Regulators to reform remuneration schemes

Risk and reward – such lovely alliteration makes this pairing feel so logical. But if there’s one thing we’ve learned in the past year, it’s that markets, economies, companies, investors and individuals rarely work in ways the average Vulcan would approve of. Much less so in a bull run such as the one that is currently crashing around our ears.

That could go some way towards explaining the hideously inflated remuneration packages director-level executives have been enjoying, while gold-plated capitalism has been filling in for an absent common sense. And the latter’s return from the dead amid what many believe is a global recession – created on the back of a philosophy of taking on huge risks and not bothering to mitigate them properly – explains why time is now being called on those inflated pay packets that, in not reflecting risks undertaken, exacerbated the disastrous consequences of those risks that we’re seeing now.

US regulators have not done much more than pay lip service to changing bad remuneration practices, focusing on financial institutions now governed by the rules of its banking bailout, involving a cap on pay and retainers for top brass while in public ownership.

But in the UK last October, the Financial Services Authority published the ‘Dear CEO’ letter it had sent to a reported 28 banks and building societies on the matter.

Chief executive Hector Sants noted in the letter the ‘widespread concern that inappropriate remuneration schemes, particularly, but not exclusively in the areas of investment banking and trading, may have contributed to the present market crisis. The FSA shares these concerns’.

The note identified various commonplace remuneration policies, from including calculating payments on the basis of revenues without counterbalancing risk controls, not deferring parts of the bonus and creating a conflict of interest by permitting front office to influence back office as undermining systems designed to control various risks. It added that these practices showed no evidence of having been aligned with a company’s stated risk appetite.

Employment lawyers are advising their clients to show they are moving to change bad practices – even if the timing of the note, when most companies are reaching the end of their bonus year and have already set in place the following year’s remuneration contracts – puts dates for any material improvements back to 2010 and beyond.

Apprehensive markets

Alistair Woodland, partner with Clifford Chance’s employment group, notes apprehension from the market.

‘Bonus structures and compensation levels are market driven and employers are unwilling to be the first to introduce some of the more radical changes that have been suggested, such as moving to a ‘multi-year’ bonus scheme, or allowing the employer to claw back bonuses from previous years. No one wants to be seen to break rank and to be the first to change because it will affect their ability to attract and retain staff.’

The ‘Dear CEO’ letter came a week after the agency fined Alliance & Leicester £7m for practices in selling its payment protection insurance that it said breached FSA business principles. It found the way A&L’s bonus structure in 2006 and 2007 incentivised its sales advisers and team managers to sell PPIs, and the fact that bonus schemes made express provision that individuals would forfeit 25% of their bonus if they did not hit sales targets, ‘increased the risk that advisers might make unsuitable sales of PPI to achieve those bonuses’ and ‘translated in practice into a situation where customers were not treated fairly by A&L when being sold PPI.’

One example of a European financial services firm taking a proactive approach is UBS, which in November announced a new compensation model taking greater account of long-term value creation and sustainability.

Up to a third of the annual variable cash component of compensation will be paid at year-end subject to ‘positive business development’, while the larger portion will be held in an escrow account. The overall amount will be reduced ‘if regulations are grossly violated, if unnecessary high risks are undertaken or if individual performance targets are not met’. UBS’s variable equity programme will only vest shares after three years and oblige top managers to hold onto these for longer.

‘Some disproportionately large risks had been assumed… earnings, and the bonuses linked to them, had not been sufficiently tied to the amount of assumed risk,’ the bank said. ‘Bonuses had been calculated on short-term results and without sufficient appraisal of the quality of sustainability of those earnings.’

The days of bonus policies reflecting only the need to attract and retain staff – not the inherent risks that these policies can indirectly pose to regulatory compliance, keeping an eye on shareholder values and best practice – may be numbered.

A survey of executive pay among European financial services companies published in January 2007 by Mercer found that more than 70% of compensation paid to the chief executives in the financial services sector was paid through bonuses and that an average 25% of total direct compensation paid to bank CEOs was paid to them as a base salary: so more of their pay is performance-based. Moreover, restricted stock and performance share plans are identified as the most popular long-term incentives – with the most common performance measure being shareholder return relative to peer group.

Raising risk

Ironically, as the demand for risk manager types, such as heads of treasury has increased in the past three years, remuneration for these roles has shot up, raising the inherent risk in the remuneration package itself. Mercer says treasury managers saw an average 12% rise in their salary in 2006, while chief risk officers received an average 14% increase in their salary – both ‘above-average’ rises, says Mercer.

‘The FSA is expecting firms to use remuneration policies to create an incentive for employees to act in accordance with its rules and principles and with good risk management procedures, rather than incentives to maximise profits alone,’ says Andrew Hart, a principal at Freshfields Bruckhaus Deringer.

Clifford Chance’s Woodford agrees that introducing HR to your risk managers, your compliance and regulatory people is a cornerstone of the philosophical shift companies are being asked to make.

‘Make sure you can show you’ve started off dialogue between those setting the benefits policies at your company and the regulatory and compliance department, to get regulatory oversight of those policies,’ he says, ‘to recognise the link between benefit structures and legal requirements to manage risk’.

He recommends a carve-out of non-key positions from the new policies to control the cost in changing the system: in cases where bonus contracts are binding into 2009 and beyond, companies may have to settle them and start a fresh one, so costs may be unavoidable.

Starting work in earnest now will be crucial to ensuring the FSA looks kindly on financial services businesses. Freshfields’ principal Margaret Cole warns that the agency is looking to create ‘credible deterrents’ to these practices and warns that companies could be made an example of if they do not take the guidance seriously, suffering ‘meaningful consequences if they fail to raise their game and improve standards of behaviour’.

This article first appeared in the January issue of our sister publication Financial Director