The Securities and Futures Commission recently issued a press release stating that it had written to several major investment banks in Hong Kong calling on them to review their remuneration practices and to ensure that their incentive structures are consistent with prudent risk management.
We discuss the implications of this initiative and steps financial institutions can take to prepare themselves for the new regulatory environment in this newsletter.
A. Implementation of FSB Principles in Hong Kong
1. Although the SFC has so far only directly addressed certain major investment banks, it may soon make this a more general policy. Accordingly, a number of other financial firms within the purview of the SFC are examining the FSB Principles and undertaking a review of their remuneration practices by reference to them.
2. Remuneration policies are to be reviewed by reference to the Principles for Sound Compensation Practices (FSB Principles) issued in April last year by the Financial Stability Board (FSB) which were endorsed by the G20 as international standards on sound remuneration practices. These are designed to ensure effective governance and oversight of employee remuneration practices as well as the alignment of employee remuneration with prudent risk taking. The FSB Principles were followed, in September, by a set of Implementation Standards which accompany the FSB Principles.
3. The FSB intends to periodically review actions taken by financial institutions and by national authorities to implement the FSB Principles and Implementation Standards.
4. Additionally, in March 2010, the Hong Kong Monetary Authority (HKMA) issued a Supervisory Policy Manual module on Guideline on a Sound Remuneration System (CG-5) for all Authorised Institutions under the Banking Ordinance. CG-5 reflects the key elements of the FSB Principles and Implementation Standards. The HKMA has stated that it expects Authorised Institutions to take prompt action to bring their remuneration systems into line with CG-5 and achieve consistency with its principles before the end of 2010.
B. The FSB Principles and Implementation Standards
1. The FSB Principles and Implementation Standards, among other things, stipulate various principles for structuring employee remuneration so as to be better aligned with prudent risk taking. The key elements of these include:
(a) A substantial portion of remuneration to be variable: For senior executives and other employees whose actions have a material impact on the firm’s risk exposure, a substantial portion of remuneration should be variable and reflect individual, business-unit, and firm-wide performance. The criteria should include both financial and non-financial factors (including adherence to risk management policies, compliance and ethical standards, and corporate values).
(b) Variable remuneration pool available should reflect full range of risk: The size of the variable remuneration pool and its allocation within the firm should take account the full range of current and potential risks (including difficult-to-measure risks such as liquidity risk, reputation risk and cost of capital). Negative performance should generally result in contraction of the total variable remuneration – both in current remuneration and in reductions to previously earned (including through claw back arrangements).
(c) A substantial portion of variable remuneration should be deferred: A substantial portion (40-60%) of variable remuneration should be payable under deferred arrangements so as to be sensitive to the time horizons of risk. The proportion subject to deferral should increase significantly in line with the employee’s level of responsibility or seniority. Senior management and the most highly paid employees should have above 60% of their variable remuneration subject to deferral arrangements.
(d) Deferral should be no less than 3 years: Deferral periods should be not less than 3 years and vesting should not occur faster than on a pro rata basis.
(e) Variable remuneration should be a mix of cash and non-cash: More than 50% of variable remuneration should be awarded in shares or share-linked instruments (or other non-cash instruments) provided that they create incentives aligned with long-term value creation and the appropriate time horizons of risk. These should be subject to an appropriate share retention policy which requires employees to retain such instruments for a specific period of time before they can dispose of them. The remaining deferred compensation can be paid as cash vesting gradually. The appropriate mix of non-cash and cash components will vary depending on the employee’s seniority, role, and responsibilities. Firms should be able to explain the rationale for the particular mix chosen.
(f) Variable remuneration should be subject to appropriate claw back: In the event of poor performance of the firm and/or business unit in any year during the vesting period, unvested portions should be forfeited. Additionally, claw back of unvested portions should occur if it is later discovered that the assessment of a performance measure was based on misstated data (subject to realised performance of the firm or business unit) or if the employee engaged in fraud, malfeasance or violation of internal control policies.
(g) Early departure should not trigger pay out of unvested variable remuneration: Departure of an employee from the firm should not trigger early payout of deferred remuneration but rather forfeiture of such amounts.
(h) Guaranteed bonuses are to be avoided: Guaranteed bonuses should not be part of prospective compensation plans. Exceptional minimum bonuses should only occur in the context of hiring new staff and should be limited to the first year of employment.
(i) Termination payments should not reward failure: Existing contractual payments related to termination of employment should only be retained if they are aligned with long-term value creation and prudent risk taking. Prospectively, such termination payments should be linked to performance over time and designed so as not to reward failure.
(j) Remuneration for risk and compliance employees should be independently determined: For employees in risk and compliance functions:
(i) remuneration should be determined independently of other business areas and should not be influenced by personnel in front-line business areas;
(ii) performance measures should be based principally on the achievement of the objectives of their functions; and
(iii) remuneration should be adequate to attract qualified and experienced staff.
(k) Employees not to hedge their remuneration exposures: Employees should not use personal hedging or remuneration-and liability-related insurance to hedge their exposures in relation to the unvested portions of their deferred remuneration. Firms should implement compliance arrangements for this, such as seeking written declarations from employees.
C. Practice in Hong Kong
1. In terms of practice regarding bonus deferral schemes in the financial services industry in Hong Kong, we commonly see forfeiture/clawback provisions in the following circumstances:
(a) Significant financial losses of the group or part of the group which are deemed to be attributable in part to the employee’s performance;
(b) Significant downward restatements of the annual results of the group or part of the group which are deemed to be attributable in part to the employee’s performance;
(c) A material breach by the employee which leads to a significant reputational risk;
(d) A material breach of risk management activities by the employee.
(e) Termination of employment, or notice of termination. In some cases, we see restrictions placed on employees in joining a competitor although issues relating to enforceability may exist in relation to these types of provisions.
(f) Deferral arrangements can involve cash, shares, bonds or a combination of these.
(g) Generally the arrangements are mandatory, the length of the deferral period is typically 3 years, and from 20% to 50% of the bonus is deferred.
(h) In terms of performance conditions, these can be both financial and behaviourally based with reference to both business unit and group performance using risk adjusted factors.
(i) The bonus pool can be determined by local, regional or overall results.
(j) Bonus payments are not normally capped and discretion is often maintained in terms of quantum.
D. Implementation of FSB Principles in the PRC
The China Banking Regulatory Commission recently released guidelines on remuneration of commercial banks which have been effective since 1 March 2010 and apply to all commercial banks. The guidelines were made with reference to the FSB Principles. While the guidelines do not specify particular sanctions that would be applied for failure to comply with their terms, the CBRC may take disciplinary action in response to a bank’s non-compliance with the guidelines. The key points in the guidelines include:
1. The establishment of a uniform remuneration management system with remuneration divided into three broad components: fixed remuneration, variable remuneration and benefit-type remuneration.
2. A general discouragement of the practice of paying guaranteed bonuses unless there is an actual requirement. Where there is an actual requirement, the payment of guaranteed bonuses should be limited to the first year of employment of new employees.
3. The fixed remuneration component shall generally not exceed 35% of the total remuneration.
4. The performance-related component of the remuneration of the key personnel in charge of the bank shall be determined based on the results of the annual examination of the operations of the bank and shall be an amount no more than three times of the amount of the fixed remuneration component.
5. At least 40% of the performance-related component of the remuneration of senior management personnel and personnel in positions with a material impact on risk shall be paid in deferred installments over a period of at least three years. In the case of key senior management personnel, the percentage of the performance-related component that is subject to deferred payment shall be more than 50%, and where conditions permit, 60%. The deferred payment shall be paid based on the principle of equal installments and shall not be structured with a front-loading of the total deferred payment amount.
6. The establishment of rules for the claw-back of performance-related remuneration so that if within the period specified under the rules, the risk-related losses suffered by the Bank are higher than normal, the Bank shall have the right to claw-back all of the performance-related remuneration that has already been paid and to cease the payment of any unpaid performance-related remuneration of senior management personnel or other relevant personnel. The claw-back rules shall also apply to personnel who have left the employment of the Bank.
7. The lock-up period of medium and long term incentive plans shall be determined with reference to the relevant risk period and shall be at least three years.
E. Practice in the PRC
1. In terms of practice regarding bonus deferral schemes in the financial services industry in the PRC, we have seen forfeiture/clawback provisions in the following circumstances:
(a) if the employee received an award based on materially inaccurate financial statements or other performance criteria;
(b) if the employee knowingly engaged in providing such inaccurate information;
(c) if the employee materially violated any risk limits, balance sheet or working or regulatory capital guidance established or revised by management or the business risk function;
(d) if the employee’s employment terminates on account of his misconduct.
F. Strategies for introducing changes to employee remuneration
It goes without saying that remuneration is an area of great concern to employees. Accordingly, it is critical that employers manage the introduction of any changes to employee remuneration most carefully.
Best practice is to obtain the consent of employees before introducing changes to remuneration structure, especially the introduction of non-cash components, deferral arrangements and claw backs. Ideally, consent would follow after employees have been provided with adequate notice of the changes and information dissemination or consultation has taken place and any process prescribed by contracts, policies or handbooks have been observed.
If it is not possible or practicable to obtain employee consent, firms should seek legal advice on how best to introduce the changes so as to minimise the risk of such changes being successfully challenged.
If you have any questions relating to this article, please contact:
Rowan McKenzie (rowan.mckenzie@linklaters.com) or
Prue Bindon (prue.bindon@linklaters.com).
