26 May 2023

The Financial Reporting Council (FRC) has published a consultation paper on proposed changes to the UK Corporate Governance Code (the Code). The consultation paper covers a broad range of governance topics, including remuneration. This alert summarises the key remuneration-related proposals.
 
The proposed changes will be relevant to those companies that must adopt the Code as a requirement of the UK Listing Rules (currently that is all companies with a premium listing on the London Stock Exchange) and those other companies that voluntarily choose to adopt the Code. The deadline for consultation responses is 13 September 2023.
 
Background
 
The Code sets out a broad range of principles that seek to ensure that impacted companies establish and maintain effective governance across a wide range of areas, including board composition, remuneration and audit. Following a previous government consultation and response on restoring trust in audit and corporate governance, and publication of the FRC's  position paper on this in 2022, the FRC has now published this new consultation on the proposed changes, which build upon the themes set out in that position paper.

Key remuneration-related proposals

1. Changes to strengthen links to overall corporate performance. The FRC proposes to strengthen the links between companies’ remuneration policies and wider corporate performance, including ESG objectives, and hopes that the proposed adjustments will address the issue of companies basing their pay structures only on market benchmarking methods or the advice of remuneration consultants.
   
   In particular, the revised principles: (a) set out the overarching expectations of directors’ remuneration policies, including an emphasis on the importance of transparency and a link to long-term sustainable success; (b) specifically include reference to environmental, social and governance objectives in the context of performance measurement and delivery of long-term strategy; and (c) add a reference to workforce pay and conditions as a factor which remuneration committees should have regard to in determining executive pay.
    
2. Malus and clawback. The FRC proposes to introduce a specific expectation that impacted companies include malus and clawback provisions in the relevant remuneration-related documentation, although there was already an existing expectation that companies included “provisions that would enable the company to recover and/or withhold sums or share awards”.
   
   To ensure greater investor visibility of a company’s malus and clawback arrangements and how they may be used, the FRC also proposes to set out a requirement for additional information to be included in companies’ remuneration reports, including: (a) the minimum circumstances in which malus and clawback provisions could be used; (b) the minimum period for applying these provisions and why this period is best suited to the organisation; (c) whether the provisions have been used in the last reporting period and, if so, a clear explanation of the reason; and (d) an explanation of the company’s use of the provisions in the last 5 years.
    
3. Changes to improve the quality of reporting. The FRC found that there was room for improvement of the reporting for those aspects of the remuneration committee’s work which should be reported in company annual reports, with many companies providing brief or generic information when reporting on certain aspects, often using wording directly from the Code.
   
   To help companies improve the quality of their reporting in the relevant areas, the FRC proposes to replace text in the Code that is often used by companies as template language in annual reports and instead list the factors which remuneration committees should address. The FRC hopes that companies will report on these factors in a way that is specific to their own circumstances.
   
   The FRC also proposes to amend the principle that sets out what should be covered in the description of the work of the remuneration committee in the annual report and take a more direct approach in asking how a company’s executive remuneration policies, structures, and performance metrics support company strategy, including ESG objectives. It is proposed to remove reference to pay ratios and pay gaps that was previously included in this principle to reduce duplicate disclosures within annual reports.

Next steps and timing

The deadline for consultation responses is 13 September 2023. The FRC sets out specific questions within the consultation paper but also gives information on how to send more general feedback.  Responses should be sent by email to: codereview@frc.org.uk.

The revised Code is expected to apply to accounting years commencing on or after 1 January 2025.

The revised Code will be supported by updated guidance and work is currently underway to revise, in particular of relevance to remuneration, the Guidance on Board Effectiveness so that the guidance will be aligned with the revised Code. The process of finalising the revised guidance will continue alongside the consultation and the FRC plans to have the new guidance available when the new Code becomes applicable.
 
Tapestry comment
This consultation is not unexpected, and is welcome as the next stage in the process of change, following last year’s position paper. As anticipated, the key theme of the proposed remuneration-related changes is a desire for increased transparency, including in ensuring alignment between pay, performance and the successful delivery of the company’s long-term strategy, the nature and use of malus and clawback arrangements, and also the quality of remuneration-related reporting generally. The proposed changes, and the updated guidance that is expected to follow, should help to clarify the FRC’s expectations, particularly in relation to remuneration reporting.

Once changes are confirmed, companies will need to assess whether their remuneration policies and practices correctly align with the revised Code, and ensure that the revised reporting requirements are complied with through clear and meaningful disclosure. That said, for most companies, the proposed changes are unlikely to result in a fundamental change to how remuneration is structured or set.

We expect that the revised reporting requirements for malus and clawback will be of particular interest for impacted companies. It should be noted that the FRC has not, at this time, chosen to include a specified list of minimum required malus and clawback triggers within the Code, which had previously been considered as part of the Government consultation process, although example triggers are set out in the existing FRC Guidance on Board Effectiveness.

Impacted companies, or companies that may become impacted in the future (including UK standard listed companies that are not currently subject to the Code but that are expected to become subject to the Code as part of the proposed reforms to the UK listing regime) should carefully consider the proposed revisions to the Code and respond to the consultation with any feedback, particularly if the proposed revisions are likely to create any burdensome issues.

Please do let us know if you have any questions or comments on this, or if we can assist you with your remuneration arrangements.

Matthew Hunter & Suzannah Crookes

14 February 2023

On 10 February 2023, the UK’s Prudential Regulation Authority (PRA) published a Policy Statement containing the final PRA policy on how existing unvested and deferred financial instruments awarded to Material Risk Takers (MRTs) as part of their variable pay should be dealt with where, in particular, a change to those instruments is appropriate to manage a conflict of interest arising from a MRT seeking a senior public appointment linked to financial policy or financial services regulation.

The Policy Statement follows the PRA’s consultation from July 2022 and contains the PRA’s feedback to consultation responses.

The new policy applies to PRA-authorised banks, building societies, and PRA-designated investment firms, including third country branches, that are subject to the Remuneration Part of the PRA Rulebook. The new policy took effect from 10 February 2023 and a revised ‘Remuneration’ Supervisory Statement (SS2/17) has been published to reflect the new policy.

Background
Except where certain derogations are available, firms that are subject to the Remuneration Part of the PRA Rulebook will generally be required to: (a) ensure that a substantial portion, which is at least 50%, of any variable remuneration payable to a MRT consists of an appropriate balance of permitted instruments, including shares or share-linked instruments (non-cash requirement); and (b) defer a substantial portion, which is at least 40%, of variable remuneration for a period varying between at least 4 and 7 years.

The PRA indicated that they were aware that an unvested, contingent claim to equity-based instruments (or other instruments) arising from these requirements could create a conflict of interest, or a perception of the same, in particular where a MRT or former MRT seeks to take up a senior public appointment linked to financial policy or financial services regulation. In such situations, it may be appropriate to change the instruments that are comprised in the award to other instruments or cash. Those situations are the focus of the Policy Statement.

Whether or not a firm wishes to explore if a change to the instruments underlying unvested, deferred variable pay is appropriate to manage a conflict of interest is a matter for the firm and the PRA sets no expectations in such cases. Where a firm believes that such a conflict could not be managed by means other than changing the underlying instruments, the new policy will apply.

Key features of the new policy
The final policy is the same as the proposed approach that was set out in the consultation paper but with a small number of changes to clarify the position, as summarised in the Policy Statement. There were no significant changes.
In summary, the key features of the new policy are as follows:

1. in general, the instruments that comprise unvested, deferred variable pay for MRTs, including any amounts above the minimum set out in the Remuneration Part of the PRA Rulebook, should not be changed after the relevant award has been made;
2. in exceptional circumstances, it may be appropriate for equity-based instruments to be converted into other instruments (or vice versa) and, where that is the case, the firm should seek the prior non-objection of the PRA. When considering whether its non-objection is appropriate, the PRA will be guided by certain considerations, including whether it would not be appropriate or sufficient for a potential conflict to be avoided or mitigated through other means;
3. where an unvested, deferred sum is converted from an equity-based instrument to other instruments, the relevant post-vesting retention requirements should remain unchanged;
4. in wholly exceptional circumstances, where a change in the instruments is not sufficient to mitigate conflicts, conversion to a cash award may be appropriate. Where conversion to a cash award would breach the minimum non-cash requirement, this would require a waiver or modification from the PRA. The new policy sets out circumstances which, if satisfied, would mean that a successful waiver or modification request would be more likely, including: (a) where the individual is due to join a public sector employer in a senior capacity and where their financial services experience is directly relevant to the role; and (b) where the cash award would replicate the deferral, malus and clawback provisions that applied to the original award and no early payment takes place;
5. in cases where a firm is seeking the PRA’s prior non-objection to a conversion or makes a request for a waiver or modification, the PRA should be presented with a reasoned case outlining why this, together with other measures, would be appropriate and sufficient to address the conflict of interest identified; and
6. it is the responsibility of a potential public sector body looking to employ a MRT to consider what mechanisms may be available to it under its own code of conduct to address any conflict of interest arising from unvested remuneration. Where a public sector employer’s conflict of interest policy can address a potential conflict of interest without need for any alteration of variable remuneration, that route should be pursued instead.

Tapestry comment
In the PRA’s Policy Statement, the PRA notes that most respondents welcomed the proposals or viewed them as helpful, although further clarification was requested on certain aspects. The new policy is materially the same as the proposed policy covered by the consultation and the additional clarifications (including the insertion of descriptive footnotes) are helpful.

Although the Policy Statement sets out reasonably clear expectations, whether a non-objection, waiver or modification will be granted by the PRA will be determined based on the specific facts of a potential conflict scenario, and the new policy does not set out clear circumstances when such a non-objection, waiver or modification will definitely be granted.

Where a potential conflict scenario of the kind covered by this Policy Statement arises for a firm, a careful review of the facts should be undertaken. The review should first consider whether the potential conflict can be mitigated in a way that does not involve the alteration of variable remuneration. If the firm is satisfied that an alteration to variable remuneration will be necessary, the firm should then consider if a change to the underlying instruments will be appropriate and justifiable, and, if not, whether a modification or waiver will be needed instead to convert the award to a cash award. In each situation, a reasoned case must be presented to the PRA.

Please do reach out if you would like any support with your incentive arrangements. We would be delighted to help.

Matthew Hunter

20 December 2022

The UK’s Prudential Regulation Authority (PRA) and Financial Conduct Authority (FCA) have launched a joint consultation on the removal of the bonus cap requirements that apply to UK banks, building societies, PRA-designated investment firms and third-country branches that are subject to the Remuneration Part of the PRA Rulebook and the FCA’s SYSC 19D Dual-regulated firms Remuneration Code. The deadline for consultation responses is 31 March 2023.

Background
Currently, UK banks, building societies, PRA-designated investment firms and third-country branches that are dual-regulated by the PRA and the FCA under the Remuneration Part of the PRA Rulebook and the FCA’s SYSC 19D Dual-regulated firms Remuneration Code, respectively, are subject to limits on the ratio between the fixed and variable components of total remuneration that can be paid to certain staff members. With limited exception, variable remuneration is limited to 100% of fixed remuneration or 200% of fixed remuneration where qualified shareholder approval is obtained. This is known as the ‘bonus cap’.

The bonus cap derived from the EU’s Capital Requirements Directive IV that was published in 2014 and transposed in the UK in line with the UK’s legal obligations as an EU member state at the time. The then UK Chancellor, George Osborne, unsuccessfully challenged the imposition of this requirement at the time, with the bonus cap being criticised for hindering the UK’s ability to compete for talent with other key financial centres, such as New York and Singapore.

The bonus cap has also been criticised for its role in driving up fixed remuneration, which is not ‘at risk’ or subject to deferral, payment in instruments, malus or clawback, thereby reducing a firm’s ability to adjust costs to absorb losses in a downturn. This is due to the fact that firms, to remain competitive on total remuneration, would need to pay higher fixed remuneration to permit higher variable remuneration to be awarded. The Bank of England explored this practice in a study that was published yesterday.

In September 2022, as part of the ‘mini-budget’ delivered by the then UK Chancellor, Kwasi Kwarteng, the government announced that it would remove the bonus cap to help the City of London to remain competitive with other key financial centres and to help boost productivity. Although most of the other aspects of the mini-budget have since been dropped, the decision to remove the bonus cap remained. The PRA and FCA have a statutory duty to consult when changing rules and that is the reason for the present joint consultation.

Key points

The key points raised in the consultation paper are as follows:

• The initial rationale for the bonus cap was that it would limit risk-taking by capping the maximum bonus that a Material Risk Taker could receive. It is possible that removing the bonus cap could lead to higher total remuneration for some employees, which could, in turn, incentivise excessive risk-taking, although the PRA does not consider that the proposals create material risks in this regard. There is no apparent evidence that the bonus cap has had any positive impacts on limiting risk-taking and there are other remuneration and accountability rules in place to mitigate excessive risk-taking behaviours.
• The proposed removal of the bonus cap aims to: (a) strengthen the effectiveness of the remuneration regime by increasing the proportion of compensation ‘at risk’ that can be subject to incentive setting tools, including deferral, payments in instruments, malus and clawback; and (b) remove unintended consequences of the bonus cap, namely the growth in the proportion of the fixed component of total remuneration.
• The proposed changes will remove limits on the ratio between fixed and variable remuneration and related provisions on shareholder approval and discount rates from the Remuneration, Disclosure (CRR) and Disclosure (CRR) - Pillar 3 Templates and Instructions Parts of the PRA Rulebook, the PRA’s SS2/17 ‘Remuneration’ Supervisory Statement and the FCA’s SYSC 19D Dual-regulated firms Remuneration Code.
• The proposed changes would not remove the requirement that a firm must set an appropriate ratio between the fixed and variable components of total remuneration and ensure that: (a) fixed and variable components of total remuneration are appropriately balanced; and (b) the level of the fixed component represents a sufficiently high proportion of the total remuneration to allow the operation of a fully flexible policy on variable remuneration components, including the possibility to pay no variable remuneration component.
• Many of the adverse impacts of the bonus cap, namely the relative growth of fixed remuneration, have already occurred but the removal of the bonus cap would allow firms to restructure their pay over time by giving firms greater flexibility over remuneration structure design, allowing firms to rebalance towards the variable component.
• The regulators considered alternatives to removing the bonus cap, including setting a higher limit, retaining the bonus cap only for certain people and/or having alternate mechanisms for setting the limits. The regulators determined, however, that a regulatory limit on the ratio between fixed and variable components of total remuneration is undesirable from the perspective of meeting their statutory objectives and removing it will help to enhance their objectives.
• The proposed changes would come into force the next calendar day after the publication of the final policy, which is anticipated for Q2 2023, and would apply to a firm’s performance year starting after that. For most firms, that is likely to be the performance year starting in 2024. There would be a transitional provision for remuneration awarded for a performance year starting before the implementation date of the final policy with such remuneration still being subject to the current requirements.
• The PRA considers that there may be scope to improve the alignment of, and interlinkages between, certain other remuneration requirements (i.e. other than the bonus cap) and the Senior Managers and Certification Regime to further support senior management accountability for risk-taking and the effectiveness of risk adjustment tools. The PRA indicates that they “will consider these issues further in due course”.

Next steps

The proposed changes are subject to consultation and so the final policy changes may differ to those set out in the consultation paper. The consultation closes on 31 March 2023. Comments or enquiries should be sent to CP15__22@bankofengland.co.uk or to: Governance Remuneration and Controls Policy Team, PPD, Prudential Regulation Authority, 20 Moorgate, London EC2R 6DA.

Tapestry comment
The proposed removal of the bonus cap will be welcomed by many firms. Many firms that we have spoken to consider the bonus cap to have had no positive impact on limiting risk-taking and have noted that it instead raises fixed costs, increases the cost and time burden of compliance and hinders the firm’s competitiveness with other UK businesses and overseas competitors.

It is important to note that the removal of the bonus cap will generate a range of practical challenges that firms should start to consider as soon as possible. The following are a few indicative examples:

• The removal of the bonus cap will, in most cases, have no automatic impact on existing contractual arrangements. This means that any contractual terms that govern salary and role-based allowances will need to be considered. If a firm wishes to reduce either of these elements, there will be: (a) a contractual question – i.e. how can we lawfully reduce these elements, particularly as these should be permanent and non-recoverable remuneration components; and (b) a communication question – i.e. how can we communicate to / convince staff members with regard to the reduction of their fixed remuneration without this causing legal or retention issues. It will, therefore, likely be difficult to quickly restructure remuneration for existing employees. We have, on a few occasions, seen the terms of some role-based allowances that refer to the allowances only being payable when the staff member is subject to the bonus cap and so those terms would also need to be considered, where relevant.
• The removal of the bonus cap may not allow a firm to immediately restructure the remuneration that it offers to new hires. For example: (a) in a market where a relatively high component of fixed remuneration is paid, it may be difficult to convince a well-informed new hire to accept lower (guaranteed) fixed remuneration initially, particularly if they are moving from a comparable role which currently pays high fixed remuneration; and (b) firms will need to carefully consider anti-discrimination and equal pay laws and policies to ensure that the firm does not inadvertently breach these laws and policies through the offer of a different (less beneficial) remuneration structure to someone with a protected characteristic compared to a suitable comparator. 
• Firms that are part of EU CRD-regulated groups will need to continue to apply any applicable bonus cap that would apply to UK-based staff members as a consequence of the applicable EU rules, if any.

Firms will also need to update any applicable documentation and policies which may refer to the bonus cap, such as the firm’s remuneration policy, directors’ remuneration policy (if applicable) and any Material Risk Taker letter or other communications. We would be happy to help with identifying and then making these updates, if helpful.

Firms should carefully consider the proposals and respond to the consultation paper with any comments or concerns that they may have. In particular, the regulators encourage firms that believe they may be disproportionately disadvantaged by the proposed timing of the final policy to respond on this point.

If you would like to discuss these changes, particularly how you may navigate the practical challenges that may arise due to the removal of the bonus cap, please do reach out to me or to your usual Tapestry contact.
 
Matthew Hunter

28 November 2022

The Philippines Bureau of Internal Revenue (BIR) recently announced the proposed abolition of the distinction between the tax treatment of share plans for managerial/supervisory staff and ‘rank and file’ employees.

Background
 
Currently, the taxation treatment of share plan income in the Philippines depends on the position of the employee at vest/exercise. Income from share plan awards for employees at managerial and supervisory level is taxed as Fringe Benefits Tax (FBT). Income from share plan awards for other 'rank and file' employees is taxed as income. These terms are broadly defined and depend upon function rather than title.

FBT is a tax imposed on the employer rather than the employee, so it is the employer who is obliged to report and pay the FBT. If FBT is payable, the employee is no longer required to report or pay tax on the share plan income. The employer may only pass on the costs of FBT to an employee if this is agreed by the employee. 
 
What has changed?

On 7 October 2022, the BIR released Revenue Regulation No. 13-2022 (RR13-2022) which removed the distinction between managerial/supervisory staff and ‘rank and file’ employees in terms of the tax treatment for employee share plans. The effect of this is that all share plan income will now usually be subject to income tax at vest/exercise, regardless of the employment status of the recipient of the award, who may be in a managerial/supervisory role or part of the ‘rank and file’ workforce.
 
When will the changes takes effect?
 
RR 13-2022 takes effect 15 days following publication in the Official Gazette or in a newspaper of general circulation. We are advised by our local counsel that RR 13-2022 was published in The Manila Times on 14 October, so is expected to take effect on 29 October 2022. 

Tapestry comment 
In simplifying the tax treatment of share plans, this will be a welcome development for companies offering equity plans in the Philippines. This change will also provide equality in the tax treatment of awards for local employees, which is a helpful result.

It is worth noting that employer tax withholding obligations vary in the Philippines, depending on whether or not the cost of the plan has been recharged to the local employing company or the local subsidiary records the plan as an expense in its local accounts. Our recommendation is that companies review their share plan tax processes in the Philippines to prepare for the new change to take effect. 
 
We would like to thank our partner firm in the Philippines, Quasha Law, for their assistance with this alert.

As always, if you have questions about any of the content of this alert, or there is any assistance you need in relation to your share incentives, do not hesitate to contact us.

Sonia Taylor and Sharon Thwaites