Red flags to look for when spotting financial abuse
On 23 June 2015 the Financial Conduct Authority (FCA) issued their final rules and guidance to implement the proposals set out last year in their Consultation Paper in relation to remuneration. Whilst it is probably fair to say there were no huge surprises, these latest developments in the regulation of remuneration in the financial services sector form another milestone in the transformation of the regulatory regime which has been on-going since the financial crisis. According to the Treasury, Britain now has the toughest rules on bankers’ pay of any major financial centre. However, major questions remain unanswered, and bonus disputes appear inevitable once the new rules are applied in practice.
Scope of the new rules & related reforms
The relevant changes apply to banks, building societies and PRA-designated investment firms, including UK branches of non-EEA headquartered firms. The rules apply to all Material Risks Takers (MRTs) who are within the scope of the remuneration code at these firms, including Senior Managers under the Senior Managers Regime (SMR) from 2016.
As noted by Martin Wheatley, the CEO of the FCA, these latest rules form ‘part of a wider package that is being announced over the summer to embed an accountable culture in the City’. This package forms part of the FCA’s policy of credible deterrence through which it will incentivise good behaviour and hold individuals to account, through enforcement action, for misconduct or breach of its rules. The promotion of market integrity as a key objective of the FCA was demonstrated by the elevation of financial crime as a key area of focus in the FCA’s 2015/16 business plan. Prior to the financial crisis, City regulators already had a range of civil, regulatory and criminal sanctions at their disposal. These are being increasingly strengthened as evidenced by these new rules on remuneration. This year has also seen the extension of the criminal offence of making misrepresentations in the course of setting a relevant benchmark, introduced to combat future attempts to manipulate LIBOR, to encompass seven additional benchmarks. Further, and although likely only to apply in the most exceptional cases, the new offence of reckless banking came into force this year, aimed at punishing senior persons for the failure of a financial institution.
As such, the regulation of bankers’ bonuses and remuneration is just one part of the picture and parallel changes will be introduced to the Approved Persons Regime. These will result in a strengthened regime for the regulation of senior persons and a new fit and proper licensing regime for more junior employees.
The new rules on deferral and clawback will apply to bonus awards for performance periods commencing on or after 1 January 2016, with various other rules and guidance effective from 1 July 2015.
Bonus payments - deferral & clawback
As expected from the consultation, bonus awards will be subject to lengthier deferral periods, although consultation has resulted in some change to the applicable periods, depending on seniority and role. The regulators’ view is that the combination of lengthier deferral periods and malus (the employer’s power to reduce or cancel unvested awards in broad circumstances, including financial downturn) is a crucial part of their policy goal of discouraging
Excessive risk taking and short-termism.
Previously the deferral period for all MRTs (in line with the CRD IV Directive) was ‘at least three to five years’. Under the new rules, Senior Managers as defined under the SMR with the greatest influence over the strategic direction of the business will be subject to the longest deferral periods, with the introduction of a minimum seven year deferral period, no vesting before the third anniversary of the bonus award, and then vesting no faster than pro rata. The minimum deferral period in the case of risk managers at PRA regulated firms will be five years (with no vesting faster than pro rata from year one). This new category of staff is designed for the next tier of management at PRA regulated firms with senior, managerial or supervisory roles, such as the heads of business units and their direct reports, function heads, and the managers of MRTs. Other MRTs at PRA and/or FCA regulated firms will be subject to a minimum three to five year deferral period.
The minimum clawback period, by contrast, will remain seven years, but now the FCA is introducing clawback rules that are comparable to the existing PRA rules. In addition, firms will be required to extend the clawback period by up to three years (to a total 10 year period) for Senior Managers where there are outstanding internal or regulatory investigations at the end of the normal seven year period. Whilst this latter proposal was widely opposed in consultation, its introduction is unsurprising as conduct and culture in the financial sector remain firmly in the spotlight. The ability to recover bonuses up to 10 years after their award will allow employers to go back further in time than a court would be able to under proceeds of crime legislation if the individual were prosecuted and convicted for their conduct.
Clawback – the big questions remain unanswered
The original clawback rules only came into force on 1 January 2015 in relation to awards made on or after that date. Consequently, the big questions concerning the scope and enforceability of clawback remain unanswered. There are, for example, technical questions outstanding concerning how non-cash bonus awards will be valued in clawback cases, and whether clawback will apply to the gross or net value of bonus awards. More fundamentally, the grounds on which firms seek to clawback bonuses are bound to be controversial. Inevitably clawback disputes are going to occur when firms seek to recover vested and paid bonuses, awarded up to seven (or even ten) years previously.
Firms are required to ensure that their rules and contractual powers in relation to malus and clawback cover situations where an employee participates in or is responsible for conduct resulting in significant losses or fails to meet appropriate standards of fitness and propriety. They must make ‘all reasonable efforts to recover’ (i.e. clawback) the ‘appropriate amount corresponding to some or all’ vested bonus pay in two scenarios.
The first is where there is ‘reasonable evidence of employee misbehaviour or material error’. On the face of it, this ‘reasonable evidence’ test sets the evidential bar at a low level for what will in effect be a financial penalty for the individual. The second is risk management failure within a firm or business unit. In deciding whether and to what extent it is reasonable to seek recovery of vested bonus pay firms must take into account ‘all relevant factors’ including (in the case of risk management failures) the proximity of the employee to the failure in question and their level of responsibility.
The FCA’s new guidance for firms on the application of malus and clawback reinforces the clear message previously given by the PRA that the scope of these rules extends far beyond staff directly at fault. In cases of risk management failure or misconduct, firms are expected to consider cancelling and/or clawing back bonus awards in relation to those employees:
As the emphasis moves towards the accountability of senior management for conduct and culture, senior executives in the City will increasingly be at risk of bonus cancellations and clawback claims, in many cases after a period when the vesting of prior awards has been frozen pending the conclusion of internal or external investigations. The low evidential threshold and wide ambit will lead to situations where individuals are the subject of lengthy criminal investigations, then are not prosecuted or are acquitted at trial, yet still find themselves subject to malus and clawback by their firms.
There have been recent examples of banks not seeking to recover the bonuses of employees who have been dismissed for gross misconduct for their role in setting benchmarks. These new rules mean that firms will be under increased regulatory and reputational pressure to claw back bonuses where they would not have done previously and even where they might incur significant costs, particularly if the claw back is the subject of legal challenge by the employee.
Although it concerned very different circumstances (the outcome of an employer’s investigation into the cause of a death at sea, resulting in no death in service benefit being payable based on a finding of suicide) the recent Supreme Court decision in Braganza v BP Shipping highlights that the exercise of contractual decision making powers can be the subject of successful legal challenge. This is particularly true when the contractual decision making power is exercised by an employer, to the significant financial detriment of the other, weaker party to the contract, i.e. the employee. In the case of clawback, the employer will reserve the contractual power to require the repayment of bonus pay at its broad discretion. This may well be in circumstances where the employer itself has been the subject of substantial fines, for example for failing to have adequate systems and controls in place, and then seeks to claw back part of that amount from its employees. This inherent tension gives rise to further scope for challenge by employees. The Supreme Court’s confirmation that the personal nature of the employment relationship and the implied duty of trust and confidence that exists in every employment contract may justify a more intense scrutiny of an employer’s decision making process than would be appropriate in commercial contracts is therefore important in the context of the largely unchartered territory of bonus clawback.
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