UK: Changing remuneration practices

Amidst calls for reform at many levels in response to the current global economic crisis we consider the changes that can be expected in the remuneration practices of UK businesses, particularly those within the financial services sector. Firms will now need to review their remuneration policies and to take steps to change them if necessary. Whilst the calls for reform are currently being directed at the financial sector, principles of good remuneration practice will equally apply to business operating in other markets.

Calls for change

On 13 October 2008 both the FSA and the Treasury called for changes in remuneration practices for banks and other financial institutions. There have also been international developments in this area both at the EU level and at the recent G-20 summit.

FSA Guidance

The FSA issued, to a number of banks, a letter http://www.fsa.gov.uk/pubs/
ceo/ceo_letter_13oct08.pdf on remuneration policies which followed on from the FSA's earlier discussions with London-based firms.

The FSA lists its current thinking on "good" and "bad" remuneration policies. Against these benchmarks, businesses are urged to carefully consider their own remuneration policies as they apply to all levels of staff.

Benchmarks for good remuneration practice include:

• calculating remuneration on the basis of profits and other business goals rather than current revenue;
• using a measure of risk-adjusted return;
• including a sufficient fixed element of pay;
• including an appropriate mix of cash and share-based incentives;
• deferring a significant part of bonuses and adjusting payment in line with true performance;
•  providing independent oversight of remuneration policies and managing conflicts of interest

The FSA's letter is not regulatory, but constitutes guiding principles. The FSA proposes to produce further guidance once a more in-depth review of current practices has been carried out, but confirms that if a firm's policies "are not aligned with sound risk management, that is unacceptable."

The extent to which the FSA ultimately become involved in any increased regulation in this area may be impacted by current international developments.

Terms of the financial support to the UK banking sector

HM Treasury's press notice http://www.hm-treasury.gov.uk/press_105_08.htm outlines the terms on which the government is providing financial support to the UK banking sector. In addition to a freeze on 2008 bonuses, banks using the government's recapitalisation fund will have to commit, in relation to senior executive remuneration, to review their current incentive schemes and ensure that, going forward, they are linked to long-term value creation, taking account of risk and restricting the potential for "rewards for failure".

As part of its wider enquiry into the banking crisis, the House of Commons Treasury Committee is currently considering incentive structures, including remuneration policies, within financial institutions and, in particular:

• the relationship between the structure of remuneration packages and excessive risk-taking;
• how incentives can best promote long-term growth and financial stability;
• the approach of the FSA with respect to remuneration;
• the role of remuneration committees and shareholders in overseeing compensation packages;
• the need for a co-ordinated international approach to executive pay;
• good practice around disclosure and transparency of compensation arrangements.

Once these issues have been debated, it is likely that guidance will be forthcoming, and firms affected may wish to pre-empt any future requirements by taking action to review their incentive arrangements now.

What is happening in the market?

Significant changes in compensation policies are being announced by major banks globally. Changes announced or currently being considered include:

• the voluntary waiver of bonuses for 2008 by executive directors;
• the introduction of deferred cash bonuses for all levels of staff whose work exposes the firm to substantial financial risk to provide that bonuses are payable over three years and potentially subject to a multi-year adjustment for performance delivered;
• the replacement of existing equity incentive arrangements for executive directors and management with new performance shares which only vest after three years subject to internal and external performance criteria and which are subject to further share retention requirements;
• the replacement of cash bonuses with equity incentives which vest over a three year period, such that the value of those bonuses is then is linked to share price performance;
• movements towards absolute performance targets rather than relative performance against a comparator group, focussing executives on shareholder value creation;
• an increased use of share options as additional means of aligning the interests of employees and ensuring that gains are not made without share price growth.

Where we can help

Companies seeking to put into practice modifications to their remuneration policies will face a number of legal and design hurdles. These include the need to take into account:

• existing contractual arrangements with employees, including the potential for any claw-back of pay;
• disclosure requirements under the Listing Rules and Companies Act 2006;
• investor guidelines on best practice;
• the appropriate design of performance-adjusted, deferred compensation arrangements, including provisions on cessation of employment and a change of control; and
• compliance with deferred compensation rules under US legislation, where applicable.

Please contact us for further information in relation to reviewing your current remuneration arrangements.