Paul Ellerman and Bradley Richardson, Herbert Smith Freehills, 6 November 2013


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 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
  • 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.


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).


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

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.


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.


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.


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.


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.

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