At the end of September 2013, it was announced that the UK Government had launched a legal challenge in the Court of Justice of the European Union against the cap on variable remuneration introduced by the new capital requirements directive (“CRD IV”). We had, earlier, published an e-bulletin on the details of the bonus cap imposed by CRD IV, which can be accessed here. The cap is designed to come into effect on bonuses awarded from 2014. It will apply to European headquartered groups, European subsidiaries of non-European groups and the worldwide staff of European banks.

The UK’s challenge focuses on the legal basis for the bonus cap, but also highlights other issues including a challenge to the extra-territorial effect of the cap, the lack of proper consultation and impact assessment, as well as alleging that the powers delegated to the European Banking Authority go beyond developing technical standards to formulating policy.

The announcement highlights the UK’s concern over the level of power that has been delegated to the European Banking Authority to develop binding standards. It also makes clear that the UK believes that real improvements in the alignment of bankers’ pay with risk and performance have already been made, and that the proposed bonus cap would undo this good work by forcing banks to increase salaries and therefore fixed costs, making it harder for banks to reduce pay rates when profits are falling.

Although the UK’s challenge may ultimately result in the cap being overturned, firms may nonetheless have to implement the CRD IV provisions in the interim, as the legal challenge may not be resolved before the 2015 remuneration round, when the cap will first affect bonuses. As such, affected banks and building societies will need to continue preparing their response to the cap, whilst including flexibility to cater for the various possible outcomes of the legal challenge. Affected banks in Asia will also need to consider how to best attract and retain their key staff in the post CRD world.

The cap on variable remuneration

The key remuneration provision of CRD IV is that bonuses of “Identified Staff” will be capped at one times the staff members’ annual fixed remuneration (which includes basic salary, as well as other non-variable benefits and allowances). The cap can be raised to two times the staff member’s annual fixed remuneration, but only with shareholder approval.

Whilst “Identified Staff” are generally the senior managers and risk takers of the institution, critically, this definition is set to be widened significantly under the CRD IV provisions so that an increased number of staff will be caught by both the existing remuneration rules and the new bonus cap. The new rules identify a list of 14 criteria capable of bringing a staff member within the definition of “Identified Staff”; all but two of which are absolute, such that if any one of them is met, the staff member must be treated as “Identified Staff” (without any further consideration as to whether or not the individual in question in fact has a material impact on the risk profile of the bank). The British Bankers’ Association are anticipating a twenty-fold increase from the current number of affected staff.

PRA and FCA announce details of UK implementation of the bonus cap

Earlier this month, the proposed approach to the UK implementation of the cap on variable remuneration was announced by each of the Prudential Regulation Authority and the Financial Conduct Authority in a set of consultation documents. The consultation documents give much more certainty as to which banks, building societies and investment firms will (and will not) be subject to the bonus cap. As expected, banks and building societies will generally have to apply the cap across their entire group. Investment firms will, however, generally be permitted to disapply the bonus cap (subject to certain exceptions). The consultation documents do not deal with how the bonus cap will apply in practice; so many key outstanding issues remain unresolved for those affected.

How the industry can respond

There are some options available to institutions to mitigate the effect of the bonus cap, and to continue to hire, reward and retain their key personnel.

The market response will undoubtedly include, to some extent, an increase in base salaries. There are, however, a number of draw-backs to increasing base salaries, such that it de-links pay and performance and increases the banks’ fixed cost base. As such, banks should consider the range of alternative options available.

In Asia, the European banks will need to create an overall package that is attractive to the best staff. This includes considering alternative remuneration mechanisms which seek to maintain remuneration at competitive levels, but also improving and maximising the retentive effect of the staff members’ overall employment package and particularly elements that may have been overlooked as a result of a previous focus on bonus levels.

Employers could also consider offering affected employees additional cash or equity based fixed allowances, which would not form part of the basic salary, so as to limit pension costs and costs incurred in the event of a departure. Alternatively, banks could consider reviewing elements of the employment contract such as pension cover, health cover, holiday entitlements and alternative working arrangements, which may be key in creating a competitive overall package.

Over and above the changes to remuneration structures is the possibility of changes to the structure of the banks themselves. The ultimate response to the changes would be for a bank to move its headquarters out of Europe. Alternatively, as stand-alone asset management or pure corporate advisory firms will generally be outside the scope of the bonus cap, non-European banks operating within Europe may want to consider corporate structures that would put their European asset management or advisory operations on a level playing field with those stand-alone European firms.

We will be following the progress of the UK’s challenge and will provide updates when available. In the meantime, if you have any queries in relation to the possible impact of the CRD IV remuneration provisions, please contact Gareth Thomas or Helen Beech.