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«Recent European Compensation Developments: Financial Institutions and Beyond April 23, 2013 Almost half a decade after the onset of the financial ...»

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Recent European Compensation Developments:

Financial Institutions and Beyond

April 23, 2013

Almost half a decade after the onset of the financial crisis, populist sentiment and the resulting political

environment continue to fuel stricter regulation of executive and director compensation, with the latest

wave in Europe including substantive restrictions on compensation in the financial services industry and “say-on-pay” initiatives (i.e., initiatives providing for shareholder approval of compensation). This

memorandum describes these recent European compensation developments, namely:

 The so-called “banker bonus cap” – substantive limits on the amount of variable compensation that can be paid to certain employees at financial institutions; and  Say-on-pay developments in the E.U. and Switzerland.

Banker bonus cap. Last week, the European Parliament approved restrictions on bonus payments by financial institutions as part of Capital Requirements Directive (CRD) IV, which greatly amends the E.U.’s rules on capital requirements for credit institutions (including banks) and investment firms. 1 This memorandum describes these limits and related restrictions for financial institutions in the E.U. Notably, the bonus cap is not only an issue for E.U. employees, but will also apply to certain U.S. employees of financial institutions that are in the E.U. and to E.U.-based employees of financial institutions, regardless of where the institutions are headquartered. And, while the bonus cap has received the most press, there are several other items of interest, including certain pension deferral requirements and the collection of information relating to employees receiving €1,000,000 or more per fiscal year.

Say-on-pay. This memorandum also describes the recent groundswell of say-on-pay initiatives that has swept across Europe – ranging from the E.U. as a whole to individual countries inside and outside of the union. For example, the U.K. is expected to implement binding say-on-pay and limitations on “loss of office” payments by October 2013. 2 Germany, Spain and Switzerland have also made progress with their own say-on-pay and compensation measures.

Details of the foregoing proposals and the timing of their implementation remain in the works, since they must make their way through their respective legislative processes.

CRD IV is a directive and is required to be incorporated into the national laws of the E.U.’s member states. Thus, the rules on financial institution remuneration, among other items, will remain the responsibility of the member states’ national competent authorities. The procedural force of the CRD IV rules is in contrast with other aspects of the new rules that are part of the Capital Requirements Regulation (CRR), which sets forth prudential requirements for capital, liquidity and credit risk. As a regulation, the CRR applies directly in every member state. It is a “single rule book” applicable to all investment firms and credit institutions across the E.U.

Here are a number of useful links relating to CRD IV: text of the directive; press release; background note published by the Director for the Media; and CRD IV / CRR frequently asked questions.

For our prior discussion on the subject of binding say-on-pay in the U.K., please see here (blog post regarding the U.K.

government’s consultation paper on say-on-pay), here (memorandum regarding the U.K. government’s package of proposals) and here (blog post regarding the U.K. government’s consultation paper on company remuneration reports).

Davis Polk & Wardwell LLP davispolk.com E.U. bonus cap for financial institutions Background and effective date On April 16, 2013, the European Parliament approved various elements of CRD IV, including restrictions on bonus payments by credit institutions and investment firms, despite marked disagreement by the U.K.

government and by the financial services sector in the City of London. The next step in the legislative process is approval by the Council of Ministers, which is slated to occur without further discussion.

Subject to this process and publication of the rules in the Official Journal by June 30, 2013, it is expected that the bonus cap, together with the other elements of CRD IV, will become effective on January 1, 2014 and will restrict bonuses paid in 2015 for performance in 2014. If, for some reason, the rules are not published by June 30, 2013, then they will apply starting July 1, 2014. These provisions will apply whether or not the financial institution’s equity securities are publicly traded.

CRD IV follows CRD III, which was introduced post-financial crisis with the intent to implement the internationally agreed upon Financial Stability Board Principles for Sound Compensation Practices and the Commission Recommendation of April 30, 2009 on remuneration policies in the financial services sector. CRD III’s compensation provisions focused on the structure of remuneration for material

risk-takers at financial institutions. These included, in particular:

 At least 50% of any variable pay should consist of equity-linked instruments; and  At least 40-60% of variable pay should be deferred over a period of not less than three to five years.

CRD III did not prescribe any ratios between the fixed and variable components of total compensation.

–  –  –

CRD IV includes specific procedures that financial institutions must follow in order to obtain shareholder approval. Among other things, there is a requirement to provide shareholders with a detailed recommendation containing the reasons for and the scope of any approval sought, including the number of employees affected, their functions and the expected impact on the financial institution’s capital base. A financial institution must promptly inform its regulator of, among other things, its recommendation to shareholders and their decision.

–  –  –

Scope of the bonus cap Subject entities. The bonus cap will apply to all credit institutions (including banks) and investment firms in the E.U. and the non-E.U. subsidiaries of such entities, as well as to the E.U. subsidiaries of financial institutions headquartered outside the E.U. For example, if a financial institution is headquartered in London or Madrid or Paris, all of its subject employees (including subject employees located in New York or Hong Kong) will be affected, and, even if a financial institution is headquartered in New York or Hong Kong, its subject employees working for an E.U. subsidiary will be affected.

Subject employees. The bonus cap will not apply to all employees of a subject entity; rather, it will only affect employees whose professional activities have a material impact on the risk profile of the relevant

financial institution. Examples of such employees include:

 Senior management;

 Risk-takers;

 Employees engaged in control functions; and The EBA came into being as of January 1, 2011 and superseded the Committee of European Banking Supervisors. The EBA acts as a “hub and spoke network” of E.U. and national bodies and is intended to safeguard public values, such as the stability of the financial system, the transparency of markets and financial products and the protection of depositors and investors.

Davis Polk & Wardwell LLP 3  Employees whose total pay takes them into the same bracket as senior risk management and risk-takers.

The EBA will prepare draft standards regarding the qualitative and quantitative criteria used to determine these categories of subject employees and will then submit these standards to the European Commission by March 31, 2014 for adoption in final form. Moreover, by June 30, 2016, the European Commission and the EBA will review and report on the bonus cap’s impact on competitiveness and financial stability, and on the non-E.U. employees of E.U. financial institutions. In particular, the report will consider whether the bonus cap should continue to apply to such non-E.U. employees.

Other noteworthy aspects of CRD IV While the bonus cap has been the subject of much of the discussion of CRD IV’s compensation-related

provisions, other noteworthy aspects include the following:

 CRD IV aims to ensure that every financial institution has sound and fair remuneration policies, so that pay reflects effective risk management and performance, without encouraging unjustified risk-taking.

 Guaranteed pay “is not consistent with sound risk management or the pay-for-performance principle” and is generally prohibited as a prospective matter, except under exceptional circumstances, where the financial institution is hiring a new employee, where it has a sound and strong capital base and where the guarantee is limited to the first year of employment.

 A financial institution’s pension policy is required to be in line with the business strategy, objectives, values and long-term interests of the institution. If an employee leaves before retirement, discretionary pension benefits must be held by the institution for a period of five years.

If an employee reaches retirement, then such benefits must be paid subject to a five-year retention period. 5  Financial institutions that “are significant in terms of their size, internal organization and the nature, the scope and the complexity of their activities” are required to establish a remuneration committee.

The committee is required to be constituted in such a way as to enable it to exercise o “competent and independent judgment on remuneration policies and practices and the incentives created for managing risk, capital and liquidity”.

The chair and other members of the remuneration committee are required to be o members of the management body who do not perform any executive function at the financial institution. 6 As is the case whenever there is the possibility of extending the payment timetable of deferred compensation, an issue that will need to be considered for any employees subject to U.S. federal income taxation is Section 409A of the U.S. Internal Revenue Code, which generally requires that compensation that constitutes non-qualified deferred compensation be paid out only upon permissible payment dates or events.

A “management body” should be understood to have executive and supervisory functions. In member states where management bodies have a one-tier structure, the board usually performs management and supervisory tasks. In member states with a two-tier structure, the supervisory function of the board is performed by a separate supervisory board that has no executive functions, and the executive function is performed by a separate management board, which is responsible and accountable for the day-to-day management of the undertaking.

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E.U. say-on-pay 8 On December 12, 2012, the European Commission announced its intent to propose an initiative to allow shareholders to approve the remuneration policy and any remuneration report of listed companies incorporated in any of the 27 member states of the European Union. 9 On March 6, 2013, the European Commissioner for Internal Market and Services further commented on the proposal, indicating that the shareholder vote would be mandatory. However, details remain unclear, as draft legislation that would implement the proposal has yet to be published.

ESMA is an independent E.U. authority that is intended to contribute to safeguarding the stability of the E.U.’s financial system by ensuring the integrity, transparency, efficiency and orderly functioning of securities markets, as well as enhancing investor protection.

Say-on-pay is already binding in a number of European jurisdictions, including Denmark, the Netherlands, Norway and Sweden.

In addition, among other items, the European Commission indicated its desire to harmonize the disclosure requirements of individual director remuneration across the E.U.’s member states. It also expressed its view that employee share ownership schemes “could play an important role in increasing the proportion of long-term oriented shareholders” and announced its intent to “identify and investigate potential obstacles to trans-national employee share ownership schemes” with the goal of encouraging employee share ownership throughout Europe.

For our prior discussion on the European Commission Action Plan on Corporate Governance of Listed Companies, please see here.

–  –  –

Say-on-pay in European countries U.K.

The U.K.’s annual advisory say-on-pay vote has been the harbinger of say-on-pay in other jurisdictions, including the Unites States. Now, a package of binding say-on-pay and related proposals is pending before the U.K. Parliament as part of the Enterprise and Regulatory Reform Bill 2012-13. The House of Commons recently returned the bill to the House of Lords, with amendments. Once both Houses reach agreement on the form of the bill, it will come into force as an Act of Parliament. The bill is expected to come into force on October 1, 2013, which would impact general meetings held in fiscal years beginning on or after that date. As part of this initiative, the U.K. government has made available a set of frequently asked questions and draft regulations, summarized as follows.

Policy report A binding shareholder vote would be held at least every three years on a company’s compensation policy report, which is prospective in that it sets out the company’s future policy regarding the compensation (including “loss of office” payments) of directors, including executive directors.

The policy report would cover the following elements:

 Tabular disclosure of the key elements of pay and supporting information (including how each supports the achievement of the company’s strategy), the maximum potential value and performance metrics.

 Principles that the company would apply in establishing a compensation package for a new director, including the maximum level of salary which may be awarded.

 Information on the provisions in directors’ employment contracts or terms of appointment that could give rise to or affect remuneration or loss of office payments.

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