Employment: Bonus of contention

Huge payments to staff at financial institutions have lent themselves to headlines and sweepingly critical perceptions of the banking industry.

The public consensus is that bonuses awarded to bankers were a key factor in causing the current crisis, encouraging high-risks and, in hindsight, rewarding failure. There is a perceived mis-alignment between short-term staff incentives and longer-term interests of shareholders and wider stakeholders.

However, it is important to remain realistic about the extent to which remuneration policy can ever ensure sensible risk assessment compared with other regulatory levers (such as capital adequacy) and broader cultural and behavioural factors. Latterly commentators appear to be “downgrading” the extent to which remuneration structures have contributed to the financial crisis. Nevertheless, there remains real political pressure for international regulatory intervention into pay structures. In addition, the financial pressure on many companies to save cash means they face difficult decisions about appropriate rewards going forward.

Typically, cash bonuses are calculated by reference to individual performance, peer-group/team performance and/or wider group performance, with levels of award based predominantly on quantitative short-term criteria.

The contractual basis for bonus entitlement will often be set out expressly in the terms of employment. Bonuses are commonly stated to be payable only at the complete discretion of the company but this must be treated with caution. Although a scheme may be described as discretionary, if the bonus forms a significant proportion of total compensation, contractual rights to receipt could be established (either expressly or impliedly by previous practice) unless the bonus arrangements are agreed to be non-contractual. The courts have recently reaffirmed this principle in Small vs Boots Co (23 January 2009), underlining that it should be clear what elements the company’s discretion applies to.

Companies may also be obliged to pay a bonus where it has been presented as a reward for service and relevant key performance indicators have been achieved. Courts have been willing to construe that an executive has established a vested right even though the company may wish to deny bonus payment for other commercial reasons.

The Turner Review suggests remuneration policies should be designed to avoid incentivising undue risk and should integrate risk management considerations into the incentive process. It also recommends the development and enforcement of both UK and international regulation. Indeed, a global response to remuneration issues would seem logical in today’s borderless HR context where companies act multijurisdictionally, with significant international mobility of talent, even internally.

The Financial Services Authority (FSA) has prepared a draft code on remuneration practices (the Code) based upon a central rule that: “A firm must establish, implement and maintain remuneration policies, procedures and practices that are consistent with and promote effective risk management”. Compliance may therefore require ­wholesale change to company policies and amendments to terms and conditions. This will not be a straightforward exercise, albeit made easier by the current economic climate.

The Code recommends, among other things, that remuneration procedures should be clear, documented, based on longer-term performance, risk adjusted and that remuneration committees are able to demonstrate that decisions are consistent with a reasonable assessment of the financial situation. This would appear to further confuse understanding of “discretion” in this context.

Another FSA recommendation is that executives are better incentivised to manage risk if short-term cash bonuses are wholly or partly deferred into long-term share-based rewards. Under a deferred bonus arrangement, the company grants the executive a conditional award over a number of shares equivalent to the value of the calculated bonus. This aligns an executive’s interests with long-term shareholder value because the number of shares delivered is reduced for underperformance and the ultimate value of the reward tracks the market share price. Deferral could also operate as a one-off measure to assist companies with liquidity issues in the current crisis.

The FSA has also said that, in certain circumstances, companies should consider “clawing back” bonuses. This, however, raises considerable legal, practical and taxation difficulties. An employer’s ability to recoup a paid bonus depends on the executive having sufficient assets. Additionally, the reputational and monetary costs of enforcement may inhibit legal proceedings. Deferral may therefore provide a more practical alternative. Latterly, the regulatory focus seems to have shifted from “claw back” of paid bonus to retention of unpaid bonus amounts.

As remuneration comes under greater scrutiny, HR teams will have to accept more responsibility for managing expectations and ensuring that awards are made ­pursuant to clear, documented structures, based on regularly reviewed objective targets that promote long-term development. This must be achieved while avoiding employee discontent and while ensuring that recruitment and retention are not adversely affected.

Short-term cultural attitudes to risk must be aligned with longer-term shareholder interests in marrying sustainable growth with stability. Finally, all measures put in place to align reward with sensible risk management will ultimately be successful only to the extent that the major financial centres around the world adopt a consistent and cohesive approach.

Paul Griffin and Peter Talibart are partners at Norton Rose