UK update November 2016 PRA policy statement on buy-out awards On 28 September 2016 the Prudential Regulation Authority ( PRA ) published its final policy statement on buy-out awards (the Policy Statement ). This Policy Statement is the finalised version of a draft originally published for consultation in January 2016. The full text of the Policy Statement can be found here. www.pwc.co.uk
Contents Executive summary 1 Introduction 1 Summary of key provisions 1 Structure of this note 2 Background and scope 3 Background 3 Scope of the New Rules 3 Definition of buy-out 3 Timing of implementation 4 Consequences of breach 4 Key provisions of the New Rules 5 On hire 5 On an event at the previous employer 6 Application of malus and clawback by the new employer 7
In a nutshell What is it? The Policy Statement on buy-out awards, including new provisions to be added to the PRA Rulebook. Who has published it? The Prudential Regulatory Authority (PRA) When was it published? 28 September 2016. Who is this relevant to? All Level 1 and Level 2 firms with staff subject to the remuneration requirements of the PRA Rulebook. Where can I find it? The Policy Statement can be viewed here. What is the timing? The final rules are to apply to all buyout awards agreed after 1 January 2017. What should I do next? Consider the impact of the proposals with regards to current policies and processes for making buy-out awards. Map documentation and process required to support compliance. Set out process for operationalising the requirements. Draft templates for remuneration statements, buy-out notices, and reduction notices. Who can I contact? Any of the PwC contacts on the final page of this booklet, or your usual PwC advisor will be happy to assist you. 4 PwC
Executive summary Introduction On 28 September 2016, the PRA published its final rules on buy-out awards for banks, building societies and PRA-designated investment firms. This is further to a consultation that it previously published on draft rules in January 2016. Overall, the rules have been finalised largely as drafted. However, the PRA has made a pragmatic change to the way in which new employers deal with obtaining the necessary information in order to make a buy-out award. While this will be a welcome change for firms, the buy-out rules overall remain highly complex and the practical and commercial challenges in operationalising the processes needed to comply will be significant. Summary of key provisions The new rules apply to variable remuneration given to a new hire which is (or is deemed to be) compensation for outstanding deferred remuneration from a previous employer that has been forfeited as a result of termination of employment. This portion of the variable remuneration the buy-out award has to be subject to malus and clawback on similar terms to the forfeited award. Where an event occurs that would have resulted in malus and clawback being applied to the forfeited award (as determined by the previous employer) the new employer must clawback the amount determined by the previous employer. The previous employer has a number of important responsibilities in the process envisaged by the new rules, as it is their determination that triggers the application of malus and clawback. The rules provide that they must, in making their determination, act fairly and reasonably. This includes giving details and reasons to their former employee, as well as enabling the former employee to make representations and take those representations into account. Individuals have a right to sue the previous employer if they act in breach of their obligation to act fairly and reasonably. The rules also contain constraints on the structure of the buyout award - the duration of any deferral, postvesting retention, malus and clawback terms must be no shorter than those that applied to the award being bought out. We have set out below a diagram illustrating the process by which firms will need to go through in order to comply with the buy-out requirements. PwC 1
Structure of this note This update note examines a number of key themes arising from the proposed amendments, broadly following the structure of the rules themselves. The rules can be broken down into three key areas, as follows: On hire; On an event at the previous employer; Application of malus and clawback by the new employer 2 PwC
Background and scope Background The PRA has expressed concern for a number of years with the practice of buy-out awards (i.e. awards made to a new employee to compensate them for unvested deferred compensation forfeited on leaving a previous employer). Their primary concern has been that this practice deprives the old employer of the opportunity to apply ex-post risk adjustments (i.e. malus/clawback) to these awards as and when risks crystallise in the future. This effectively removes the intended effect of deferral and ex-post risk adjustment where employees leave a firm. However, the PRA has also recognised the commercial necessity of buy-out awards and the challenge of regulating any such awards in an international employment market. As a result, when the PRA and FCA first consulted on this topic in June 2014 they set out four suggested approaches for firms to comment on as part of the consultation. These were: 1. To ban buy-outs; 2. To require firms to maintain unvested deferral awards after employment ceases; 3. To apply malus to bought-out awards; or 4. To rely on existing clawback rules. When the final Policy Statement for this consultation was published by the PRA and FCA in June 2015, no decision was made on this issue. Instead, the PRA acknowledged the practical challenges of either option 1 or 2 and stated that they would investigate the possibility of adopting option 3 (option 4 being effectively the approach in place at the time). In January 2016, the PRA issued a second consultation paper which reported the outcome of this further investigation. The outcome of this was suggested changes to the PRA Rulebook to enforce the third approach i.e. the application of malus and clawback to bought-out awards. It should be noted that, unlike the previous consultation, this was a PRA consultation only. The text of the consultation paper was explicit that the changes proposed would only apply to PRA regulated firms, although its introduction stated that the FCA would follow the progress of the consultation closely and consider whether any changes to its rules were required at a later date. On 28 September 2016, the PRA published its final Policy Statement, which sets out the result of the 2016 consultation and the final version of the proposed PRA Rulebook amendment (the New Rules ). The FCA have issued no comments on this policy and have not included similar requirements within their consultation on other remuneration issues, released on the same day as this Policy Statement. The final version of the New Rules on buy-outs is broadly unchanged from the draft that was consulted on. This is not unexpected, as this is an area that the PRA has expressed concern about for some time, and the consultation draft followed extensive work by the PRA in this area. There was therefore significant momentum and political support behind the proposals. Scope of the New Rules The New Rules take the form of amendments to the Remuneration requirements in the PRA Rulebook, and as such apply to all staff who were classed as Material Risk Takers ( MRTs ) at their previous firm and have moved to a new firm subject to the Rulebook. The New Rules only apply in respect of buy-outs of remuneration relating to employment with a previous employer that was subject to the remuneration requirements of the PRA Rulebook, and at which the individual in question was an MRT. Although not explicit, the references within the New Rules to the structural remuneration requirements (which are subject to proportionality) strongly implies that the rules will only apply if the individual was an MRT at a level 1 or 2 firm. We understand that the PRA is, at this time, unlikely to expect level 3 firms to comply with these requirements. Definition of buy-out The term buy-out is defined in the New Rules as the part of an employee s variable remuneration that is agreed at hire, and has a value less than or equal to any unvested remuneration that they forfeited when leaving the previous employer. PwC 3
This definition means that variable remuneration offered to a new hire will automatically be treated as a buy-out up to the level of forfeited unvested remuneration from a previous employment - a new employer cannot decide that an award offered in these circumstances is not subject to the New Rules. Firms will still be able to offer guaranteed variable remuneration, but will be required to follow the specific rules from the PRA on this (most notably demonstrating it has been made in exceptional circumstances). The PRA has also been clear in its separate consultation paper that they will continue to expect guarantees of this type to be offered rarely. An offer of fixed remuneration to a new hire would fall outside the rules, as would a payment made prior to hire and not contingent on employment. However, both of these options are unlikely to be commercially attractive in the majority of cases. The New Rules contain a requirement that buy-out awards are not structured so as to put an award that would otherwise fall within the definition of a buyout outside that definition. This is broadly unchanged from the existing rule on this within the PRA Rulebook and is also aligned to the FCA requirements. Timing of implementation The final rules are due to apply to buy-outs agreed after 1 January 2017. However, the delay in finalising these rules has resulted in a short transition period, which is likely to be a concern for many firms. The complexity and challenge in ensuring that appropriate policies, systems and processes are in place to support the regime are likely to be significant - in particular, given that the majority of firms with calendar year-ends will also be preparing for their annual compensation rounds during this time. Consequences of breach The New Rules contain two provisions which apply in the event that they are breached: Compensation Individuals are entitled to sue to recover losses arising as a result of the previous employer s failure to act fairly and reasonably; and Voiding provisions The PRA Rulebook contains voiding provisions applicable to Level 1 firms (rules 16.9 to 16.13) which if applied would render any remuneration granted in contravention of the New Rules void, and impose on the employer the obligation to recover it. These provisions are included to provide mechanisms by which the New Rules can be enforced. Taken together, these represent several possible sources of challenge to actions taken by both the previous and new employer, which may at times pull in opposite directions. Companies will need to consider carefully any action they take in an effort to comply with the New Rules. 4 PwC
Key provisions of the New Rules On hire The New Rules contain a number of provisions that apply at the time an individual is hired and is given a buy-out award. The draft rules had placed the onus of compliance in this area onto new employers. However, the final rules have been amended to place greater responsibility with the previous employer. Old employers must provide employees with a remuneration statement. This should set out: All periods during which the employee was a MRT; The amount of unvested remuneration which can be bought out, which relates to the periods in which the employee was a MRT; and The retention, deferral, performance and clawback arrangements that apply to each amount or part of an amount. ensure that they retain information on awards from previous employers until such awards are outside of the malus and clawback window and update this accordingly. So, for example, the period for which an employee was an MRT could contain multiple entries from a series of employers. New employers must: Obtain remuneration statements from an individual before making a buy-out award offer; Ensure that the periods for deferral, post-vesting retention, malus and clawback applicable to the buy-out are no shorter than those that applied to the forfeited award; and Ensure that the employee s contract allows the employer to apply malus or clawback to the buyout award(s), when notified by the relevant previous employer(s) of the need to do so.; and The previous employer must provide this within 14 days of receiving notice from an individual. The individual may pass on all/some remuneration statements to the new employer. It is important to note that this statement must include historical information. Employers will have to When the employee has entered into such a contract, notify the previous employers in writing (by way of a buy-out notice ) of the amount attributable to that employer and the duration of the retention, deferral, performance and clawback arrangements which apply to that part of the award. PwC Comment The PRA s decision to require the old employer to produce the remuneration statement in place of the new employer obtaining this information is a pragmatic change to the final rules that will be welcomed by firms. The draft requirement to identify separately the unvested remuneration that relates to each of perhaps several previous employers, and the retention, deferral, performance and clawback arrangements that apply to each element, implied a complex system of allocating elements of an award between historic employers. The remuneration statement removes this issue for new employers, but also creates challenges for old employers. However, it appears that the new employer would still need to contact all previous employers where an historical award is bought out. This will add time and complexity to the recruitment process, particularly when the requirements are considered alongside the new regulatory referencing requirements. Record keeping The rules do not set a time limit within which previous employees should request a remuneration statement from employers. Firms will therefore have to ensure that they keep sufficiently detailed records of former employees for a sustained period of time in order that, for example, they have adequate evidence to provide a remuneration statement to a former employee from up to 7 years ago (which may extend to 10 years for Senior Managers). PwC 5
A further complexity will be updating records to reflect the periods in which an individual was/was not a MRT and the relevant awards that apply. In particular, this may occur for individuals identified under the quantitative criteria. Existing policies The new rule that the periods for deferral, retention, malus and clawback should be no shorter than those that applied to the forfeited award is in line with existing requirements. Employers need to think carefully about how the terms of any buy-out will fit within their existing policies, particularly where an award bought out is subject to longer deferral, holding period or malus and clawback periods. Contracts All PRA firms will need to review their existing contracts and develop new contract terms that will operate where the buy-out rules apply. It will be important to do this proactively, as changes may take some time and firms will wish to be ready to operate their recruitment process as normal from 1 January 2017. The requirement for new employers to obtain a remuneration statement from the individual before making a buy-out offer is likely to create practical issues regarding the timing of making a formal offer. On an event at the previous employer On the occurrence of an event which would lead to the application of malus and clawback (specifically either employee misbehaviour/error or a material failure in risk management by the business), the previous employer must promptly consider any misbehaviour or material error of all former employees who they have received a buy-out notice in respect of. They must then identify if it would be appropriate to apply malus and clawback to legacy awards for any of these individuals. The previous employer must then determine the amounts by which it would have applied malus or clawback had the former employee still been employed. This determination must be made fairly and reasonably. To ensure that this occurs, the New Rules state that the previous employer must: Enable the former employee to make representations countering the determination; and Take account of those representations when making the determination. After it has finalised its determination, the previous employer must then notify the new employer within 14 days of making the determination via a reduction notice. It is important to note that as the malus and clawback requirements within the PRA Rulebook are subject to proportionality our understanding is that this step is only required for level 1 and 2 firms. Provide the former employee with details and reasons for the determination; 6 PwC
PwC Comment Some areas that will require careful consideration when applying these provisions include: Malus and clawback events Firms will welcome the clarification from the PRA that the buy-out rules will not apply where malus or clawback is being considered due to a material downturn in financial performance (provided this was not caused by individual employee misconduct or error). However, the requirement to consider previous employees as part of malus and clawback decisions will be complex. It may be challenging in some cases to determine if an individual would have been included if they were still at the firm. This may not be as straightforward as using the events that applied while the individual was employed as the consultation paper made clear, some of these may be unnecessary or inappropriate to apply to a former employee. Where an event occurred a number of years ago, records of the role and responsibility of the individuals at this time may also be difficult to obtain. Fair and reasonable determination Proving that the determination to apply malus and clawback to a former employee was fair and reasonable may be challenging. It would be expected that some employees may wish to challenge the decision and it is unclear how long this could continue for and how much evidence and explanation the previous employer would need to provide. Record keeping - Firms will have to ensure that they keep sufficiently detailed records of former employees for a sustained period of time in order that, for example, they have adequate evidence to make a determination in relation to the conduct of the former employee from up to 7 years ago (which may extend to 10 years for Senior Managers). Commercial sensitivity The requirement for the previous employer to notify the new employer of the application of malus or clawback raises some challenging issues in terms of how much should be disclosed. This will be particularly acute because, in all likelihood, the new employer will be a competitor firm, and the event triggering malus and clawback may well be sensitive in nature. The repositioning of the suggestion that the new employer could apply for a waiver to not enact the malus and clawback (which was in the original consultation paper) is helpful (and more information is provided in the next section). This is because it largely removes the expectation that the new employer has a role in determining if a reduction is appropriate, which means that they are less likely to request detailed information. However, the new employer may well still wish to receive certain information. In particular, given that a reduction could be due to a discovery that the employee did not act with fitness and propriety, firms will likely need to know this as it would likely have an impact on the individual s regulatory reference, certification and, where applicable, Senior Manager responsibilities. Annual reporting The consultation paper stated that the PRA will expect at least annual reporting of any application of malus and clawback against bought out awards, although this is not explicitly stated in the New Rules. It appears that this would occur through the existing Remuneration Policy Statement (RPS) templates. We would therefore assume that only level 1 firms will be required to actively submit this information to the PRA annually. Application of malus and clawback by the new employer On being notified of a determination by the previous employer, the new employer must reduce or make all reasonable efforts to reduce the relevant buy-out award. This reduction must be made: For malus, before vesting of the next deferred payment; and For clawback, within a reasonable period, and in any event before the end of the 7 year period for which clawback must be applied (which may be extended to 10 years in respect of MRTs in a senior management role). PwC Comment The consultation paper contained a number of indications that the process of applying malus and clawback may not be straightforward in every case. Waiver Section 138A of the Financial Services and Markets Act 2000 provides for the possibility that firms can apply to the PRA for a waiver or modification to a provision of the PRA Rulebook, and the PRA will adjudicate on that claim. In the original consultation paper, it was suggested that new employers may PwC 7
wish to make such an application if they believe that the previous employer is manifestly unfair or unreasonable. However, in the final Policy Statement the PRA have repositioned this, suggesting instead that they would expect waivers to be unlikely, as the new employer will be expected to act solely as an executer of the malus or clawback. This significantly reduces the burden on the new employer to review and challenge malus and clawback decisions, which will be welcome. It also somewhat addresses the commercial concerns raised by many about sharing highly confidential information of events with competitors. Tax The operation of clawback may result in adjustments being required to the new employer s corporation tax computations for the current year. Furthermore, the individual employee s tax position is likely to be affected they may be able to reclaim income tax, National Insurance and capital gains tax suffered on the award from HMRC. Both the new and the previous employer may need to consider whether the amount clawed back should be adjusted to reflect the tax position of the individual. Disclosure The new employer will need to consider whether and how the operation of clawback may need to be disclosed. Clawback may be relevant under the Pillar 3 regime, and the Directors Remuneration Reporting rules. In addition, tax disclosures (e.g. via the online Employment Related Securities process) may be required. Regulatory issues The application of malus and clawback could have implications for whether the individual is a fit and proper person for the purposes of the Senior Manager Regime. The new employer will need to consider whether it is able to certify fitness and propriety where it knows that the individual has been subject to malus and clawback, and this may in turn have an impact on regulatory references the firm is required to give to a subsequent employer. 8 PwC
Start a conversation Jon Terry Tom Gosling T: +44 (0)20 7212 4370 T: +44 (0) 20 7212 3973 E: jon.p.terry@uk.pwc.com E: tom.gosling@uk.pwc.com Katy Bennett T: +44 (0)20 7213 5168 E: katy.e.bennett@uk.pwc.com Join the conversation #buyouts #PRA #malus #clawbacks This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, PricewaterhouseCoopers LLP, its members, employees and agents do not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it. 2016 PricewaterhouseCoopers LLP. All rights reserved. In this document, PwC refers to the UK member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. 160229-150314-DC-OS