30 Jul 2014

(Un)Lucky number seven

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The Prudential Regulation Authority (PRA) has published its finalised rules on the compulsory application of clawback to variable incentives for seven years. New consultations have also been released on a range of issues, including the extension of the new clawback rules to Financial Conduct Authority (FCA) regulated firms, and extended deferral/vesting and clawback periods for senior individuals.

Clawback: the rules

The details of the PRA's original clawback proposals were set out in our March 2014 e-alert. We highlight below the key aspects of the new rules, and some of the changes made to the original proposals:

  • When do the new rules take effect? – 1 January 2015.
  • Which firms are caught? – All PRA-regulated Level 1 firms (total assets exceeding £50 billion) and Level 2 firms (total assets between £15 to £50 billion).
  • Which employees are caught? – All Material Risk Takers (MRTs), as defined in the MRTs Regulation 604/2014 which came into force on 26 June 2014 (basically those who have a material impact on a firm's risk profile, which includes but is slightly broader than the old definition of Code Staff).
  • What is caught? – All variable incentives (deferred and undeferred) awarded on or after 1 January 2015. The original proposal to apply clawback to historic awards retrospectively met with heavy criticism from respondents to the consultation, not least because of the practical difficulties of amending employment contracts to accommodate this. Although contracts will still need to be amended before January 2015 in respect of future awards, dropping the retrospective application of the new clawback rules is perhaps the PRA's biggest concession.
  • How long must clawback apply for? – At least seven years from the date on which variable incentives are awarded. Given the Remuneration Code's lengthy vesting periods - up to five years post-grant – the PRA's original proposal to allow clawback for up to six years post-vesting would have made it possible for clawback to apply for up to 11 years after the date on which variable incentives were first awarded, sparking concerns that this would deter firms from using the required vesting periods. Applying clawback from the date of award only is designed to address this.
  • When will clawback be applied? – Firms must make all reasonable efforts to clawback variable incentives where: (a) there is reasonable evidence ofemployeemisbehaviour or material error,or(b) the firm or relevant business unit suffers a material failure of risk management (the third ground originally proposed, where the firm or the relevant business unit suffers a material downturn in its financial performance, has been dropped). Firms can adopt a proportionate approach in deciding whether and the extent to which it is reasonable to clawback any/all variable incentives but should account for this in their internal policies.

Next steps for employers

The most immediate action points for all firms caught by the new rules are to:

  • Review and amend employment contracts and other documentation relevant to variable incentives so that they allow for clawback of awards made on or after 1 January 2015 for up to seven years post-award. Careful drafting will be required to avoid clawback provisions falling foul of the doctrines of restraint of trade or penalties; and
  • Ensure that internal policies reflect the firm's approach to utilising the flexibility afforded by the PRA in terms of deciding whether to apply clawback, and if so to what extent.

And finally, watch this space…

...for further developments. The PRA and FCA have released further consultations on a number of issues including:

  • Clawback – The FCA's proposal to introduce the same seven year clawback period to all MRTs of FCA-regulated firms and the PRA/FCA's proposed extension of the clawback period for a further three years (10 in total) for all 'Senior Managers' where there are ongoing investigations at the end of the seven year period. This is aimed at the most senior decision makers with the regulated firm, namely those performing a 'Senior Management Function' (SMF) as defined in Section 59ZA FSMA 2000 (see below).
  • Roles classed as SMFs – Broadly, Section 59ZA FMSA 2000 provides that an SMF is a function requiring the person performing it to be responsible for managing, or participating in the taking of decisions about, an aspect of the firm's regulated activities which might involve serious consequences for the firm. The PRA proposes that a range of senior executive/non-executive positions be classed as SMFs, including the Chief Executive/Finance/Risk functions, Head of Internal Audit, Chairman, Chair of the Risk/Audit/Remuneration Committees, as well as heads of key business areas who meet certain quantitative criteria. Similarly, the FCA has proposed that Executive Directors, Money Laundering/Compliance officers and Non-Executive directors should all be classed as SMFs.
  • Deferrals - The introduction of a two-tier deferral/vesting mechanism of no less than seven years for Senior Managers and five years for all other MRTs.
  • Buy-outs – Options for regulating buy-outs, ranging from a total ban to a requirement to honour all/part of any unvested awards.
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