The UK’s Financial Conduct Authority has published a ‘consultation document’ to resolve many of the outstanding issues surrounding the implementation in the UK of the remuneration rules introduced by the European Union’s Alternative Investment Fund Managers Directive (AIFMD). Paul Ellerman and Bradley Richardson of Herbert Smith Freehills explain why it is likely to be helpful to fund management firms. The policies that they discuss have their analogues in all the international financial centres of the EU.

The UK’s Financial Conduct Authority has published a ‘consultation document’ to resolve many of the outstanding issues surrounding the implementation in the UK of the remuneration rules introduced by the European Union’s Alternative Investment Fund Managers Directive (AIFMD). Paul Ellerman and Bradley Richardson of Herbert Smith Freehills explain why it is likely to be helpful to fund management firms. The policies that they discuss have their analogues in all the international financial centres of the EU.

The AIFMD came into force in the UK on 22 July 2013 and all the relevant fund management firms will have to be authorised by 22 July 2014. The AIFMD contains rules that govern the way in which fund managers can pay their staff. These rules are being implemented in the UK as the FCA’s “AIFM Remuneration Code”, a collection of rules that the regulator will finalise after the period of consultation ends.

THE RULES IN SUMMARY

The AIFM Remuneration Code does four things:

• it sets out a number of general remuneration principles, including general risk management requirements in respect of the firms’ remuneration policies, while banning any agreements to pay bonuses of guaranteed amounts;
• it requires fund firms to set up non-executive remuneration committees;
• it contains more onerous rules to govern the payment of key staff – these ‘Pay-Out Process Rules’ require 40% - 60% of ‘variable remuneration’ to be deferred over 3 to 5 years; 50% of each of the upfront and deferred components of ‘variable remuneration’ to be paid in the form of fund units or equivalent instruments; and ‘variable remuneration’ to be subject to ‘malus’ and/or ‘clawback’ provisions; and
• it requires fund managers to include ‘remuneration disclosures’ in the annual reports of all the alternative investment funds (AIFs) that they send to investors.

‘Malus’ provisions are a mechanism to enable firms to reduce the amount of deferred, but not yet paid, bonuses when certain events occur (including a significant downturn in performance or a material failure of risk management), whereas ‘clawback’ provisions would apply in similar circumstances but so as to require the repayment of bonus amounts that have already been paid.

TIMING IS THE KEY

An important subject that firms have been considering is the FCA’s time-line for required compliance with the AIFM Remuneration Code. The consultation paper makes it clear that each firm will only have to subject its remuneration regime to the new rules in respect of the first full ‘performance period’ (which in many cases will mean the firm’s financial year) commencing after the firm obtains authorisation as an AIFM. Thus, when a firm has a calendar-year performance period and waits to become authorised until 22 July 2014 (the ‘long-stop date’ that the directive imposes for authorisation), the first performance period caught by the rules will be 1st January to 31st December 2015. This would mean that the first bonus payments to be subject to the rules would be those paid in the first quarter of 2016.

Although the FCA is proposing to delay the time until firms’ remuneration policies have to come into force, firms should still continue to prepare those new policies now. This is because the application that each firm has to make to the FCA before the regulator will change (‘vary’) its ‘permissions’ and authorise it (with the new ‘permission’ of ‘managing an AIF’) must include a confirmation that the new remuneration policy is in place. It must also enclose a summary of that policy (although the policy will have a delayed start date).

PROPORTIONALITY: ABLE TO OVERRIDE IMPORTANT REQUIREMENTS

The ‘proportionality principle’ states that firms only need to comply with the rules in a manner befitting their size, organisation and complexity. How will this apply in respect of the onerous Pay-Out Process Rules?

The FCA is taking a very helpful approach to fund management firms in its proposals, although the process that they will have to go through is more involved than one might have expected. It is also more complex than the equivalent process under the existing CRD Remuneration Code.

Each firm will have to undertake a two-stage analysis. Firstly, it will have to compare its total assets under management (AuM) with set thresholds. The nature of the alternative investment funds in the portfolio – whether or not they are leveraged and whether they are open-ended or closed-ended – will dictate the threshold that applies. Although the FCA does not say so expressly, it seems to view the two thresholds that it mentions as the two ends of a risk spectrum – leveraged funds at one end, and unleveraged, closed-ended funds at the other. It is not yet clear how the thresholds apply to fund firms with portfolios that include funds at both ends of this spectrum or include types of fund not covered by the FCA guidance.

This first step in the analysis is only designed to create a presumption as to whether or not the Pay-Out Process Rules apply. The firm in question will then have to analyse all other factors that affect its risk profile. These other considerations can override the initial presumption.

The ‘proportionality principle’ can also be relied on to disapply the requirement to establish a non-executive remuneration committee. The current FCA consultation paper does provide detail on this point, but this is because guidance has already come from the European Securities and Markets Authority (ESMA) and the FCA has promised to comply with it.

WHEN FUND FIRMS DELEGATE JOBS TO OTHERS

Those ESMA guidelines also introduced the principle that whenever an AIFM delegates the management of a portfolio and/or risk management, either to a different entity in its own group or to a ‘thirdparty’ (external) investment manager, the AIFM must ensure:

• (i) that the so-called ‘delegate’ is subject to regulatory requirements that are ‘equally as effective’ as those applicable under the AIFMD; or
• (ii) that appropriate contractual arrangements are there to ensure that there is no circumvention of the AIFMD remuneration rules.

The FCA has again taken a pragmatic approach here and states that it will generally accept that delegate-firms that are subject to the existing Capital Requirements Directive Remuneration Code will be treated as satisfying the ‘equally as effective’ test. This will be of help to UK fund managers, although foreign fund managers will have to consider whatever guidance their home-state regulators have published, even if they are delegating these jobs to UK entities.

INSTRUMENTS AS A MEANS OF PAYMENT

The consultation paper again takes a pragmatic approach in respect of the requirement to ensure that the ‘variable remuneration’ of the senior managers of the AIFM in question and those staff members who have a material impact on the risk profile of either the AIFM or the funds under management (collectively referred to in the UK as ‘code staff’) is paid in part in the form of ‘instruments’. These are units in the funds for which the individual is responsible, or equivalent interests.

Firstly, the requirement to use instruments is subject to the legal structure of the fund in question. The FCA follows the directive in this respect and states that wherever it is impractical to pay remuneration in the form of fund units or equivalent interests due to the legal structure of the fund, the fund manager need not. The regulator says it may be impractical to use fund units:

• when the fund is closed-ended and no units are available;
• when minimum investment thresholds would not be met; or
• when it would be prohibited by ‘other regulation’.

There are issues that a fund management firm might have to bear in mind when seeking to rely on this guidance. It would have to undertake analysis to decide whether or not it would be impractical to pay remuneration in instruments on a fund-by-fund basis. Even if it could not pay remuneration in the form of actual fund units, it would instead have to use equivalent instruments (such as synthetic units), unless it could also show that it would be impractical to do so.

Whenever a fund management firm does disapply this requirement, the FCA recommends that it should still consider paying part of ‘variable remuneration’ in the form of shares in itself or its parent company, or in an index of the funds under management. This is, however, only a recommendation and even if the firm does do so it will have complete flexibility in determining what proportion of remuneration will be paid in this way (normally, at least 50% of both the upfront and deferred components of ‘variable’ remuneration must be paid in instruments).

Secondly, even when it is possible for a fund manager to pay remuneration in the form of shares in the funds under management, the FCA recognises that in some cases this requirement would be disproportionately onerous. In such a case, the FCA will permit the use of shares in the management firm or its parent company, or of units in an index of the funds under management. This approach could be justified for senior managers whose jobs relate to the whole firm and not to any specific fund. Similarly, the payment of remuneration in the form of fund units may create a conflict of interest for people in risk and compliance jobs in respect of those funds, and so shares in the fund firm might be more appropriate.

Any firm that has a portfolio that is less than 50% alternative investment funds (by net asset value) should also take account of the ESMA guidelines that govern the proportion of ‘variable’ remuneration that must be paid in instruments. Whereas normally 50% of ‘variable’ remuneration must be paid in instruments, if AIFs account for less than half of the total portfolio that minimum 50% requirement can be reduced to a proportion that reflects the proportion of AIFs in the portfolio.

WHICH REMUNERATION IS SUBJECT TO THE RULES?

When a staff member’s role solely relates to the management of AIFs, as in the case of a portfolio manager, it is clear how the rules apply because they govern the whole of his remuneration. However, other staff may do jobs that relate partly to AIFs and partly to “non-AIFMD” business – which includes managing Undertakings for Collective Investment in Transferable Securities (UCITS). In this case, the FCA says that the individual’s remuneration can be apportioned, with only the AIF-related proportion being subject to the AIFMD rules.

For many firms that are already subject to the existing Capital Requirements Directive Remuneration Code, the non-AIF proportion of remuneration will still be subject to that existing code, but the consultation paper states that the ‘proportionality principle’ already embedded in that regime can continue to be relied on, as it is now.

Another consideration arises for fund firms structured as partnerships. In this case, the FCA has said that partnership drawings will be treated as remuneration subject to the AIFM Remuneration Code. However, the FCA will permit owner-managed partnerships to exclude a part of the partnership drawings (those that represent a commercial return on the capital invested by the partners) from the ambit of the rules. Although this guidance is helpful, it is not clear if it applies to limited-liability partnerships that can be seen as ‘subsidiaries’ of wider groups by virtue of having corporate members and other partnerships will also still have to issues to deal with in formulating effective and tax-efficient deferral arrangements.

DISCLOSURE – WHAT SHOULD HAPPEN AND WHEN

The biggest outstanding issue not addressed by the consultation paper is that of the directive’s disclosure-related requirements. Each fund management firm will have to include ‘remuneration disclosure’ in the annual report of each AIF and provide it to investors (but not the public). In summary, an AIFM will have to disclose the remuneration of its entire staff membership, split by fixed and variable pay, and a single total remuneration figure for each of its senior managers and every other member of its ‘code staff’ (i.e. every important risk-taker).

The crucial outstanding question is about timing – the FCA’s plan for the disclosure rules seems to envisage the fund management firm having to make ‘remuneration disclosures’ as soon as it has become authorised. However, this does not sit well with the substantive remuneration rules only becoming effective for the first full performance period after authorisation.

There appears to be good evidence for arguing that the disclosure requirements should first apply in respect of the first full financial year of the AIF that begins after the manger becoming authorised. This would save fund firms from having to disclose remuneration for periods when they were not subject to the directive, which would be an odd result and one that might confuse investors. It is hoped that the FCA will issue guidelines on these subjects and resolve the uncertainties that firms are facing.

Paul Ellerman is a partner and Bradley Richardson is a senior associate in the Herbert Smith Freehills LLP Remuneration and Incentives group. Paul can be reached at +44 20 7466 2728 and paul.ellerman@hsf.com; Bradley at bradley.richardson@hsf.com and +44 20 7466 7483.