Compliance and corporate governance codes for large financial institutions will undoubtedly include provisions to regulate high pay in the future
Bank bonus season is upon us again. But this year the round of announcements revealing the share of profits doled out by investment banks comes with intensified focus on the levels and manner of executive pay.
The issue has never been far from the headlines in the past few years, since the discrepancy between banks’ losses and the bonuses paid
to their chief executives emerged following the financial crisis.
It shot back to prominence last week as Royal Bank of Scotland chief executive Stephen Hester turned down his £963,000 bonus following a public and political outcry.
The EU was the first authority to try to address the issue, introducing remuneration provisions in the third iteration of the Capital Requirements Directive (CRD), which came into force in January 2011. As Freshfields Bruckhaus Deringer’s employment team pointed out in a recent briefing, the directive’s wording means CRD III was interpreted differently by different member states, although guidelines were produced to ensure a uniform implementation.
CRD III is likely to be strengthened by CRD IV in a relatively short period of time, but meanwhile those institutions covered by the rules – mainly banks and investment companies – must ensure their senior management and ’risk takers’ are remunerated according to the rules.
In the UK, FSA rules covering remuneration were also introduced last year, transposing CRD III into UK law. The FSA continues to monitor implementation of the rules, which govern the way financial institutions pay bonuses and address the question of proportionality.
However, CRD III and the FSA code are far from being the end of the debate. In November last year the independent High Pay Commission (HPC) published its report on executive pay, which followed a year’s inquiry on the issue.
“The HPC report concluded that pay packages have become increasingly complex, damaging relations with shareholders and creating confusion, and it calls for ’a radical simplification of executive pay’ and additional solutions based on the key principles of transparency, accountability and fairness,” according to Dechert, reporting on the findings.
The HPC’s solution to the problem of increasing pay centres on making changes to the UK Corporate Governance Code, thus adding compliance requirements to companies.
Covington & Burling highlighted several key points in a December tax and employment alert. The main changes proposed by the HPC, the firm said, include a proposal for a “radical simplification of executive pay” that would restrict pay structures to a basic salary and an additional performance-related element.
The report also recommended disclosure of the top 10 pay packages earned by executives below board level, the presentation of directors’ remuneration reports in a standard format, full disclosure of voting decisions in respect of listed company shares made by institutional investors and fund managers, and the inclusion of employee representatives on remuneration committees.
If the HPC’s recommendations progress companies will also have to publish annual statements setting out the distribution of their income over three years. Non-executive director vacancies will have to be advertised openly and companies will have to disclose any services provided by consultants advising the remuneration committee.
The HPC also recommended the establishment of a permanent body to monitor executive pay.
As Linklaters noted in a briefing last November: “The Commission has no formal governmental status and the report carries no official weight. Nevertheless, its recommendations have received considerable media attention.”
The firm pointed out that the HPC proposals fall broadly in line with those made by the Department for Business, Innovation and Skills (BIS) in its consultation on executive remuneration. The BIS consultation period ended on 25 November and the department published its response on 23 January.
“Overall respondees agreed that the current remuneration landscape needed to be improved, but views were mixed on the best way of achieving this,” the Government response stated. “This included some scepticism that more regulation was needed when greater clarity and good shareholder and company practice would be most effective.”
Business secretary Vince Cable added in a speech the following day that while the culture would be changed partially through regulatory reform, companies needed to show leadership and to uphold the Corporate Governance Code to deal with remuneration issues.
“It seems likely there will be some regulatory changes resulting from the BIS consultation (possibly more disclosure, employee representation on boards etc) which will apply from 1 October 2012, so most companies will need to consider any such changes by reference to their 2013 reporting period,” stated Linklaters.
Dechert agreed. Its corporate and employment update noted: “[Cable] said many of the options the Government is consulting on in connection with the BIS Discussion Paper are reflected in the HPC report and has said repeatedly in recent weeks he would like to introduce legislation next year to curb executive pay.
“Currently, Cable’s office is weighing up which of the suggestions contained in the BIS Discussion Paper need fresh legislation or whether the majority of reforms can be simply inserted into codes of practice such as the Code but either way, it is likely that the HPC’s recommendations will be implemented in one way or another given the current public disenchantment with top earners in the City.”
Shoosmiths said banning high pay completely was not on the agenda.
“At this stage the intention is to stimulate debate rather than make firm proposals for change,” it said. “The Government does not intend to prevent generous remuneration packages providing they are sustainable and in line with a company’s long-term objectives. Linking remuneration to long-term company performance in such a way is likely to be a key factor underlying any changes.”
BIS is not the only Government department focusing on what changes should be made to regulation to better govern executive remuneration. The Treasury has also launched a consultation under the auspices of its ’Project Merlin’, seeking views on forcing large UK banks to publish the pay details of their eight highest-paid executives.
Project Merlin was launched in February 2011. As well as covering remuneration it is aimed at encouraging UK banks to lend more to small businesses. The latest consultation, which closes next week (14 February), asks for views on the draft Financial Services Act 2010 (Executives’ Remuneration Report) Regulations 2011.
The main aim of the regulations, said Clifford Chance in December, is “to bridge a gap in current disclosure regimes imposed by the Companies Act and the FSA Remuneration Code so that there is greater transparency in relation to the remuneration of highly remunerated non-board executives. The Government believes that this will encourage better shareholder governance.”
Approximately 15 banks will be caught by the regulations if they are passed – those that are based in the UK, or the UK operations of foreign banks, with £50bn or more in assets.
Although the regulations will cover senior management they will not catch star traders who may be earning more than the executives, but without any of the management responsibilities.
Banks will have to prepare a remuneration report, to be filed at Companies House.
“The Board of Directors must approve the remuneration report prior to publication and may be guilty of a criminal offence punishable by a fine in the event of breach of the Regulations,” noted Clifford Chance.
The regulations will also have a so-called ’sunset clause’, meaning that in the absence of the Government legislating to the contrary they will cease to apply after seven years.
The Treasury is required to conduct a review of the regulations within five years of them coming into force.
One concern that has been raised several times in the debate on executive pay is whether the demands of complying with any new regulations will make the UK less attractive to large financial institutions.
“Pay data is commercially sensitive and although these disclosures will be provided on an unnamed basis in reality it may be relatively easy to identify the individuals concerned,” said Clifford Chance. “Greater transparency of remuneration information will almost certainly have an impact on retention and recruitment costs and could lead to an upward ratchet of remuneration in certain circumstances; although the Government believes that in the context of an international market this is unlikely.”
However, the realities of the economic environment mean that tighter controls over remuneration are inevitable, and complying with these requirements will be at the top of every in-house team’s agenda.
Focus on bankers
In the aftermath of the need for banks across the Western world to be bailed out with public money, scrutiny has been focused on bankers’ remuneration.
Increasingly, the perceived problem of high pay is being dealt with through regulation and extra compliance requirements, with both the EU and the UK seeking
a solution this way.