CP8/22 - Remuneration: Unvested pay, Material Risk Takers and public appointments

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Responses are requested by Tuesday 20 September 2022.

The PRA prefers all responses to be sent by email to: CP8_22@bankofengland.co.uk.

Alternatively, please address any comments or enquiries to:
Terry Allen
Prudential Regulation Authority
20 Moorgate
London
EC2R 6DA

1. Overview

1.1 This Consultation Paper (CP) sets out the Prudential Regulation Authority’s (PRA) proposed expectations in respect of changes to the instruments or claims that comprise unvested, deferred sums awarded to Material Risk Takers (MRTs) as part of their variable pay. It considers, in particular, cases where a change is prompted by the need to manage a conflict of interest arising from a MRT seeking a senior public appointment linked to financial policy or financial services regulation (a public-sector appointment).

1.2 The proposals in this CP would result in changes to Supervisory Statement (SS) 2/17 ‘Remuneration’ (Appendix 1).

1.3 The CP is directly relevant to PRA-authorised banks, building societies, and PRA-designated investment firms, including third country branches, subject to the Remuneration Part of the PRA Rulebook (firms). This CP is not relevant to credit unions or PRA-authorised insurers. In addition, while it is not directly applicable, it may be of interest to MRTs and former MRTs seeking to undertake public-sector appointments, and also to those who may consider employing a MRT or former MRT to perform such a role.

1.4 These proposals would create an expectation that firms should not ordinarily convert unvested, deferred pay awards to MRTs from equity to other instruments (or vice versa). However, the PRA considers there may be circumstances, notably seeking to address a conflict of interest that might arise from a public-sector appointment, where conversion might occur subject to the PRA’s prior non-objection. It is proposed that SS2/17 also be amended to outline the circumstances in which the PRA considers it more likely that a waiver or modification to its rules would meet the FSMA statutory test, where, in wholly exceptional circumstances, an adjustment is sought in relation to a public-sector appointment with a view to converting an award comprising equity or other instruments to a cash sum. In such cases, it is envisaged that such a conversion would be subject to contractual terms that ensured the discipline inherent in the PRA’s remuneration rules was maintained.

1.5 The PRA has considered its primary and secondary objectives, and the ‘have regards’. The PRA considers that its proposed expectations in respect of the instruments that comprise unvested, deferred claims would promote its primary objective. The proposed addition to SS2/17 would clarify that conversion from one instrument to another should not occur if this could undermine the PRA’s objective to promote safety and soundness of firms by aligning the long-term interests of MRTs with the long-term interests of firms. The proposal also seeks to make the PRA’s approach more transparent, and to avoid circumstances where its remuneration requirements may give rise to an undue burden.

1.6 The PRA considers that creating expectations limiting the conversion of instruments, while allowing for changes where this is consistent with the ongoing alignment of interests between firms and MRTs, in particular in the context of public-sector appointments, should not place an undue burden on firms. The PRA considers it is a matter for firms whether they wish to assist in addressing conflicts of interest that might arise from MRTs, or former MRTs with contingent equity or other claims on that firm seeking a public-sector appointment. The PRA does not seek to create any expectation or offer guidance in this regard. In consequence, any administrative costs that arise from seeking to convert the claims that comprise such sums from one form to another in relation to a public-sector appointment would be considered voluntary.

Background

1.7 The variable pay of MRTs employed by Capital Requirements Regulation (CRR) firms is subject to a number of requirements set out in the PRA Rulebook.^{footnote [1]} The main purpose of these is to promote better incentives for risk management, and therefore prudential safety more broadly, by aligning the longer-term interests of senior employees with those of their employers. To that end, firms must ensure that a substantial portion (at least 50%) of any variable remuneration payable to a MRT consists of an appropriate balance of:

1. Shares; subject to the legal structure of the firm concerned; equivalent ownership interests; subject to the legal structure of the firm concerned, share-linked instruments; or equivalent non-cash instruments; and
2. where possible, other instruments which are eligible as Additional Tier 1 instruments, or are eligible as Tier 2 instruments or other instruments that can be fully converted to Common Equity Tier 1 instruments or written down, that in each case adequately reflect the credit quality of the firm as a going concern and are appropriate for use as variable remuneration.^{footnote [2]}

1.8 Additionally, there is a requirement that a firm must not award variable remuneration unless a substantial portion of it (at least 40%) is deferred, for a period varying between at least four and seven years, depending on factors such as whether the relevant MRT is a higher-paid MRT, on the management body and/or performing a Senior Management Function.^{footnote [3]}

1.9 Aligning the long-term interests of senior employees with those of firms is also supported by contractual provisions allowing for malus and clawback.

1.10 The PRA is, however, aware that an unvested, contingent claim to equity (or other instruments) arising from these requirements may on occasion create a conflict of interest (or perception of such a conflict) where a MRT or former MRT seeks to take up a public-sector appointment. This CP is directed, in particular, to this situation. It does not, however, propose any changes to existing PRA requirements or expectations in cases where a MRT seeks to move to any other roles, including a competitor firm.

Summary of proposals

1.11 This CP proposes that a new section is added to chapter 4 of SS2/17 setting out the PRA’s expectations that:

1. in general, unvested, deferred claims that comprise the variable pay of MRTs should not be converted from an equity claim into a claim on other instruments (or vice versa) after an award has been made;
2. this expectation should apply to all unvested, deferred sums, and not exclude amounts above the regulatory minima; and
3. in exceptional circumstances, such as where there are potential conflicts of interest arising from a (proposed) public-sector appointment that cannot otherwise be sufficiently mitigated, it may be appropriate for a conversion to occur subject to the prior non-objection of the PRA, and on the basis that the relevant retention requirements remain unchanged.

1.12 Moreover, the PRA considers that in wholly exceptional circumstances, where conversion to an award that comprises other instruments is not sufficient to mitigate conflicts, conversion to cash may be appropriate. Where conversion to cash would breach the minimum non-cash instruments requirement,^{footnote [4]} this would require a waiver or modification, where the PRA would consider any application in each particular case in accordance with the statutory test.^{footnote [5]}

Implementation

1.13 The PRA proposes that the implementation date for the changes resulting from this CP would be Monday 12 December 2022.

Responses and next steps

1.14 This consultation closes on Tuesday 20 September 2022. The PRA invites responses on the proposals set out in this consultation. Please address any comments or enquiries to CP8_22@bankofengland.co.uk. Please indicate in your response if you believe any of the proposals in this consultation paper are likely to impact persons who share protected characteristics under the Equality Act 2010, and if so, please explain which groups and what the impact on such groups might be.

1.15 Unless otherwise stated, any remaining references to EU or EU-derived legislation refer to the version of that legislation which forms part of retained EU law.^{footnote [6]}

2. The PRA’s proposals

The PRA’s proposed expectations in relation to the conversion of unvested, deferred variable pay in equity and other instruments.

2.1 As noted in Chapter 1, firms have a degree of choice when they initially determine which instruments comprise that part of a MRT’s variable remuneration that must be awarded in equity or other instruments. While the PRA considers that its Remuneration Rules do not of themselves prevent a firm from ex-post conversions of unvested, deferred variable remuneration, the PRA nevertheless views that, in accordance with the overall purpose and structure of its remuneration requirements, ex-post conversions are not ordinarily appropriate other than in exceptional circumstances. The PRA therefore proposes that following an award, changes to the instruments that comprise that award should not ordinarily occur to ensure the consistent alignment of the long-term interests of firms and MRTs.

2.2 There may be circumstances in which such a conversion is appropriate and may be judged consistent with the purpose of the PRA’s remuneration requirements. A particular case may arise where a firm is prepared to consider converting instruments that comprise unvested, deferred pay where a MRT or former MRT seeks a public-sector appointment in order to address a potential conflict of interest (eg such as could exist where a former MRT continues to have a contingent claim on the equity of a firm). Whether or not a firm wishes to explore this possibility, is a matter for the firm; the PRA sets no expectations in such cases. In addition, the PRA considers that it is the responsibility of a potential third-party (public-sector) employer to consider what mechanism may be available to it (eg under its own code of conduct) to address any conflict of interest (eg declarations, recusal) arising from such unvested remuneration.

2.3 However, where a firm (having previously awarded unvested, deferred pay, and wanting to help facilitate a public-sector appointment) believes it would not be appropriate or sufficient for a potential conflict to be managed by other means, the PRA’s proposed expectation is that the firm should seek the PRA’s prior non-objection to changing the instruments that comprise unvested, deferred pay awards (eg from equity to other instruments, or potentially from instruments to cash where the sums involved do not fall within the regulatory minima). The purpose of this approach would be to ensure that such conversions are consistent with the objectives of the PRA’s remuneration requirements. In proposing this expectation, the PRA is not seeking to amend the retention periods applicable to awards in equity or other instruments once these vest.

2.4 The PRA (along with the FCA) also has a statutory power under FSMA to waive or modify its rules in circumstances where it is satisfied that compliance with the unmodified rules would be unduly burdensome or would not meet the purpose for which the rule was made, and where the waiver or modification would not adversely affect advancement of any of the PRA’s objectives.

2.5 In relation to public-sector appointments and potential conflicts of interests, a firm may in wholly exceptionally circumstances consider requesting a waiver or modification of the PRA’s remuneration rules to allow an unvested, deferred claim in equity or other instruments to be converted into a cash claim. Each waiver or modification decision will be considered on the basis of the facts of the individual case. The PRA cannot, therefore, state in advance the outcome of any request. The PRA considers, however, that a request by a firm to convert an unvested award comprising equity or other instruments to a cash claim would be more likely to meet the FSMA test where:

• individuals are due to join a public-sector employer in a senior capacity, and where their financial services experience is directly relevant to the role;
• the PRA is satisfied that it would not be appropriate or sufficient for a potential conflict to be addressed through other means (including conversion from an equity claim to one based on other instruments);
• any cash claim would replicate the deferral, malus and clawback provisions that applied to the original claim, and no early payment takes place;
• contractual terms are adopted that replicate the relevant features of other instruments, including: (a) write-down at the relevant Common Equity Tier 1 (CET1) trigger, and (b) a pro-rata reduction where distribution restrictions are triggered under chapter 4 of the Capital Buffers Part of the PRA Rulebook or equivalent s.55M requirement;^{footnote [7]} and
• a firm demonstrates how contractually, the alignment of interests between firm and MRT that arises from the relevant retention period for equity or other instruments could be replicated (eg by extending the vesting period).

2.6 In cases where a firm seeks the PRA’s prior non-objection to a conversion or makes a request for a waiver or modification, the PRA proposal envisages that it 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. If an adjustment to the basis on which variable pay is awarded, along with other measures, is not effective in addressing the conflict, it is unlikely that the PRA would provide its non-objection or grant an application for a waiver or modification.

2.7 Where a request is made to the PRA for non-objection to conversion, or for a waiver or modification, it would be for applicants to identify whether there are other legal or regulatory constraints that might prevent the firm from converting an unvested award to other instruments or cash, or which require certain steps to be taken prior to such conversion. Similarly, it would be for firms to determine whether any conversion between unvested equity and other claims is permitted by their own company statutes or governance provisions, and the terms and procedures by which this might occur. The PRA would work with the FCA on any requests to the structure of awards requiring a waiver or modification to a rule that forms part of SYSC 19D Dual-regulated firms Remuneration Code within the FCA’s Handbook applicable to a dual regulated firm.^{footnote [8]}

2.8 The PRA recommends that its proposed expectations apply to all unvested, deferred sums, and do not exclude amounts above the regulatory minima.

2.9 The PRA considers that its proposed expectations in respect of the instruments that comprise unvested, deferred claims would clarify the need for a consistent approach to aligning the long-term interests of firms and MRTs. In doing so, they promote safety and soundness by avoiding misaligned incentives. The proposal also has regard to the responsibilities of the senior management of PRA-authorised persons, seeks to make the PRA’s approach more transparent, and to avoid circumstances where its remuneration requirements may give rise to an undue burden.

3. The PRA’s duty to consult

3.1 When not making rules, the PRA has a public law duty to consult widely where it would be fair to do so.

3.2 The PRA fulfils its statutory obligations and public law duties by providing the following in relation to the proposed policy:^{footnote [9]}

• a cost benefit analysis;
  • compatibility with the PRA’s objectives: an explanation of the PRA’s reasons for considering that making the proposed policy is compatible with the PRA’s duty to act in a way that advances its general objective,^{footnote [10]} insurance objective^{footnote [11]} (if applicable), and secondary competition objective;^{footnote [12]}
  • FSMA regulatory principles: an explanation of the ways in which having regard to the regulatory principles has affected the proposed policy;^{footnote [13]}
  • impact on mutuals: a statement as to whether the impact of the proposed policy will be significantly different to mutuals than to other persons;^{footnote [14]}
  • HM Treasury (HMT) recommendation letter: the Prudential Regulation Committee should have regard to aspects of the Government’s economic policy as recommended by HMT;^{footnote [15]} and
  • equality and diversity: the PRA is also required by the Equality Act 2010^{footnote [16]} to have due regard to the need to eliminate discrimination and to promote equality of opportunity in carrying out its policies, services, and functions.

3.3 Appendix 1 lists the statutory obligations applicable to the PRA’s policy development process. The analysis in this chapter explains how the proposals have had regard to the most relevant matters listed in paragraph 3.2, including an explanation of the ways in which having regard to these matters has affected the proposals.

The PRA’s proposed expectations in relation to the conversion of unvested, deferred variable pay in shares and other instruments

3.4 The PRA proposes creating expectations such that:

• in general, unvested, deferred claims that comprise the variable pay of MRTs should not be converted from an equity claim into a claim on other instruments (or vice versa) after an award has been made;
• this expectation should apply to all unvested, deferred sums, and not exclude amounts above the regulatory minima; and
• in exceptional circumstances, such as where there are potential conflicts of interest arising from a (proposed) public-sector appointment that cannot otherwise be sufficiently mitigated, it may be appropriate for a conversion to occur subject to the prior non-objection of the PRA, and on the basis that the relevant retention requirements remain unchanged.

3.5 The PRA considers that its proposed expectations in regards to the conversion of unvested, deferred variable remuneration are consistent with its primary objective, while allowing for a more proportionate application of its remuneration policy and improving transparency.

Cost benefit analysis

3.6 The proposals in this CP seeks to amend SS2/17 to clarify the PRA’s expectations relating to the conversion of unvested, deferred sums arising from variable pay awarded to MRTs. They also clarify the circumstances in which the PRA would be prepared to modify these expectations or grant a waiver or modification in cases where this might be disproportionate, and gave rise to an undue burden.

3.7 Unvested variable pay supported by equity will generally display greater asset price volatility than subordinated debt instruments. Changing the instruments that support unvested variable pay could call into question the long-term alignment of the interests of firms and MRTs that is central to the PRA’s remuneration rules. Consequently, the PRA considers proposing an expectation that changing the instruments that comprise an award should not ordinarily occur once an award has been made, while allowing for modification in circumstances where this is consistent with the ongoing alignment of interests, should advance its primary objective.

3.8 The PRA considers it is a matter for firms whether they wish to assist in addressing conflicts of interest that might arise from MRTs with contingent equity or other claims on that firm seeking a public-sector appointment. The PRA does not seek to create any expectation or offer guidance in this regard. Rather, the PRA proposes to clarify its approach where firms seek to make contractual adjustments to unvested, deferred pay on behalf of MRTs. In consequence, any administrative costs that arise from seeking to convert the claims comprising such sums from one form to another would be considered voluntary.

3.9 The PRA therefore considers that the associated costs attached to its proposals are likely to be minimal.

PRA objectives

3.10 The PRA considers its wider remuneration policy promotes its primary objective of advancing the safety and soundness of firms, by seeking to ensure that the long-term incentives of firms and MRTs are aligned. The PRA considers its proposals centred on an expectation that firms should only convert unvested, deferred equity sums into other instruments (or vice versa) with the PRA’s prior non-objection supports this policy. At the same time, the proposals would allow (exceptionally) for modifications, where it is appropriate to do so, subject to the continued alignment of the interests of firms and MRTs.

3.11 The PRA considers its proposals would not have a material effect on the PRA’s secondary competition objective.

Have regards

3.12 In developing these proposals, the PRA has had regard to the FSMA regulatory principles, the aspects of the Government’s economic policy set out in the HMT Recommendations letter from 2021 and the supplementary Recommendations letter sent April 2022. The following factors, to which the PRA is required to have regard, were significant in the PRA’s analysis of the proposal.

FSMA regulatory principles

3.13 In developing these proposals, the PRA has had regard to the regulatory principles. The following principles are of particular relevance:

1. The principle that a burden or restriction which is imposed on a person should be proportionate to the benefits which are expected to result from the imposition of that burden: The PRA considers that articulating the circumstances in which claims supporting unvested, deferred variable pay may be converted into other claims recognises that there may be circumstances where the unadjusted application of policy may lead to a restriction or burden that is not proportionate.
2. The principle that the PRA should exercise its functions transparently: Publication of the proposal would offer guidance to firms allowing them to understand what is expected of them when aligning the interests of firms with those of those senior executives who are MRTs.
3. The desirability of sustainable growth in the economy: The proposal could have a positive effect on the labour mobility of senior persons, although the PRA considers that the overall effect on the UK economy in this regard is likely to be small.
4. The responsibilities of the senior management of PRA-authorised persons subject to the requirements imposed by FSMA in compliance with those requirements: The proposal supports the principle by outlining the ongoing need to align the long-term interests of firms and senior executives who are MRTs.

3.14 The PRA has considered the remaining FSMA regulatory principles, and concludes that they are not relevant to this proposal.

Impact on mutual

3.15 The PRA considers that the impact of the proposed policy changes on mutuals is expected to be no different from the impact on other firms.

HMT recommendation letter

3.16 The PRA has considered all aspects of government economic policy as laid out in the HMT recommendation letter, and considers that its proposals by potentially increasing the supply of persons with relevant financial experience who might take on public-sector roles would tend to have a modest positive effect in respect of matters outlined in HMT’s recommendations.

Equality and diversity

3.17 The PRA considers that the proposals would not give rise to adverse equality and diversity implications, and may at the margin increase the pool of individuals who might be considered for public-sector appointments in the area of financial policy or financial services regulation.