Commentary: Why We Should Care About European Curbs on Compensation
Traders Magazine Online News, July 13, 2010
On July 7, the European Parliament approved an amended series of rules to restrict compensation for employees of financial institutions. The European Council, effectively the legislative upper house, has agreed to approve the Parliamentary version on July 13.
Under European rules, legislation originates with the European Commission. The European Parliament, the only elected body for the European Union, and the European Council, can only react to legislation that has been drafted by the Commission. In this case, Parliament thought the Compensation Directive proposed by the European Commission was "only a cautious first step." So, Parliament made substantial amendments to the European Commission's draft, resulting in a much more specific and restrictive regime.
The Compensation Directive consists of amendments to the Banking Consolidation and Capital Adequacy Directives. Strictly speaking, it therefore applies to institutions that are regulated under the Markets in Financial Instruments Directive (MiFID) and required to maintain capital, which includes banks and other credit institutions, as well as most hedge funds. While private equity and real estate managers are not affected by the Compensation Directive, these other fund managers that have escaped compensation restrictions for now will be subjected to a similar regime when the Alternative Investment Fund Managers Directive is adopted as expected later this year.
The financial press has focused on provisions that enable national authorities some discretion to relax the compensation restrictions for local firms. It has been argued that this should relieve the panic the Compensation Directive has caused within the community of hedge fund managers.
I believe the magnitude of this relief has been overstated. National authorities are permitted to grant relief where necessary to satisfy the principle of "proportionality." The idea is to avoid hardship to smaller, local firms, while maintaining the essential principles embodied in the Compensation Directive. However, the European Parliament expressed great concern about the need to avoid "regulatory arbitrage" within Europe. Any relief that would induce a firm to relocate from Paris to London, for example, to take advantage of beneficial local rules, would fail this test. The European Banking Authority (EBA), which is soon to be established, has been charged with a duty to make sure the Compensation Directive is applied uniformly throughout the European Union.
The Compensation Directive's provisions generally will apply to employment contracts entered into after January 1, 2011. However, to avoid firms creating contracts before the end of the year that are intended to escape the restrictions, the rules will apply to any compensation earned after the first of next year, even under pre-existing contracts, or compensation earned prior to January 1, 2011, that has not yet been paid to the employee. I would expect a big rush to pay bonuses in December, rather than waiting until January or February, when they will be caught by the new rules.
The Compensation Directive does not limit the amount of compensation that can be paid directly. Instead, its goal is to restrict compensation schemes that encourage undue risk-taking. So, "variable compensation" cannot be greater than 50 percent of total annual compensation. Between 40 to 60 percent of a bonus must be deferred for at least three years, and it must be recoverable by the firm if investments do not perform as expected. At least 50 percent of the bonus is to be paid as "contingent capital," which means that if an institution fails, other creditors would be paid first.
For more information on related topics, visit the following channels:
