Financial Services seminar: Managing regulatory change for the buy-side Breakout session: Remuneration Kennedy Masterton-Smith - Associate Norton Rose Fulbright LLP 30 July 2013 Good afternoon my name is Kennedy Masterton-Smith and I am an associate in the Norton Rose FULBRIGHT financial services team here in London I am gong to be guiding you through the ever changing world of remuneration for the buy-side – which is quite a hot topic at the moment particularly as people are always worried about what they get paid. I will take this opportunity to highlight that I have included quite a lot of detail in the slides but that is because we only have 20 minutes and there is a lot of detail on these topics. Hopefully the slides will act as a good guide and if you have any questions or require any further information please do not hesitate to speak to me during the coffee break or later at the drinks.

Setting the scene The global mandate The starting point Wide public perception that the financial crisis was, at least partly, the result of bankers and others in financial services receiving large bonuses and incentivising them to take large and ill thought out risks G20 2009 Pittsburgh summit: “excessive compensation in the financial sector has both reflected and encouraged excessive risk taking. Reforming compensation practices is an essential part of our effort to increase financial stability.” The starting point General remuneration guidance: CRD III and CEBS guidelines which FSA implemented through the Remuneration Code (the Code) EU keen to introduce consistent requirements on remuneration CRD IV - Tackle excessive risk taking AIFMD and UCITS V rationale - Key concept is investor protection ESMA Guidelines on remuneration policies and practices under MiFID Global Mandate Led to a great deal of focus and change in remuneration regulation Currently have CRD III and the UK Remuneration Code CRD IV - New requirements inserted with regard to the relationship between the variable and fixed remuneration, disclosure and transparency requirements AIFMD and UCITS V MiFID Guidelines – consumer protection – clients best interest focus General feeling in the market that the European bodies are seeking to apply bank style restrictions on the buy-side industry and that this is disproportionate to the risk they pose to the system.

How do the rules fit together? CRD IV The CRD IV is a comprehensive review of the EU's prudential requirements Same objectives as CRD III - view that CRD III was implemented incorrectly Applies to MiFID investment firms and credit institutions Includes a bonus cap Applies to AIFMs when undertaking ancillary services set out in Article 6(4) of AIFMD AIFMD Applies to authorised AIFMs Regulates the remuneration policies and practices for the AIFM and their ‘identified staff’ UCITS V AIFMD CRD MiFID MiFID Guidelines Focused on ensuring investor protection when investment services are provided under MiFID Applies to MiFID investment firms and those AIFMs and UCITS management companies when they are providing investment services of individual portfolio management or non-core services Bottom up approach with regard to ‘relevant persons’ UCITS V Focuses on undertakings for collective investment in transferable securities Applies to UCITS management companies and UCITS investment companies that do not designate a management company Detailed ESMA guidance expected Q4 2013 on application of rules Key question is how all of these different rules fit together We will come back to the application of each set of rules in more detail later on in the presentation but the critical point here is to appreciate that these pieces of legislation (AIFMD, UCITS V, CRD IV and MiFID Guidelines) do not operate in isolation Firms or groups that undertake multiple asset management and MiFID activities will need to consider how these rules apply concurrently to the same group, a firm or even an individual Question about gold plating group policies which should be borne in mind as we look the detail of each of the pieces of legislation

Ok let’s dive straight in with the remuneration rules under AIFMD BREATHE SMILE Ok let’s dive straight in with the remuneration rules under AIFMD

Nuts and bolts: AIFMD Where to find the key provisions Article 13 AIFMD Annex II AIFMD ESMA guidelines on sound remuneration policies under the AIFMD The general principles AIFM to have remuneration policies and practices consistent with and promote sound and effective risk management Remuneration policy to be in line with the business strategy, objectives, values and interests of the AIFM and the AIFs it manages or the investors of such AIFs What remuneration? All forms of payments or benefits paid by the AIFM Any amount paid by the AIF itself including carried interest Any transfer of shares or units in the AIF When in exchange for professional services rendered by the AIFM’s Identified Staff Excluding reimbursement of costs and expenses made directly by the AIF AIFMD most detailed set of rules and guidelines. Level I and Level II texts contain the basic rules – Article 13 of AIFMD imposes restriction on the amount and form of remuneration that the AIFM can pay senior staff and requires the AIFM to put in place remuneration policies and practices to promote sound and effective risk management and not to encourage risk taking which is inconsistent with the risk profiles and rules of the AIFs it manages The detailed provisions are contained in the ESMA final guidelines The general principles What remuneration? All forms of payments or benefits paid by the AIFM Any amount paid by the AIF itself including carried interest - Any transfer of shares or units in the AIF - When in exchange for professional services rendered by the AIFM’s Identified Staff Carried interest is defined as “A share in the profits of the AIF as compensation for the management of the AIF and excluding any share in the profits of the IF accrued to the AIFM as a return on any investment by the AIFM into the AIF” Any payment which is a pro-rata return on an investment into the AIF is out of scope see para 12 of the ESMA Guidelines – see distinction between this and carried interest

Recap on key requirements (1) Fixed and variable remuneration to be appropriately balanced No variable remuneration cap (contrast with CRD IV) At least 50% of variable remuneration should consist of units or shares of the AIF Unless the management of the AIFs account for less than 50% of the total portfolio managed by the AIFM; shares to be subject to retention provisions Deferral At least 40% variable remuneration to be deferred over 3-5 years (unless AIF life cycle is shorter) Where variable remuneration exceptionally high at least 60% to be deferred Contraction Total variable remuneration to be considerably contracted where there is subdued or negative financial performance of the AIFM or the AIF Ex-post risk adjustment – performance adjustment Closely based in CEBS Guidelines and CRD III. HOWEVER the provisions under AIFMD will be new to some asset management firms who are currently in Level 3 for proportionality purposes – as the more prescriptive rules (e.g. deferral and non-cash instruments can be neutralised) Under AIFMD 50% of variable remuneration should consist of units or shares. This is unless the management of the AIF accounts for less than 50% of the total portfolio management by the AIFM . This threshold is to be based on net asset value of the AIFs Deferral 40% with an upper limit of 60% - no guidance on upper limit but current upper UK threshold is £500,000 Contraction

Recap on key requirements (2) Guaranteed variable remuneration Exception rather than the norm Limited to new hires and first year of employment Performance criteria Based on individual performance, performance of the business unit or AIF and the overall results of the AIFM Based on multi-year framework that reflects the life cycle of the AIF Remuneration committee AIFMs significant in terms of size or the size of AIFs managed, their internal organisation and the nature, the scope and complexity of activities All non-executive members of the AIFM and majority of members must be independent Disclosure AIFMs seeking authorisation will need to disclose details of remuneration policy Underlying requirement that fixed and variable remuneration and the number of beneficiaries be disclosed in AIF’s annual report Rem co - Examples of instances where a remuneration committee is not required are set out in ESMA guidelines but seen as a matter of good practice

Who is in: Identified Staff Non-executive and executive directors of the AIFM Senior management Staff responsible for heading the portfolio management, administration, marketing and human resources Other risk takers such as staff whose activities can exert a material influence on the risk profile of the AIFM or the AIF Criteria that AIFMs can use include an assessment of staff members or a group, whose activities could potentially have a significant impact on the AIFM’s results and/or balance sheet and/or on the performance of the AIFs managed Control functions Other employees Remuneration takes them into same bracket as senior management or risk takers Professional activities have a material impact on the AIFM or AIFs managed: Includes staff of entities to which portfolio management or risk management have been delegated by the AIFM Rules on governance apply to AIFM as a whole ESMA guidance on general governance Annex II of the ESMA Guidelines sets out which guidelines apply to the AIFM as a whole and which apply to identified staff only. Remuneration bracket – see ESMA Guidelines and compare with CRD IV EBA technical standards

Restrictions on avoidance AIFMs should ensure that variable remuneration is not paid through vehicles or using methods to avoid the rules on remuneration The governing body of the AIFM has the primary responsibility for ensuring that the ultimate goal of having sound and prudent remuneration policies and structures is not improperly circumvented Delegation covered expressly Situations that pose greater risk Using other forms of benefit (including non-monetary benefits) Outsourcing to firms outside scope Use of tied agents Transactions with third parties where risk takers have a material interest Using structures that involve the payment of dividends or performance fees Paragraph 17 - Dividends or similar distributions that partners receive as owners of an AIFM are not covered by the rules unless the material outcome of the payment of such dividends results in circumvention of the relevant remuneration rules, intention to circumvent is irrelevant

Delegation Delegate portfolio management or risk management activities – new requirement regarding remuneration AIFM must ensure that entities which have been delegated to are subject to “regulatory requirements on remuneration that are equally as effective as those applicable to the AIFM” OR Contractual arrangements are put in place with the entities to ensure that there is no circumvention of the remuneration rules No guidance on whether there is a de-minimis in relation to the level of delegation that is captured This delegation condition was added in the AIFMD Guidelines on sound remuneration

Proportionality Principle that remuneration provisions are applied in a way and to an extent that is appropriate to their size, internal organisation and the nature, scope and complexity of their activities Some requirements may be dis-applied if it is reconcilable with the risk profile, risk appetite and the strategy of the AIFM and AIF May dis-apply rules in relation to Retention Deferral Variable remuneration in instruments Ex post risk for variable remuneration No express proportionality levels – size only one aspect of the analysis Firms need a robust audit trail should they dis-apply a requirement In line with the approach taken in the CEBS guidelines to neutralisation Size plus other considerations: [see text of AIFMD] Internal organisation Nature, scope and complexity of activities undertaken Proportionality works in both ways – some firms will require more sophisticated policies and procedures and for some simpler and less burdensome policies will be appropriate Audit trail – should be able to evidence their rational for every single requirement Proportionality in respect of different categories of staff

Timing and UK approach EU AIFMs start complying with AIFMD from 22 July 2013 but note transitional provision providing a one year grace period for remuneration provisions But staff with performance and salary years ending 31 December 2013 will need to be assessed to ensure relevant requirements are met on 22 July 2014 Non-EU AIFMs must adhere to remuneration requirements should they wish to benefit from the marketing passport in 2016 In 2019 national private placement regimes may end and non-EU AIFMs may be required to become an authorised AIFM and will then be subject to the remuneration requirements FCA Policy Statement on AIFMD implementation 28 June 2013 Consultation on certain remuneration aspects deferred until later in 2013: (i) changes to FCA Handbook to integrate ESMA guidance (ii) guidance on the AIFMD proportionality framework Timing

UCITS V BREATHE SMILE

Nuts and bolts: UCITS V Where have we got to? Commission legislative proposal published in July 2012 Co-decision procedure still on-going: Latest Council compromise proposal dated 11 December 2012 but European Parliament adopted amended version of an ECON report on 3 July 2013 Crucially the proposed bonus cap was removed Express restriction concerning where the fund is not distributed exclusively to professional advisers also removed FCA to publish consultation on UCITS V (depending on when Level 1 text is agreed) ESMA to publish technical standards, advice and guidelines in Q4 to include guidance on partial neutralisation Originally envisaged that UCITS V would apply from end of 2014 but now end of 2015 looks more likely

Nuts and bolts: UCITS V Key concepts What remuneration? Implement remuneration policies that are consistent with and promote sound and effective risk management of the UCITS fund they manage Idea is to reduce incentive to increase the level of risk in the portfolio in order to increase returns Disclose the amount of remuneration in each financial year with appropriate detail in the UCITS fund’s annual report – encourage accountability Remuneration requirements to be consistent with the equivalent provisions of the AIFMD What remuneration? Remuneration of any type paid by the management company and to any transfer of units or shares of the UCITS in respect of Identified Staff Remuneration paid from the fund to the management company

Recap on key requirements (1) Fixed and variable remuneration to be appropriately balanced Currently no proposal for a bonus cap (still subject to change) Non-cash remuneration At least 50% is payable in cash and 50% in units/shares in the UCITS that is managed, unless UCITS is half of the total portfolio of funds under management where the 50% minimum does not apply Deferral At least 25% variable remuneration to be deferred over 3-5 years (unless the UCITS life cycle is shorter) Where variable remuneration is very high at least 60% shall be deferred but like AIFMD remuneration there is no explicit reference to what the upper threshold would be Guaranteed variable remuneration, contraction, performance criteria Similar to AIFMD proposals – specific investor protection concern Independent review Remuneration policy must be subject to at least annual central and independent internal review

Recap on key requirements (2) Disclosure The annual report shall set out The total remuneration for the financial year, split into fixed and variable remuneration and the number of beneficiaries and, where relevant, the carried interest paid by the UCITS The aggregate amount of remuneration broken down by categories of staff of the financial group, the management company and the investment company Proportionality UCITS management companies to apply the requirements according to their size and complexity of activities and the size of the UCITS they manage No guidance on proportionality so far ESMA to work with the EBA and issue guidelines on sound remuneration policies in the asset management sector (Q4 2013) Remuneration committee Includes employee representatives Remco Interesting in relation to remuneration committee – an earlier draft of CRD IV did include the requirement for an employee representative. However, this language has been softened and it no provides for “If employee representation on the management body is provided for by national law, the remuneration committee shall include one or more representatives

Who is in: Identified staff Includes those in a UCITS management company and UCITS investment company who are: Fund managers Senior management Persons who take real investment decisions that affect the risk position of the fund Persons with the power to exercise influence on such staff including investment policy advisers and analysts Risk takers Control functions Staff receiving total remuneration that takes them into the same bracket as senior management and decision takers and whose professional activities have a material impact on the risk profiles of the management company or the UCITS they manage Makes specific reference that the above applies to temporary or contractual members of staff at fund or sub-fund level Only applies to UCITS managers but may follow AIFMD route and be extended to delegates outside the EU

CRD IV BREATHE AND SMILE YOU KNOW THIS STUFF

Nuts and bolts: CRD IV CRD IV published in Official Journal on 27 June 2013 Provisions come into effect on 1 January 2014 – will effect remuneration paid in respect of services provided during 2014 No guidance on transitional provisions FCA and PRA consultation paper on UK implementation due end of July/beginning of August Focus on prudential regulation Same objectives as CRD III – address the concern that CRD III failed because was not implemented correctly CRD IV has to be the piece of legislation that has gained the most press coverage and industry focus – primarily due to the quite incorrectly titled ‘bankers bonus cap’ In summary - provisions will come into force on 1 January 2014 but will apply to remuneration paid in respect of services provided during the course of 2014 Need to be implemented in the UK by the PRA and the FCA – consultation paper expected last week in July and first week in August - any time now. I went to the EBA plenary session on the draft technical standards on identified staff and the view was the CRD IV has the same objectives as CRD III but that CRD III was implemented incorrectly and as such there is a need to revisit these rules

Scope issues – Which firms are in? (1) Application of CRD IV Credit institutions and investment firms undertaking MiFID business Carve out in the CRR definition of ‘investment firm’ Firms are excluded from the scope of the CRR if Only authorised to carry on one or more of these MiFID activities – reception and transmission of orders, execution of orders, portfolio management and investment advice AND Not allowed to and do not safeguard and administer assets AND Not hold client assets National regulators must ensure that when establishing policies for code staff under CRD IV, firms must comply with the principles in a way that is appropriate to their size, internal organisation and the nature, scope and complexity of their activities Previous carve-out under CRD III – FSA did not take this approach in relation to the application of the Code Pending FCA consultation paper on application Question re proportionality CRD IV applies to investment firms – this definition is taken from the CRR the regulation. The CRR does include a carve out for in basic firms that only undertake certain services and do not have the permission to hold client money or client assets There has been a good deal of discussion in the market regarding whether firms who fit within the scope of this carve-out will be out of scope for the CRD IV rules. We don’t yet have any formal guidance on this from the FCA However – it is interesting to note that there was a similar carve out under CRDIII – which the FSA did not take up. The FSA in the consultation paper covering the remuneration code stated that it was appropriate for all firms to comply with the quantitative measures of CRD III – with the ability to neutralise certain quantitative measures. This is an approach the FCA could look to take with CRD IV That being said – the bonus cap is politically sensitive and as such they may elect to take a different view this time around

Nuts and bolts: CRD IV (1) Fixed and variable remuneration to be appropriately balanced A basic ratio of fixed and variable elements at 1:1 which can only increase to 1:2 with shareholder approval (with a quorum of 50% of shareholders, 66% of votes in favour would be required, and, if that quorum is not reached, 75% of votes in favour) Defined approval process Bonus cap applies to staff or subsidiaries operating outside the EEA Use of long-term incentives Maximum 25% of total bonus can consist of long term financial instruments, discounted with reference to factors reflecting risk inherent in the instruments Long term instruments shall be fully subject to clawback Disclosure Existing rules in chapter 11 of BIPRU CRR requires firms to disclose the number of individuals being remunerated €1 million or more per financial year, broken down into pay bands of €500,000 As you probably all know the headline provision in CRD IV is the bonus cap – It provides that variable remuneration is limited to 100% of salary – with shareholders able to increase that maximum to 200% There is a defined process for undertaking this shareholders vote – shareholders should be provided with reasonable notice and should provide a detailed recommendation giving reasons. Firms should notify the regulator of the recommendation to shareholders and to demonstrate that the maximum requested will not conflict with the firm’s capital requirements Staff who would benefit from the increase, where they are shareholders cannot vote Firms will want to think about when these votes should be schedules and whether they need to be incorporated into the annual shareholders meeting 25% discount where a firm is using long term instruments that are deferred for a period of not less than five years (although member states may apply a lower maximum) – EBA to publish further guidance on this Disclosure

Nuts and bolts: CRD IV (2) Non-cash remuneration At least 50% of variable remuneration shall consist of a balance of shares or equivalent interests and where possible other instruments that can reflect the credit quality of the institution Deferral At least 40% variable remuneration to be deferred over 3-5 years Where variable remuneration is very high at least 60% shall be deferred - no explicit reference to what the upper threshold would be Independent review Remuneration policy must be subject to at least annual central and independent internal review Non-cash instruments –the EBA published draft regulatory technical standards yesterday. We are working with out incentives team to look at options for firms in relation to these structures.

Who is in: Identified staff Senior management and risk takers Control functions Employee receiving total remuneration that takes them into the same bracket as senior management and risk takers, whose professional activities have a material impact on the risk profile EBA survey on implementation EBA consultation on draft technical standards Draft RTS provides that individuals must satisfy one or more of the internal, qualitative and/or quantitative criteria Captures a much larger group of individuals Specified roles Employees with the ability to commit the firm to trading book or credit exposures Overall pay – gross remuneration of more than €500,000 Highest paid 0.3% Employees whose variable pay is both 75% of fixed remuneration and more than €75,000 All employees whose gross total remuneration in either of the two preceding years was equal or more than the lowest remuneration received by a person undertaking a specified role Current rules are set out in CEBS Guidelines and the Code EBA found that there was no standard approach to the application of the rules – levels of identified staff differ significantly On that basis they have produced more detailed rules – in order to create a more harmonised approach At the EBA plenary session the subtext of the rules being to capture more staff In order to determine its identified staff, firms should undertake a self assessment using its internal criteria It should then also apply the quantitative and qualitative criteria - BOTH STEPS REQUIRED to be undertaken

MiFID Guidelines BREATHE

MiFID Guidelines MiFID guidelines published by ESMA in June 2013 General provisions similar to those in other pieces of legislation – with a different focus and different targeted staff Applies to MiFID investment firms and AIFMs and UCITS management companies when they are providing the investment services of individual portfolio management or non-core services On 11 June 2013, ESMA published a final report containing guidelines and recommendations on remuneration policies and practices under MiFID. In general terms these rules will be familiar to firms as the mirror the principles of sound and effective remuneration used elsewhere – however the staff captured is different. CRD III and CRD IV focuses on prudential concerns and material risk takers these guidelines focus on client facing staff to ensure that staff are not incentivised to act in a way that is not in the clients’ best interests Applies to MiFID investment firms and those AIFMs and UCITS management companies when they are providing investment services of individual portfolio management or non-core services

Key requirements Align policies with effective conflicts of interest and conduct of business risk management Remuneration policies should be set with clients’ best interests in mind Firms should use qualitative assessment criteria and avoid quantitative criteria Outsourcing Proportionality in MiFID applies to these guidelines The focus of the rules is to ensure the consistent application of the MiFID conduct of business and conflicts of interest management provisions and to achieve investor protection – focus is on the clients best interests The guidelines specifically provide that when setting the assessment criteria for remuneration policies quantitative criteria such as value of instruments sold, sales volumes or targets for new clients should be avoided and qualitative criteria used. For example – compliance with policies and treating customers fairly Guidelines provide a series of good and bad practice examples Outsourcing – ESMA in the final version of the guidelines said that having considered whether remuneration should be applied applied to outsourcing – EMSA is of the view that when outsourcing the provision of investment services, firms should have in mind the best interests of the client and should not use outsourcing to circumvent the MiFID rules – The guidelines state that firms should check the outsourced service providers policies and follow an approach consistent with the guidelines. 27 27

Who is in – Relevant staff Those persons who can have a material impact on the service provided and/or corporate behaviour of the firm and include customer-facing staff and sales force staff May also include other staff indirectly involved in the provision of investment or ancillary services whose remuneration may create inappropriate incentives to act against the best interests of the client Line managers Financial analysts Persons involved in complaints handling, claims processing and client retention Persons involved in product design and development Tied agents The definition of “relevant person” is different from the definition in Article 2(iii) of the MiFID Implementing Directive Tied agents important to note the issue here – previous CESR guidance highlights that an investment firm is fully and unconditionally responsible for its tied agents Compensation for tied agents can be seen as an internal payment within the firm As I have said – the MiFID Guidelines take a top down approach and capture staff who are client facing

The Jigsaw BREATHE

Drawing the different streams together CRD IV AIFMD UCITS V 1:1 cap on variable remuneration – shareholders can extend cap to 1:2. At least 40% (in some cases 60%) deferred over a period of 3-5 years No variable cap. At least 40% (in some cases 60%) deferred over a period of 3-5 years Currently no proposal for a variable remuneration cap. At least 25% (in some cases 60%) deferred over a period of 3-5 years Remuneration Committee seen as a matter of good practice – all non-execs and majority independents Remuneration Committee all non-execs – include employee representatives Implementation 1 January 2014. FCA and PRA main consultations expected this summer Implementation 22 July 2013 but note one year transition period. FCA deferred consultation Still in co-decision procedure. Implementation end of 2015 now looks likely Annual disclosure requirement. Firms to disclosure number or individuals paid over EUR 1m broken down in pay bands of EUR 500,000 Annual disclosure requirement in annual report. Annual internal independent review of policy Don’t intend to linger on this slide but it gives you an idea of some of the key differences between the regimes – despite these pieces of legislation being based on the same principles. Annual disclosure requirement in annual report Broader category of identified staff other than AIFMD and the Code Scope issues for MiFID investment firms key Proportionality accepted and ESMA guidelines published Push to align with AIFMD EBA consultation in progress on draft RTS on identified staff - Closes 21 August 2013 Broader category of staff than under the Code likely to catch more fund managers

Group context No carve-out for AIFMs who are subsidiaries of a credit institution Where an AIFMD is providing ancillary services will be subject to CRD III CRD IV MiFID Guidelines Where a person is considered to be Identified Staff under CRD and AIFMD the individual rules should apply to their remuneration on a pro rata basis Possible to extend the same analysis to UCITS management companies Group policies may need to be applied differently for each entity or at the highest level As I highlighted at the beginning of this break-out session – clearly it is important to appreciate the requirements under each piece of legislation - but crucially firms need to consider how all of the new rules are going to apply to their firm or group and where there is overlap. It is clear that ESMA does not intend to create a combined remuneration code. We have more guidance on the application of CRD and the MiFID guidelines as these rules are the most developed and ESMA has provided detailed guidance. Clearly the rules in AIFMD will apply – however, CRD III and CRD IV when it comes in and the MiFID guidelines will also apply to an AIFM when it is undertaking the non-core services set out in Art 6(4). ESMA has highlighted that the CRD rules for example will apply on a pro rata basis. Under a current structure could see a position where two managers in the same firm undertaking delegated management - one managing a UCITS and the other managing a segregated portfolio under MiFID could be subject to different rules We can use these principles to anticipate what the position is going to be for UCITS management companies also Firms will need to determine whether they want to gold plate their policies or alternatively separate staff All levels of staff now under increased focus – top down and bottom up

Going forward Further alignment UCITS VI and AIFMD II bonus caps General corporate governance and political pressure