the application of the restraint of trade doctrine in the employment sphere. Although the prohibition on guaranteed payments after the first year may give an advantage to ­potential poachers, the trend is likely to be towards greater workforce stability.
Overall, the introduction of the code will produce aftershocks in many areas of employment law. After an initial lull in which the implications are absorbed, a barrage of novel litigation points is to be expected.

Daniel Stilitz QC is a barrister at 11KBW