Global convergence of the regulation of financial sector remuneration

Remuneration excesses in the financial sector are widely blamed (whether rightly or wrongly) for contributing to the 2008 financial crisis. During 2009 political leaders in many of the advanced economies of the world have devoted much effort to developing policies and principles to ensure financial sector pay will in future take account of risk. In particular, there has been an emphasis on the need for independent remuneration committees, bonuses only to be awarded after taking into account risk and the release of awards to be phased over a number of years to ensure there can be proper risk-adjustment. Provisions for claw-back have also been proposed where a company's position has, at a later date, turned out to be in a worse state than previously believed.

There is also a widespread recognition that, if the new reforms are to work in any one country, they must be introduced across all advanced economies and must substantially converge. The G20, in its efforts to support financial stability, has been at the forefront of efforts to obtain maximum convergence and, despite the well publicised differences in approach on whether there should be a cap on individual bankers' bonus entitlements, the G20 leaders at the Pittsburgh Summit in September 2009 have laid down the principles to be followed by financial firms in the G20 countries. It will be up to the G20's new Financial Stability Board to monitor the implementation of the Pittsburgh Summit policies by firms but even before the Summit policy-makers in a number of countries were already taking steps to reform their domestic regulation of financial sector pay in line with the principles approved by the G20 leaders.

The G20 leaders' agreement at Pittsburgh does not lay down, as the French and German governments would like, a cap on individual bankers' bonuses, although the subject of a cap on the size of bonus pools is still under consideration. Apart from this issue, the principles laid down by the G20 leaders and Pittsburgh apply to firms across the G20 countries but it remains to be seen in the years to come whether interpretation of these principles is sufficiently convergent and whether policy-makers will need to move away from the present principles-based guidance to greater rule-based regulation.

Australia

The Australian Productivity Commission has been asked by the Australian Government to report by December 2009 on executive remuneration in Australia and overseas and the effectiveness of the present regulatory framework. Its Draft Recommendations published in September 2009 suggested areas for reform: strengthening the independence of remuneration committees, improving board competencies, greater disclosure of the pay of key management personnel, alignment with shareholder interests and encouraging shareholder 'say on pay'.

A Parliamentary Bill was introduced in June 2009 to require shareholder approval for termination payments to executives where the amount exceeds one years' base salary (rather than the present seven years).

EU

The European Commission published high level principles for remuneration in the financial services sector in April 2009 which generally follow the G20's principles on financial sector pay agreed at the April 2009 Summit, and in July 2009 adopted a proposal to amend the capital adequacy rules for banks which will also address the issue of reform of remuneration policies in banks.

France

On 26 August 2009, President Sarkozy outlined to senior French bankers the new "best practice" rules on banker's pay which are expected to be imposed by Ministerial Act during October 2009, including:-

• two-thirds of bonuses to be deferred and risk-adjusted (one half of the bonuses payable to other employees);
• the payment of bonuses to be spread over three years;
• payment of one-third of the deferred part of any bonus to be paid in shares;
• claw-back of bonuses paid to traders for up to two years in the event of negative performance.

President Sarkozy advocates a cap on bonus pools, limiting them to a fixed proportion of bank revenues but has not imposed this in new regulations for the time being whilst the issue is considered by the G20.

France has by Ministerial Act followed the US in appointing a pay czar who will review the pay structures of banks in receipt of state aid. If the bank does not fulfil its obligations concerning the 100 highest paid employees, the pay czar could intervene through the Commission Bancaire, the banks' board of directors or a general shareholders meeting. The French Government may refuse to allocate government business to French banks which fail to comply with the new best practice.

Germany

Act on Appropriateness of Management Board Remuneration (Gesetz zur Angemessenheit der Vorstandsvergütung – Vorst AG) of 5 August 2009, introduced by German Federal Parliament, amends governance laws to require:-

• non-binding shareholder votes on remuneration policies in listed companies;
• management board remuneration to be linked to duties and performance of the board member and to the situation of the company and not to exceed customary pay levels applying in the country/sector without specific justification and also to take into account wages and salaries paid within the company;
• in listed companies, variable remuneration components to be based on performance over several years and Supervisory Boards to consider a cap on bonuses where there are extraordinary developments;
• the remuneration of management board members to be made by the full Supervisory Board and not delegated to any committee;
• remuneration and pension entitlements on any termination of employment of a management board member of a listed company and its subsidiaries to be disclosed;
• share options to be exercisable only after four years (instead of two years);
• Supervisory Board may claw-back pay where the company's situation deteriorates and it would be "inequitable" to pay in full;
• Supervisory Board members liable to compensate the company for inappropriate levels of compensation;
• obligatory participation (Selbstbehalt) of management board member in D&O insurance which may not be less than one and a half times the amount of the annual fixed remuneration; and
• former management board members normally banned from the Supervisory Board for two years.

The Financial Market Stabilization Fund Act² provides for restrictions on pay for management board members and key executives in receipt of certain state aids. In particular, management board members and key executives may not receive inappropriate overall compensation; payments above 500,000 euros per annum will generally be considered inappropriate.

The German financial supervisor authority, BaFin, has introduced new provisions to be implemented before 31 December 2009 that exclude bonuses being based on short-term profits and prohibits rewards that encourage undue risk.

G20¹

At the Pittsburgh Summit in September 2009, G20 leaders declared that excessive compensation in the financial sector has both reflected and encouraged excessive risk-taking and that reforming financial sector pay practices was therefore an essential part of G20 efforts to increase financial stability. The G20 leaders endorsed the implementation standards of the newly formed Financial Stability Board aimed at aligning compensation practices with long term value creation and called on firms to implement sound compensation principles immediately, including:-

• avoiding multi-year guaranteed bonuses;
• requiring a significant proportion of variable pay to be spread over a number of years subject to achievement of performance targets and risk-adjustment;
• a claw-back of excess pay rewards after adjusting for risk;
• disclosure of individual high earners' pay in annual reports and making compensation practices generally more transparent;
• independent compensation committees; and
• limiting variable pay as a percentage of net revenues and ensuring a sound capital base.
   

Netherlands

The Netherlands Bankers Association published a Code of Conduct in September 2009 to cap management board bonuses (which includes the value of stock awards and options) at 100% of annual salary, but traders are not affected.

The Code also includes guidelines on risk management, corporate governance and remuneration policies.

Switzerland

The Swiss Government which was required to rescue its largest bank, UBS, in 2009 has put forward proposals through the Swiss FINMA for tighter regulation of bankers pay intended to take account of risk adjustment.

United Kingdom

The FSA Code of Practice requires remuneration policies, procedures and practices in the largest financial institutions to reflect risk. Although this requirement applies from January 2010, the FSA has reserved the right to review its practice in the light of progress in international convergence and proposes to report by November/December 2009 (not October 2009 as originally intended) on whether the Code should be extended to other FSA-authorised firms.

The Walker review of corporate governance in UK banks and other financial industry entities has made 39 recommendations for improving corporate governance in UK banks and other financial institutions, 11 of which relate to remuneration and include:-

• details of high earners rewards to be included in remuneration reports;
• as least half of any variable pay to be in the form of LTIPs subject to performance targets;
• vesting of LTIP awards to be spread over three to five years; and
• vesting of annual bonuses over a three year period.

A proposed Business and Financial Services Bill to enable the FSA to curb excessive banker bonuses is expected to be introduced by the UK Government possibly before the next election.

The Financial Reporting Council is consulting on whether the Combined Code should be amended to reflect developments in best practice recommended by the FSA, the World Bank and the European Commission.

Even before the Pittsburgh Summit, the UK was already taking steps to reflect the emerging G20 principles in its domestic regulatory framework. The FSA recognises the importance of achieving convergence and indeed has indicated that its policies will ultimately be shaped by the degree of international convergence achieved, presumably through the G20. It will be reporting later this year to update on the extent to which international convergence has been achieved.

Further information on the regulatory changes proposed in the UK are available in our previous briefings: FSA publishes Remuneration Policy Statement and Corporate governance: a change in landscape on the horizon for financial institutions and listed companies.

United States

The Corporate and Financial Institution Compensation Fairness Act 2009 (approved by the House of Representatives in July 2009 but pending Senate approval in the Autumn of 2009) requires:-

• executive compensation to be linked to risk-adjusted performance;
• independent compensation committees and an obligation on companies to appoint independent consultants and advisors on compensation;
• a significant amount of any shares held by an executive in the employing company to be held for a sufficiently long period to encourage alignment with the company's interest;
• claw-back to be included to ensure reinstatement where there has been fraud or error;
• restrictions to be introduced on the amount of termination payments and shareholder approval of golden parachutes to be mandatory; and
• annual non-binding approval of remuneration reports by shareholders.

President Obama, has in the meantime, appointed Kenneth Feinberg as his "pay czar" to review remuneration at the seven biggest institutions (including General Motors, Chrysler, Citicorp and AIG) receiving the US$757billion TARP bail-out. The pay czar has slashed the compensation of top executives at seven of the biggest bailed-out companies, demanding that these companies reduce total compensation for their top 25 highest-paid employees by 50% on average. Much of the reduction was to salary, reduced on average by more than 90%. The pay restructure takes effect from 1 November 2010.

The SEC regulator has written to firms not to give rewards which encourage them to deal excessively or risk clients' money.

President Obama has also indicated that income taxes will be raised on earnings over US$1million.
 

Footnotes

1. The G20 comprises the finance ministers and central bank governors of Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey, United Kingdom, and the United States of America and the EU (represented by the rotating Council Presidency and the European Central Bank). IMF and World Bank leaders also participant on an "ex officio" basis. The G20 represents around 90 per cent of gross global national product.
2. Finanzmarktstabilisierungsfondsgestez