Remuneration relaxation: The UK FCA's proposals in CP26/27

The revised rules will be relevant to UK AIFMs, UK UCITS management companies and UK solo-regulated MiFID investment firms (defined as "MIFIDPRU investment firms" in the FCA's rules). For simplicity, we refer to these collectively as "solo-regulated asset managers" below, although this definition would also catch, for example, a firm giving only MiFID investment advice or carrying on MiFID corporate finance business.

For the avoidance of doubt, the rules will not affect other FCA solo-regulated firms which are not currently subject to a specific remuneration code (e.g. non-MiFID personal investment firms, regulated service companies, etc.).

As noted above, the current remuneration rules are contained in three different codes, depending on the type of solo-regulated asset manager (i.e. AIFM, UCITS manager or MiFID firm). Many firms have found this unsatisfactory because:

• A firm can be subject to more than one code at the same time, which then requires an analysis as to how to satisfy often similar, but not identical requirements. In practice, this has often necessitated a "levelling up" to the highest common denominator; and
  
  
• This approach can make adopting a single, consistent group-wide remuneration policy more difficult, due to the subtle variations between the codes where a group contains more than one type of solo-regulated asset manager.

To address these problems, the FCA is proposing to repeal all three of the current codes and effectively to merge them into a new Solo-Regulated Firms Remuneration Code, which will apply consistently to all solo-regulated asset managers. In the future, this means that it may be considerably more straightforward to adopt a single, group-wide remuneration standard (at least as regards UK regulated entities).

The FCA is also proposing to repeal the related non-Handbook guidance that corresponds to the various existing codes and (via HM Treasury's legislative proposals in relation to the UK AIFMD reforms), also to delete the existing AIFMD-derived remuneration requirements in the onshored AIFMD Level 2 Regulation. This means that firms will no longer need to refer to multiple sources when determining the remuneration obligations that apply to them, which is also likely to be welcomed by the industry.

Note that the FCA is not currently proposing to repeal the MiFID-derived rules on incentives and performance management in the SYSC 19F rules. Nonetheless, as these are broad, principles-based requirements which primarily relate to having adequate policies and addressing potential conflicts of interest, firms have typically not found navigating these requirements to be particularly challenging.

The FCA is proposing that the new Solo-Regulated Firms Remuneration Code will apply to:

• full-scope UK AIFMs;
• MIFIDPRU investment firms that are not small and non-interconnected (i.e. "non-SNI" firms); and
• all UK UCITS management companies.

In relation to AIFMs, the FCA notes that it has simultaneously (alongside HM Treasury) published detailed proposals for reform of the UK AIFMD regime. Under those proposals, assuming that the revised AIFMD regime is implemented as proposed, the remuneration rules would in the future apply to medium UK AIFMs (i.e. UK AIFMs managing AIFs with an aggregate net asset value of £750 million to £5 billion) and large UK AIFMs (i.e. UK AIFMs managing AIFs with an aggregate net asset value of more than £5 billion). This means that UK AIFMs falling below those thresholds (which the FCA terms "small AIFMs" under the new regime) would no longer be subject to detailed remuneration rules.

Under the existing MIFIDPRU Remuneration Code, SNI MIFIDPRU investment firms are subject to a basic set of remuneration requirements, with non-SNI firms being subject to more detailed "standard" requirements and large non-SNI firms being subject to further "enhanced" requirements. If the FCA's proposals are adopted, SNI firms will no longer be subject to the detailed remuneration requirements at all, while all non-SNI firms would essentially become subject to principles-based requirements which would need to be applied on a proportionate basis (see below). This means that there will no longer be a concept of a "large non-SNI firm" which, under the current framework, has represented a cliff-edge risk for some firms once their balance sheets have exceeded certain size thresholds.

Under the current rules, where a MIFIDPRU investment firm forms part of a group to which prudential consolidation applies, certain remuneration requirements apply on a group-wide basis.

The new Solo-Regulated Firms Remuneration Code does not contain any proposed provisions which deal with application of requirements to the wider group. As a result, the relevant remuneration requirements will apply only to the relevant solo-regulated asset manager(s) in the group as individual legal entities, without capturing other group members.  (Firms should note, however, that individuals who are technically employed by another group entity can still be caught within the wide definition of in-scope "staff" of a solo-regulated asset manager under the Solo-Regulated Firms Remuneration Code where they provide services to, or are placed at the disposal and under the control of, the relevant asset manager.)

This is likely to be a very welcome change for current MIFIDPRU investment firm groups which are subject to the consolidation framework, as it will prevent the presence of one or more MIFIDPRU firms "contaminating" the rest of the group from a remuneration perspective.

Under the new proposed rules, "remuneration" will be broadly defined and includes the following:

• Any form of remuneration provided or awarded in connection with a person's employment by a solo-regulated asset manager (and "employment" for these purposes is defined very broadly and would include arrangements such as secondments, provision of services through a group service company, or other situations where the firm arranges with a third party for a person to provide services under the firm's direction and control).
  
  
• Any amount paid by, or on behalf of, an AIF (including carried interest) or a UCITS fund (including performance fees) which is for the benefit of a material risk taker (see below).
  
  
• Any transfer of units or shares in an AIF or UCITS fund which is for the benefit of a material risk taker.

As a result, the concept of remuneration will continue to capture a wide range of economic arrangements with employees, including salary, bonuses, carry arrangements, or awards of shares or units in a fund.

Under the new Solo-Regulated Firms Remuneration Code, the FCA is proposing that a range of high-level requirements should apply in relation to all staff in a solo-regulated asset manager. These include the following:

• Remuneration policies and practices which promote "good conduct and a healthy culture", which ensure appropriate alignment with the interests of clients, funds and investors, and which promote sound and effective risk management.
  
  
• Appropriate governance arrangements to oversee the relevant remuneration arrangements.
  
  
• Ensuring that staff employed in control functions (e.g. compliance, risk management or internal audit) are compensated according to objectives linked to their function, independent of the performance of the business areas over which they have control.
  
  
• Ensuring that the remuneration of senior officers in control functions is directly overseen by the firm's management body or remuneration committee (if it chooses to have one under the new rules). The FCA confirms that a firm can comply with this requirement at a group level – i.e. via a group remuneration committee or a group-level management body – provided that the group structure can exercise effective oversight.
  
  
• Ensuring that remuneration policies and practices contain measures to avoid conflicts of interest.
  
  
• Ensuring adequate record keeping of remuneration practices (including any relevant assessments and decisions).
  
  
• When establishing and implementing its remuneration policies, the FCA confirms that a firm can select from a range of different remuneration tools that are appropriate to its business model. Non-exhaustive examples of relevant tools for payment of remuneration to staff include payment in shares in the regulated firm, units or shares in an AIF or UCITS under management, share-linked or equivalent non-cash instruments or other types of arrangements that align the interests of staff with investors and clients of the relevant firm, having regard to the nature of its activities. The latter reference would seem to permit a firm to use carried interest arrangements as a tool to ensure alignment of an individual's remuneration with risks and outcomes.

There will be an overarching proportionality rule which states that a firm's remuneration policies and practices must be appropriate for, and proportionate to, the nature, scale and complexity of its business model and the risks arising from its activities.

In practice, as the FCA notes in the narrative accompanying its proposals, where a firm is fully compliant with one or more of the existing remuneration codes, it is likely to meet the general requirements above. Accordingly, many firms may not need to take additional implementing actions, but they may instead wish to review existing frameworks to determine if there would be additional flexibility under the new rules in relation to specific aspects of their policies and procedures.

Given the increased flexibility and the use of broad principles, it is unclear if the FCA will still publish a template remuneration policy statement under the new Solo-Regulated Firms Remuneration Codes to help firms document their remuneration policies and procedures.

Under the current MIFIDPRU Remuneration Code, non-SNI firms are required to identify material risk takers (MRTs). Where the non-SNI firm is part of an investment firm group to which prudential consolidation applies, the current rules also require the group to identify MRTs at the consolidated level.

Under the new proposed Solo-Regulated Firms Remuneration Code, there will be a revised definition of an MRT. A staff member will be an MRT if the person's professional activities or remuneration incentives have a material impact on any of the following:

• The solo-regulated asset manager's conduct in relation to its clients or investors;
• The interests of AIFs or UCITS funds, or investors in them; or
• The firm's compliance with its regulatory obligations.

The precise scope of the rules in relation to the above reference to AIF or UCITS funds and their investors is somewhat unclear from the FCA's proposed drafting, but it is presumably intended that the relevant fund need not be the direct regulatory client of the firm. For example, where an employee is carrying on portfolio management activities within a UK delegated portfolio manager which is itself providing services to an AIFM, if those activities could have a material impact on the underlying AIF or its investors, the FCA presumably intends that the individual would be an MRT, even though neither the AIF nor the investors are the regulatory client of the delegated manager.

The FCA then provides a non-exhaustive list of examples of staff members whom it considers are likely to be MRTs under this test, which includes staff members who:

• Have authority to take decisions that can materially affect investors' outcomes, the treatment of clients, or market integrity;
  
  
• Are responsible for strategic decisions;
  
  
• Are responsible for significant revenue or material assets under management, or for approving transactions;
  
  
• Can commit the firm, its clients or investors to risk exposures or business strategies that may cause material harm;
  
  
• Are able to influence the design, approval or distribution of products or services in a way that may cause material harm; or
  
  
• Have remuneration which is materially linked to outcomes where poor conduct or misaligned incentives may cause material harm.

In its narrative to the consultation proposals, the FCA indicates that it views the new MRT definition as being narrower than the current MIFIDPRU definition. However, based on the proposed new definition, it is not necessarily clear that this is true, particularly given the broad references to activities or incentives which have a potential material impact on clients, investors or regulatory obligations generally. While the prescriptive list of activities that are automatically deemed to have a material impact has been deleted, the new definition therefore still seems sufficiently broad to capture a relatively large number of staff members, depending on how it is interpreted in practice.

The FCA notes that as the MRT definition is also used to determine whether an individual falls within scope of the Certification Regime, changes to the definition may affect the population of certified staff within a firm (although this will also be subject to anticipated future reforms of the Senior Managers and Certification Regime framework). In keeping with its observation above, the FCA assumes that this would result in a reduction in the number of certified staff, but this will depend on how the revised general definition of an MRT is interpreted in practice.  

There will no longer be any requirement for investment firm groups which are subject to prudential consolidation to identify MRTs on the basis of their consolidated position, which is likely to be welcomed by firms.

Under the new proposed rules, MRTs will be subject to six new remuneration principles, which replace the existing prescriptive rules in areas such as deferral, malus and clawback. Broadly, these new principles are:

1. The structure of an MRT's fixed to variable remuneration must be appropriate to the firm's risk profile and include a sufficiently high fixed component so that variable remuneration can be reduced or not paid, where appropriate. However, there will no longer be a requirement to set a specific ratio of fixed to variable remuneration.
   
   
2. For any performance-related remuneration, the assessment of an MRT's performance must reflect both financial and non-financial criteria (including the individual's conduct and adherence to risk management and regulatory requirements).
   
   
3. Guaranteed variable remuneration (e.g. a sign-on bonus) may be paid only in the context of hiring a new MRT or compensating an MRT for remuneration forfeited from previous employment, must be time-limited and must be subject to appropriate recovery or adjustment in cases of misconduct or where misaligned incentives may cause material harm. The existing requirement for this to contain provisions on retention, deferral, vesting and risk adjustment that are at least equivalent to the terms applied by the previous employer is being deleted, although the firm must still ensure that the bonus or award does not undermine the incentives for good conduct or appropriate risk management.
   
   
4. Payments to an MRT for early termination of employment must reflect the individual's performance and must not reward failure or misconduct.
   
   
5. The firm's management body must determine whether its remuneration policies provide for deferral of variable remuneration to MRTs. When making this decision, the management body should consider the nature of the firm's business, the interests and time horizons of the firm's clients and any fund investors, and the activities and responsibilities of the MRT. The FCA indicates that it expects deferral may be appropriate where the MRT carries out activities where the relevant outcomes for the firm or for consumers may be assessed only over longer time horizons, or where the MRT is managing money or assets for AIFs or UCITS funds. (Note that the FCA has also put forward a possible alternative approach to deferral, which is discussed below.)
   
   
6. The firm must consider whether it would be appropriate to implement performance adjustment mechanisms in relation to the variable remuneration of MRTs where the outcomes from an individual's behaviour fall below the firm's expectations on conduct, compliance or risk management. The FCA gives examples of potential adjustment mechanisms, including reductions to unvested deferred remuneration, in-year adjustments, malus and clawback. However, none of those examples are mandatory, so where a firm concludes that it is appropriate to apply performance adjustment, it will have flexibility to determine which mechanisms are most appropriate to achieve the overarching objective of preventing MRTs from benefiting from their misconduct. It appears that it would be open to a firm, in appropriate cases, to conclude that no performance adjustment mechanism is appropriate, having regard to the nature of its business and the risks involved.

As noted above, in relation to deferral of variable remuneration specifically, the FCA has set out an alternative approach (although the approach described above is the FCA's preferred option). Under the alternative approach, the FCA would specify a mandatory deferral regime where a firm exceeded a specified size threshold; below the relevant threshold, the principles-based approach above would apply instead. As an example, the FCA suggests that the PRA's proportionality thresholds applicable to UK banks could be used (i.e. firms with total assets below £4 billion could disapply deferral entirely, while firms with total assets between £4 billion and £20 billion would be able to apply deferral requirements proportionately). However, the FCA notes that total balance sheet assets thresholds may not be the most appropriate metric for solo-regulated asset managers, given that non-balance sheet AUM or revenue might be better alternative risk indicators.

We anticipate that firms and industry associations will strongly prefer the FCA's preferred principles-based approach to deferral, rather than the alternative of calibrating the application of deferral rules by reference to specified size thresholds. However, the FCA notes that if it proceeds with the preferred option, it may still supplement the rules with non-Handbook guidance setting out its expectations and examples of good practice. Such an approach may not be particularly desirable either, as FCA non-Handbook guidance has often been treated by the regulator's supervisory teams as if it establishes new mandatory requirements and there is a risk of "changing goalposts" over time.

Subject to these points, the move towards a principles-based approach to the application of specific remuneration requirements to MRTs is likely to be welcomed by firms, providing them with greater flexibility to tailor arrangements in a way that is appropriate to their size and the complexity of their activities. However, one consequence of this approach is that there will be fewer "bright line" requirements, meaning that firms will need to document their approaches carefully to explain why they have concluded that their policies are appropriate to their particular situations. We anticipate that industry associations may wish to advocate for express recognition in the FCA's new rules or guidance that arrangements such as "bad actor" provisions in global carried interest or restricted stock unit (RSU) schemes can represent appropriate performance adjustment arrangements within long-term incentive structures which can be considered to achieve proper alignment of conduct and performance risks.

The FCA is proposing that the Solo-Regulated Firms Remuneration Code should also contain a general anti-avoidance rule which prohibits a solo-regulated asset manager from paying variable remuneration through financial vehicles or methods which would facilitate non-compliance with the Code. It gives the example of using arrangements where remuneration is technically fixed remuneration, but is structured in such a way as to preserve the economic substance of variable remuneration, and indicates that when supervising compliance with the Code, it will apply a "substance over form" approach.

This is similar to existing anti-avoidance provisions in the current remuneration frameworks and for many firms, this is therefore unlikely to be a particular concern. However, it is a reminder that firms which adopt potentially aggressive technical structuring of arrangements to avoid restrictions on variable remuneration may be at risk of breaching FCA rules and/or having such remuneration re-characterised under the new rules. Nonetheless, as the new framework permits more flexibility in how remuneration rules are applied in practice, complicated structural solutions may be less desirable in any case.

Under the current MIFIDPRU framework, all MIFIDPRU investment firms are required to make certain public disclosures about their remuneration policies and practices, with non-SNI firms being required to make more detailed disclosures. The FCA has concluded that these disclosures impose operational burdens on firms without significantly improving firms' approaches to risk management and therefore these requirements are being deleted from the MIFIDPRU rules.

MIFIDPRU investment firms are also currently required to submit the MIF008 remuneration report to the FCA, setting out details of remuneration paid during each performance year. Again, the FCA has concluded that these reporting requirements are unnecessary in light of its move to a broader, principles-based regime and therefore they are being deleted.

The FCA nonetheless reminds firms that they will need to keep appropriate records of how they are applying the remuneration requirements and principles so that they can demonstrate that they are complying with the new Solo-Regulated Firms Remuneration Code.

These proposals are clearly positive, reducing the compliance burden on firms and mitigating the potential issues that can arise (such as predatory hiring practices) where remuneration-related information is made public. Accordingly, we expect that firms and industry associations will show strong support for this approach in any consultation responses.

The FCA is proposing transitional provisions for performance periods which straddle the implementation date of the new Solo-Regulated Firms Remuneration Code. In that case, the existing remuneration rules (i.e. the AIFM Remuneration Code, the UCITS Remuneration Code or the MIFIDPRU Remuneration Code) will continue to apply in relation to any performance or services provided in that performance period. This will be the case even if the remuneration which is awarded in respect of any part of that performance period is actually paid after the new rules come into force. The transitional provisions also state that any associated reporting requirements (such as the MIF008 return) will also continue to apply, although there is no reference to public disclosure requirements and therefore it is assumed that the latter will not apply during the transitional period.

Firms and industry associations may wish to push back on this proposed approach in their responses to the consultation. As the transitional rules are mandatory, rather than optional, this would seem to require firms to continue to apply, for example, existing deferral, malus and clawback requirements to remuneration awarded in any performance periods preceding, or straddling, the implementation date of the new rules, even though that remuneration could take several years to vest and potentially be subject to clawback for several years thereafter. Depending on how the reference to reporting in the transitional rules is interpreted, there is an associated risk that regulatory reporting on remuneration could also persist for several years. This approach could therefore create a long "hangover" of the current framework, which seems both unnecessary and undesirable, given the de-regulatory intent behind the proposed reforms.

It is probably fair to say that in the past, we have been somewhat critical of previous "de-regulatory" proposals from the FCA, often due to concerns that the relevant reforms have been risk-averse and tepid. It is therefore refreshing to see remuneration proposals which, on their face at least, go a considerable way to addressing the UK asset management industry's concerns about the existing rulebook and its fragmented, prescriptive and overly complex requirements. Through our involvement in industry advocacy, we have consistently emphasised the importance of the regulator trusting firms to design and tailor their individual remuneration policies within the guardrails of a broad and flexible framework. We are therefore delighted to see that the FCA has taken on board these design principles in CP26/27.

Subject to certain points we have identified above which might benefit from clarification or refinement, if the FCA's proposals are adopted in their current form, UK asset managers will benefit from a significant new flexibility to design appropriate remuneration policies and practices which can genuinely address the potential risks arising from their activities, while also avoiding complex and unnecessary structural requirements which do not fit their business models.

Of course, the proof of the pudding is in the eating: ultimately, as with any principles-based regime, it is the FCA's supervision of the broad principles in practice that will define whether the new rulebook is genuinely de-regulatory. Many UK firms that are within scope of the Consumer Duty have seen first-hand the difficulties that can arise where requirements are defined at too abstract a level, with a perception that the regulator can then subsequently move the goalposts through an ever-increasing constellation of supervisory guidance and good and poor practice publications.

Nonetheless, provided that firms adopt justifiable and proportionate approaches to applying the new rules and the FCA can resist the temptation to re-construct a more prescriptive regime through non-Handbook guidance, we think that the latest proposals are a significant win for the UK asset management sector and its advocates. By taking a proportionate amount of risk, the regulator seems to have delivered a well-deserved bonus to the industry.