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Financial Institutions e-briefing: AIFMD: FCA Consultation on the Remuneration Code

    • Financial services and markets regulation - AIFMD
    • Financial institutions - Briefings and articles

    10-09-2013

    One of the major missing pieces of the AIFMD jigsaw fell in to place for UK fund managers on Friday when the FCA published its consultation on its proposed guidance on the AIFMD Remuneration Code. How does the picture look now for UK fund managers, some of whom may have been disappointed by the FCA’s recent, inevitable confirmation that it would comply with ESMA’s controversial guidelines on remuneration policy? The proposed guidance is helpful but it is ultimately the AIFM’s responsibility to assess the appropriate application of the remuneration principles to its business and there are a number of areas where firms can influence the final form of the guidance by responding to the consultation.

    The FCA proposes to split the guidance between SYSC 19B in the FCA Handbook and further non-Handbook guidance, in the same way as it did with the CRD remuneration code.  This briefing focuses on the following points covered in the draft guidance:

    • Timing for implementing the AIFMD Remuneration Code
    • Proportionality - size thresholds for disapplying the pay-out process rules
    • Guidance on applying proportionality to carried interest
    • Guidance on applying proportionality to delegates
    • Payments to partners or members of an AIFM
    • New tax rules on Partner’s deferred portion of variable remuneration
    • Variable remuneration in AIF units or shares
    • Minimum retention periods  

    Consultation process

    Fund management firms are strongly recommended to respond to the consultation accessible here, particularly in relation to the size thresholds for disapplying the pay-out process rules described below.  The consultation closes on 6 November 2013.   

    Timing for implementing the AIFMD Remuneration Code

    Once a firm becomes authorised as a full-scope UK AIFM it becomes subject to the AIFM Remuneration Code and the Guidelines. The FCA expects firms to implement the AIFMD remuneration regime for new awards of variable remuneration to relevant staff for performance periods following that in which the firm becomes authorised. So the AIFMD remuneration regime will apply only to full performance periods and will first apply to the first full performance period after the firm becomes authorised. The AIFM Remuneration Code will not apply to any remuneration payments earned, allocated or otherwise awarded in performance periods prior to the firm’s authorisation, including any remuneration previously awarded in the form of instruments that have not yet vested at the time of the firm’s authorisation or which vest in subsequent performance periods.

    Proportionality - size thresholds for disapplying the pay-out process rules

    The AIFM Remuneration Code includes rules on how remuneration can be paid out to “identified staff” (ie those staff whose professional activities have a material impact on the risk profiles of the AIFM or the AIFs it manages).  Subject to various exceptions and to proportionality as described below:

    • An AIFM must ensure that a substantial portion, and in any event at least 50% of any variable remuneration, consists of units or shares of the AIF concerned, or equivalent ownership interests, or share-linked instruments or equivalent non-cash instruments.
    • These must be subject to an appropriate retention policy designed to align incentives with the long-term interests of the AIFM and the AIFs it manages and the investors of such AIFs.
    • A substantial portion, and in any event at least 40%, of the variable remuneration component, must be deferred over a period which is appropriate in view of the life cycle and redemption policy of the AIF concerned and is correctly aligned with the nature of the risks of the AIF in question.
    • An AIFM must ensure that any variable remuneration, including a deferred portion, is paid or vests only if it is sustainable according to the financial situation of the AIFM as a whole and justified according to the performance of the AIF, the business unit and the individual concerned.
    • An AIFM must ensure the measurement of performance used to calculate variable remuneration components, or pools of variable remuneration components, includes a comprehensive adjustment mechanism to integrate all relevant types of current and future risks.

    The size of the AIFM is a starting point for considering whether these pay-out process rules may be disapplied on the grounds of proportionality. The FCA suggests a range of potential size thresholds in the consultation (AuM of £4-6bn for AIFMs which manage portfolios of AIFs that are unleveraged and have no redemption rights exercisable during a period of 5 years following the date of initial investment in each AIF, AuM of £500m – 1.5bn for other AIFMs) but intends to specify a single threshold in the final version, based on the most recent data available and evidence-based responses to the consultation.  This is different to the three level approach applied to the CRD Remuneration Code. Fund management firms who think that the thresholds should be towards the upper end of these suggested ranges are strongly recommended to provide their evidence in response to the consultation.

    Guidance on applying proportionality to carried interest

    The size threshold is just a starting point for considering whether the pay-out process rules may be disapplied on the grounds of proportionality.  If an AIFM’s AuM is above the relevant threshold, the FCA would expect it to review the other criteria in the Remuneration Code to determine whether there are other characteristics of the firm or its AIFs that, notwithstanding its size, merit disapplication of all or some of the pay-out process rules on the grounds of proportionality. Similarly, if an AIFM’s AuM is below the relevant AuM threshold, the FCA would still expect it to review the other criteria to determine whether there are other characteristics of the firm or its AIFs that merit full application of all or some of the pay-out process rules. It is ultimately the AIFM’s responsibility to assess the appropriate application of the remuneration principles to its business, and when making that decision, the FCA expects the firm to be able to justify its rationale behind any application of the proportionality principle.   In the spirit of this age of regulation by FAQ, the FCA is proposing to include supplemental guidance in the form of various worked examples of its thinking on when proportionality can and cannot allow the pay-out process rules to be disapplied.  

    Private equity and venture capital firms will be particularly interested in the FCA’s explanation of when a firm may reasonably conclude that it may disapply the pay-out process rules for the payment of carried interest to senior management on the grounds of proportionality. This will be the case when the carried interest structure satisfies the objectives of alignment of interest with investors, because it has been negotiated with prospective investors and avoids incentives for inappropriate risk-taking, such as by being paid towards the end of the lifecycle of the AIF (or earlier if the target returns agreed with investors have been achieved and there are appropriate clawback or make-up arrangements in place).

    Guidance on applying proportionality to delegates

    Where an AIFM is delegating portfolio or risk management, the ESMA Guidelines require that either the delegate is subject to regulatory requirements on remuneration that are equally as effective as those applicable under the Guidelines or appropriate contractual arrangements are put in place with the delegate in order to ensure that there is no circumvention of the Guidelines.  The FCA will generally consider CRD and MiFID remuneration regimes to be equally as effective.  Where it would be appropriate for the AIFM to put in place contractual arrangements with the delegate, the FCA expects the AIFM to tailor these arrangements so that it applies the AIFM Remuneration Code to the remuneration of the delegate’s relevant staff resulting from the delegation. For example, the AIFM need only put arrangements in place with respect to those staff of the delegate who have a material impact on the risk profiles of the relevant AIFs, and in respect of remuneration that is connected with the delegated activities.

    Payments to partners or members of an AIFM

    The ESMA Guidelines allow payments to partners as owners of an AIFM, such as dividends or distributions, to be excluded from the scope of the remuneration requirements. Many AIFMs in the UK are currently structured as owner-managed partnerships or owner-managed limited liability partnerships. Currently, payments from the AIFM to partners working in the business are classified as a profit share or distribution primarily for tax purposes, and no part is classified as fixed remuneration or variable remuneration.

    The requirements of the AIFM Remuneration Code primarily fall on the portion of a staff member’s remuneration that is considered variable remuneration. So it is necessary to determine the portion of the payments to partners that is considered remuneration within AIFMD scope and the portion that is a return on equity in the relevant firm. The FCA suggests various approaches, for example an amount of additional profit share for senior or founding partners is likely to be considered as a profit distribution that is outside of the scope of the AIFM Remuneration Code whereas an amount of discretionary profit share distributed to all partners may be considered variable remuneration. Any drawings taken in advance may be considered fixed remuneration.

    New tax rules on Partner’s deferred portion of variable remuneration

    SYSC 19B.1.17R requires at least 50% of any variable remuneration to consist of units, shares or other instruments of the AIF concerned, whether such a component is deferred or not. The allocation of any remuneration in cash or in units, shares or other instruments that are retained would give rise to a tax charge in the base year in accordance with partnership tax rules. This means that partners and LLP members are taxed on all their profit shares when they arise in the base year even when these profits are not yet distributed or received, i.e. prior to that remuneration vesting with those individuals. Effectively this tax charge would not be funded in the base year as the individuals do not have immediate access to the deferred remuneration.

    The FCA is discussing with HMRC and industry representatives proposals to put in place a statutory tax mechanism as part of the proposals of the partnerships tax review consultation to address this issue of unfunded tax charge. Further tax guidance is to be published in the autumn alongside the draft tax legislation for introduction under Finance Bill 2014. The FCA has rejected as non-compliant with the AIFMD remuneration regime the alternative of firms allowing their partners or members to have immediate access to part of the deferred remuneration on the assumption that this would be used to fund payment of tax.

    Variable remuneration in AIF units or shares

    The AIFM Remuneration Code requires that 50% of any variable remuneration consists of units or shares of the AIF concerned, or equivalent ownership interests, or share-linked instruments or equivalent non-cash instruments. However, this is subject to the legal structure of the AIF, the instrument constituting the fund and whether the management of AIFs accounts for less than 50% of the total portfolio managed by the AIFM.  The FCA’s guidance in this area will be closely studied. For example the FCA interprets the condition about the legal structure of the AIF and the instrument constituting the AIF to apply where the legal structure or instrument of the AIF makes the rule’s application impracticable considering the objectives of the AIFM. Examples of impracticability would be where the AIF is closed-ended and there are no shares available to acquire or where the AIF’s constituting instrument or rules prohibit investments by AIFM Remuneration Code staff or prescribe a large minimum investment amount that will not be met by staff investments.

    Minimum retention periods

    The ESMA Remuneration Code requires that variable remuneration taken in shares or units must be subject to an appropriate retention policy designed to align incentives with the long-term interests of the AIFM and the AIFs it manages and the investors of such AIFs. The FCA would normally consider a retention period of 6 months to be sufficient, provided that other risk management techniques within the firm are operating to secure sound and effective risk management (including, in particular, those on performance adjustment and measurement of performance). 

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