Increasing regulation of remuneration is being introduced across the European Union, including the possibility of limits on the amounts of bonuses that may be paid by certain firms. Recent European Union ("EU") legislation, including the Capital Requirements Directive and Regulation (together, "CRD IV"), proposed amendments to the EU Directive for Undertakings in Collective Investment in Transferable Securities ("UCITS") and provisions in the EU's Alternative Investment Fund Managers Directive ("AIFMD") all impose remuneration requirements on applicable institutions. The implications are significant and wide-ranging, and we summarise these below, together with some of the practical implications for alternative investment fund managers ("AIFMs") of alternative investment funds ("AIFs") and for UCITS management companies.
The possibility of limitations on bonuses has been amongst the most controversial elements of the various proposals. The industry received at least a partial reprieve on 3 July 2013, when the European Parliament voted against caps on variable remuneration and against restrictions on performance fees for UCITS funds that were proposed in the current UCITS amending directive called "UCITS V". This is welcome news for UCITS management companies and also for AIFMs, as there was a possibility that the UCITS V proposals would be extended to the AIFMD. However, CRD IV does contain a similar restriction, and this will be implemented in the EU from 1 January 2014. As CRD IV’s impact on fund managers is expected to be mitigated by the application of proportionality principles, and because the precise extent of this mitigation is currently unknown, this article focuses on UCITS V and AIFMD, which are more directly tailored to the fund management industry.
Below we consider the key remuneration requirements for both the AIFMD and UCITS V, including scope, key definitions, remuneration structure, oversight and disclosure.
An EU manager of any AIF (or AIFs in aggregate) above the relevant threshold (EUR 100 million in assets under management for open-ended funds, and EUR 500 million in assets under management for five-year fixed-term, closed-ended funds), must comply with the remuneration requirements set out at Article 13 and Annex II of the AIFMD, as implemented in EU Member States. The AIFMD's provisions are supplemented by further regulations addressing exemptions, general operating conditions, depositaries, leverage, transparency and supervision (the "Level 2 Regulations").
The UCITS V proposals will apply to all UCITS management companies.
The requirements of the AIFMD, subject to Member State implementation of it being on time and to Member State transitional relief outlined below, applied from 22 July 2013 across the EU and the Level 2 Regulations became "directly applicable" throughout the EU, similarly subject to such transitional relief, from 22 July 2013. Accordingly EU Member States have no discretion as to how the Level 2 Regulations will apply in their jurisdictions. AIFMs in the UK managing funds established prior to 22 July 2013 will have a one-year transitional period in the UK to comply with the AIFMD remuneration provisions and other transitional relief applies in other circumstances. Other EU Member States may have a different approach to transitional relief and in certain Member States certain remuneration provisions will be applicable even during one year transitional period.
The proposed amendments to the UCITS Directive were voted on by the European Parliament on 3 July 2013 in plenary session. The European Council must now agree a common position on the proposed text, before the proposal returns to the European Parliament for a final reading. The current text is therefore subject to further scrutiny and potential amendments. The implementation of UCITS V at the Member State level is currently expected to be towards the end of 2015. In the UK, the Financial Conduct Authority ("FCA") is expected to release a Consultation paper on the implementation of UCITS V and ESMA are currently expected to release technical advice and guidelines at the end of 2013.
New concepts and definitions are introduced in the remuneration requirements of the AIFMD and UCITS V proposals. Below we consider the key concepts, including the definition of remuneration and the categories of staff that are relevant to the remuneration provisions of the AIFMD and the UCITS V proposals.
The definition of "remuneration" for the purposes of compliance with the AIFMD requirements is very wide in scope. As additional guidance on the AIFMD remuneration provisions, the European Securities and Markets Association ("ESMA") produced a set of guidelines on sound remuneration policies in February 2013 ("AIFMD ESMA Guidelines"). The AIFMD ESMA Guidelines state that remuneration consists of all forms of payment or benefits paid by the AIFM, any amount paid by the AIF itself, including carried interest, and any transfer of units or shares of the AIF, in exchange for professional services rendered by the AIFM "identified staff". Remuneration is divided into fixed remuneration (payments or benefits without consideration of any performance criteria) and variable remuneration (additional payments or benefits depending on performance or, in certain cases, other contractual criteria). Given the breadth of the application of the AIFMD requirements, AIFMs must ensure that variable remuneration is not paid through vehicles (or other methods) that artificially evade the provisions of the AIFMD and the AIFMD ESMA Guidelines.
For the purposes of the UCITS requirements, the remuneration policies and practices established by the management company would cover fixed and variable components of salaries and discretionary pension benefits. We await further guidance from ESMA to clarify the definition of remuneration under the UCITS requirements, but we anticipate this definition will also be wide in scope, and probably something very similar to the AIFMD concept.
“Identified Staff” of the AIFM includes executive and non-executive members of the governing body of the AIFM, senior management, staff that hold control functions, staff responsible for heading the portfolio management, administration, marketing and human resources activities, and other risk takers (broadly, staff who have authority to take material risks. Such staff could include, for example, sales persons, individual traders and specific trading desks). “Identified staff” also includes any other employees or persons whose total remuneration takes them into the same remuneration bracket as senior managers and risk takers. If it can be demonstrated that any of the above staff do not have a material impact on the AIFM's risk profile, or on an AIF it manages, then such staff can be excluded.
Dividends or similar distributions received by partners (including members of LLPs) as owners of an AIFM are not covered by the AIFMD remuneration provisions unless the material outcome of such payment results in a circumvention of the AIFMD remuneration rules, regardless of the intention. The AIFMD ESMA Guidelines establish further criteria that AIFMs must follow to check whether they are capturing the correct staff members, which include an assessment of staff members whose activities could potentially have a significant impact on the AIFM's results and/or balance sheet and/or on the performance of the AIFs they manage.
A UCITS management company's remuneration policies and practices would need to be applied to staff of the UCITS management company, whether temporary or contractual staff, whose professional activities have a material impact on the risk profile of the management company or the UCITS they manage, including fund managers, persons who take investment decisions that affect the risk position of the fund, persons who have the power to exercise influence on staff (including investment policy advisors and analysts), senior management, risk takers, personnel in control functions, and any employee receiving total remuneration that falls within the remuneration bracket of senior management and risk takers.
It is expected that the remuneration requirements for both the AIFMD and the amended UCITS Directive will be aligned with the principles and guidance established by the Capital Requirements Directive and the European Banking Authority (“EBA”). The EBA has recently published a consultation paper in which it sets out criteria for the identification of categories of staff who have a material impact on a firm’s risk profile. The EBA considers that individuals with total gross remuneration of over EUR 500,000 or variable remuneration that exceeds 75% of fixed remuneration will be deemed to be identified staff unless a firm can demonstrate that such staff do not have a material impact on the firm’s risk profile.
The AIFMD and UCITS V remuneration provisions set out detailed requirements that must be implemented by relevant firms. Below we cover the detail of the remuneration policy, delegation and proportionality under the AIFMD and UCITS V proposals.
Article 13 and Annex II of the AIFMD establish a set of regulations regarding remuneration and a basic requirement for AIFMs to have remuneration policies and practices for all identified staff. The new Article 14a in the UCITS Directive introduces a similar requirement for the UCITS management company to introduce remuneration policies and practices. These regulations require AIFMs and UCITS management companies to design compensation to include bonus deferral and claw-back provisions to prepare additional internal policies and procedures, to establish a remuneration committee, and to provide certain disclosures to investors.
The AIFMD ESMA guidelines, published in February 2013, provide additional guidance on the AIFMD remuneration policy provisions. From these guidelines, it is clear that AIFMs will have to significantly change their policies and practices on pay. However, the precise impact of the AIFMD ESMA Guidelines in particular EU Member States still has an element of uncertainty, as national regulators are still considering whether they will require local compliance with all of those guidelines. The amended UCITS Directive also states that ESMA shall issue guidelines on remuneration policies for UCITS management companies, and such guidelines are currently expected to be published in draft at the end of 2013.
Annex II of the AIFMD requires AIFMs to establish a remuneration policy that "is consistent with and promotes sound and effective risk management and does not encourage risk taking which is inconsistent with the risk profiles, rules or instruments of incorporation of AIFs they manage". Annex II outlines the main principles that the AIFM should take into account in establishing a remuneration policy:
At least 50% of any variable remuneration shall consist of units or shares of the AIF concerned or equivalent ownership interests, or share-linked instruments (unless the management of AIFs accounts for less than 50% of the total portfolio managed by the AIFM, in which case the minimum of 50% does not apply).
A substantial portion (at least 40%) of the variable remuneration component must be deferred for at least 3 to 5 years. At least 60% must be deferred if the variable remuneration component is of a particularly high amount.
AIFMs shall establish a remuneration committee.
The AIFMs remuneration policy should be in line with the business strategy of the AIFM and the AIFs it manages or the investors of such AIFs.
Staff engaged in control functions (e.g., risk, compliance) are to be compensated in accordance with the achievement of the objectives linked to their function, independent of the business areas they control.
Assessment of performance must be set in a multi-year framework appropriate to the life-cycle of the AIFs managed by the AIFM.
Guaranteed variable remuneration shall be “exceptional” and only for first year.
Article 14b of the amended UCITS Directive proposes the introduction of a similar requirement on UCITS management companies to have a remuneration policy that promotes sound and effective risk management. The proposed remuneration policy requirements for a UCITS management company are broadly similar to that of an AIFM; at least 50% of any variable remuneration would consist of units or shares of the UCITS concerned, or share-linked instruments or the like; a remuneration committee would be required if applicable; the remuneration policy should be in line with the business strategy of the management company, the UCITS and the investors of the UCITS; guaranteed variable remuneration is exceptional also and limited to the first year.
However, under UCITS V at least 25% (40% under the AIFMD) of the variable remuneration component would be deferred for three to five years. However, 60% would be required to be deferred in the case of larger bonuses, which is consistent with the AIFMD.
UCITS V also proposes a similar "malus" provision as the AIFMD. Where the financial performance of the management company or of the UCITS is poor, variable remuneration would be reduced. This would apply to current remuneration and reductions in amounts previously earned, including through malus and clawback arrangements.
Where an AIFM appoints a third party to provide risk management or portfolio management services, the AIFMD ESMA Guidelines require an AIFM to ensure that the delegate is either subject to remuneration requirements that are equivalent to the AIFMD or that contractual arrangements are put in place to ensure that there is no circumvention of the remuneration requirements under AIFMD. There is no specific requirement in the AIFMD to impose remuneration requirements on sub-delegates, and it is hoped that the FCA's approach to implementation will clarify the extent to which remuneration principles must be applied to sub-delegates. It is also hoped that the UK FCA may give some relief to delegates based outside the EU which may not find it easy to adopt internal processes to accommodate EU requirements.
Currently under UCITS V, it is unclear how such provisions would apply to delegates, such as when investment management is delegated to a separate legal entity (including non-affiliated entities). We anticipate that the delegate position may match that under AIFMD, but we await confirmation on this from ESMA when its UCITS V remuneration guidance is released.
In line with remuneration requirements imposed by CRD IV, both the AIFMD and the UCITS remuneration requirements are subject to the principle of "proportionality". The concept of proportionality means that not all AIFMs and UCITS management companies will have to comply in full with the remuneration requirements outlined at Annex II of the AIFMD and Article 14b of the amended UCITS Directive.
The AIFMD ESMA Guidelines set out criteria for AIFMs to consider in the application of proportionality, such as the AIFM’s size, its internal organisation, and the nature, scope and complexity of its business and activities. The AIFMD ESMA Guidelines also state that, when applying proportionality, AIFMs should focus on the combination of all the above criteria and any other additional criteria that the AIFM considers to be relevant. It is the AIFM’s responsibility to assess its own characteristics and to develop and implement remuneration policies and practices that appropriately align the risks of its business and to provide adequate and effective incentives to its staff. In the UK, further rules and guidance are expected from the FCA, perhaps in early September or possibly sooner, to clarify how AIFMs should address proportionality.
Under UCITS V, the management company would have to comply with the remuneration provisions to the extent that is appropriate to the management company's "size, internal organisation and the nature, scope and complexity of their activities". We await further guidance from ESMA and national regulatory authorities (including, in the UK, the FCA) on how proportionality could be applied by UCITS management companies.
All AIFMs and UCITS management companies that are significant in terms of their size of the AIFs or UCITS they manage, and subject to other proportionality requirements, are required to establish a remuneration committee ("RemCo"). In summary, the RemCo shall be responsible for all decisions regarding remuneration. For AIFMs, based on the proportionality principle, the ESMA Guidelines sets out two limited examples where a RemCo is not required:
where the value of the portfolios of AIFs that an AIFM manages does not exceed EUR 250 million; and
where an AIFM is a subsidiary of an EU credit institution which itself is obliged to set up a RemCo and which performs its tasks and duties for the whole group.
For both a UCITS management company and an AIFM, the remuneration committee would be chaired by a member of the management body who does not perform any executive functions in the management company concerned, and the remuneration committee would include employee representatives. UCITS V states that when preparing its decisions on remuneration the remuneration committee shall take into account the long-term interest of stakeholders, investors and the public interest.
The AIFMD remuneration requirements also set out certain information regarding remuneration that must be disclosed to investors. There is no mandatory requirement for remuneration disclosures to be made public. Article 22(e)-(f) require an AIFM to include in its annual report, or a separate document that is provided to investors, the following information in respect of remuneration:
the total amount of remuneration for the financial year, split into fixed and variable remuneration, paid by the AIFM to its staff, and number of beneficiaries, and, where relevant, carried interest paid by the AIF; and
the aggregate amount of remuneration broken down by senior management and members of staff of the AIFM whose actions have a material impact on the risk profile of the AIF.
The amended UCITS Directive contains a similar requirement for the above information to be disclosed in annual report of the UCITS and management company in relation to the total amount of remuneration paid by the management company and by the investment company.
Under UCITS V, the management company would also disclose to investors information on the remuneration policy, including a description of how the remuneration has been calculated. There would also be comprehensive, accurate and timely disclosure of information about remuneration practices to all "stakeholders". In addition, details of the remuneration policies and the basis on which they have been decided shall be included in the Key Investor Information Document.
The Level 2 Regulations require an AIFM to disclose the total remuneration amount required under Article 22(e) (at (a) above) in relation to (1) the entire staff of the AIFM (together with the number of beneficiaries), (2) AIFM staff who are fully or partly involved in the activities of the AIF (together with the number of beneficiaries), or (3) the proportion of the total remuneration of the AIFM’s staff attributable to the AIF (together with the number of beneficiaries).
The AIFMD ESMA Guidelines impose a further requirement on AIFMs to disclose detailed information regarding their remuneration policies and practices to investors, albeit one that will apply "proportionately". This includes, but is not limited to, information concerning the decision-making process used for determining the remuneration policy, the composition and the mandate of the remuneration committee, information on pay and performance and the main parameters and rationale for any bonus scheme and other non-cash benefits.
Firms that are within scope of the remuneration proposals and requirements above should take steps now to ensure compliance with the remuneration proposals and requirements outlined above. These new requirements are likely to require material changes to current market practice and to the way that fund management staff are remunerated. Particularly, firms impacted by these remuneration proposals and requirements are likely to need to prepare detailed remuneration polices and also may need to implement additional governance arrangements.