FSA issues Code of Practice on remuneration policies

On 26 February 2009 the Financial Services Authority (FSA) published a draft code of conduct on remuneration policies. This will apply to all FSA regulated firms, including branches and subsidiaries of foreign-based organisations.

The FSA, and other international bodies (such as the Financial Stability Forum), are aiming to ensure that remuneration policies support and embed sound risk management practices and culture. The draft Code builds on the substance of its Dear CEO letter from October 2008. It reiterates that the FSA does not wish to set (cap) levels of remuneration, but is interested in the processes and policies by which remuneration is assessed, so that employees are not indirectly incentivised to expose firms to excessive risk.

The FSA will consult on the Code and further remuneration related proposals in March. However, it is probable that the Code will be adopted in its current form. The Code continues with the FSA’s principles based approach. While it is said to apply to all firms and does not stipulate that it does not apply to all levels of employee, much of the wording is clearly aimed at the larger firms and bigger bonus packages. The principles based approach will give the FSA latitude in drawing on the standards set out in the Code.

While the Code is still in draft and the consultation process needs to be completed, it is a clear indication of the way in which the FSA wants firms to approach remuneration. Firms must begin to consider the changes they are going to make to be able to demonstrate they are complying with the FSA’s expectations in this area.

The FSA’s Draft Code of Conduct can be found here.

The Code

The current draft is based around a General Principle: firms must ensure that their remuneration policies are consistent with effective risk management. This is then supported by 10 specific principles, under broad categories of governance, performance measurement for bonuses and long-term incentive plans and composition of remuneration.

Governance

• Firms need to exercise independent judgement and demonstrate their decisions are consistent with the firm’s financial situation and future prospects. Relevant skills and experience are needed to support that independent judgement, making sure risk and risk management are considered. Boards and remuneration committees may need to be strengthened appropriately. Subsidiaries and branches of foreign firms also need to apply this specific principle. Supporting documentation will be required.
• Firms require clear, documented procedures for setting compensation. Conflicts of interest need to be addressed. Risk and compliance as well as HR need to have significant involvement in setting compensation levels for business areas.
• Risk and compliance staff should not have their compensation packages assessed or set by the business areas they support. Firms need to apply different performance measures. This does not mean that business views should not be sought as part of performance assessment.

Performance and bonuses

• Bonus pool calculations should be principally based on profits rather than revenue or turnover. Risk adjustments (current and future) and capital and liquidity costs should also be used in the calculation. Firms will need to provide evidence to support the basis of the calculation and the risk adjustment techniques used. Firms will be pleased to note that the FSA acknowledges that there is still room for “judgement and common sense in the final decision about performance pay”.
• Performance should not be assessed purely on results from the current financial year.
• Non-financial measures need to be brought into the equation. Consideration needs to be given to how employees follow effective risk management practices, for example.

Long-term incentive plans and performance

• Long-term incentive plans, often including share based packages, should also be risk adjusted.

Composition

• Base salaries should be a higher ratio of the total compensation package. The intention is that that firms have more actual discretion to not pay bonuses. Employment related case law might make this a challenging requirement to embed.
• Where a bonus is the major portion of the overall compensation award to an employee, a significant share of that bonus should be deferred. This is intended to align the longer-term interests of the employee with the firm’s. Vesting periods and amounts will vary according to the risk involved in the employee’s business area.
• Deferred bonuses should be linked to the future performance of the division or business unit as a whole. This is true whether it is paid in cash or stock.

We will shortly publish a Law Now report with analysis of the implications of the Code by our employment, incentive schemes and regulatory experts.

If you would like to discuss the implications of the FSA’s draft Code in more detail, please contact Simon Morris or Nicholas Stretch.