Further to our alert in June last year, the Financial Stability Board (FSB) has published its final Guidance on the use of compensation tools to address misconduct risk. The Guidance has been prepared in the form of recommendations on ‘better practice’ that specifically address the link between compensation and conduct and is designed to apply to significant financial institutions.
The Guidance supplements the FSB’s 2009 ‘Principles and Standards on Sound Compensation Practices’ which established a range of compensation principles that were replicated in CRD III (and later, CRD IV) and other EU remuneration regulations.
The Principles and Standards require compensation to be adjusted for all risk types, including misconduct risk, and emphasises that subdued or negative financial performance should generally lead to a considerable contraction of the firm’s total variable remuneration, taking into account both current compensation and reductions in pay-outs of amounts previously awarded, including through malus or clawback arrangements.
The FSB states that the effective use of compensation tools based on strong governance and management of misconduct risk through compensation practices is at the centre of the Guidance. This includes, in the event of misconduct, the appropriate use of in-year adjustments, pre-vesting malus provisions and post-vesting clawback provisions.
The FSB states that firms should be able to clearly identify misconduct, should have a range of tools available to consider using when misconduct occurs, and should ensure that all variable pay is at risk of reduction when misconduct occurs. The choice of which tools to use, and in which circumstance, remains with the firm but use of the tools should be consistent with sound risk management practices. The FSB has also identified that, as risk management failures and misconduct can often take years to come to light, firms should ensure that performance adjustment could still be applied to the extent that the relevant individuals have variable compensation at risk.
The Guidance is structured in three parts:
- Governance of compensation and misconduct risk.
- Effective alignment of compensation with misconduct risk.
- Supervision of compensation and misconduct risk.
The Guidance itself is not particularly long (around 8 pages) but is detailed. It is useful to read the Guidance to understand what the FSB considers to be best practice and to compare the Guidance to your existing policies and practices. While the Guidance is not directly binding on firms, the use of malus and clawback has come under increased scrutiny by both regulators and shareholders, particularly following the Carillion liquidation, and so the Guidance is likely to become market practice in many countries. A comparison of your current arrangements against the Guidance in the form of a ‘gap analysis’ now will allow you to identify steps which may be required in the future, or steps which could be taken now to protect the firm against misconduct risk.
If you have any questions about this alert and how it impacts your remuneration arrangements or if you would like us to assist you with your malus and clawback policies and practices, please do get in touch.
Janet and Matthew