Application of the Proportionality Principle to the Remuneration Systems of Capital Management Companies with UCITS Investment Assets

Sound Compensation – Spring 2017

Background:

Since January 1, 2017, UCITS capital management companies (UCITS-CMGs) have had to comply with ESMA’s “Guidelines on sound remuneration policies taking into account the UCITS Directive” (UCITS Guidelines) for their remuneration systems, which concretize the requirements of the UCITS Directive (2014/91/EU) on remuneration systems. In practice, the proportionality principle discussed in the UCITS guidelines poses major challenges. This is primarily with a view to whether UCITS KVGs – comparable to AIF capital management companies (AIF KVGs) – can waive the application of individual regulatory requirements.

In the UCITS Directive – adopted three years after the AIF Directive (2011/61/EU) – the European legislator for the first time established legal requirements for the remuneration systems of UCITS KVGs. With the UCITS Guidelines, ESMA has fulfilled its mandate as defined in the UCITS Directive to provide guidance to practitioners on the application of the requirements of the UCITS Directive in remuneration systems. It had to follow its guideline for sound remuneration policies taking into account the AIF Directive (AIF Guideline) in the design of the UCITS guidelines as required by the UCITS Directive.

The UCITS Directive and the UCITS Guidelines are binding for UCITS KVGs domiciled in Germany. So far, the German legislator has not made use of the authorization provided for in the KAGB for an ordinance to legally specify the requirements for the remuneration systems of UCITS KVGs.

1. what is the content of the proportionality principle for compensation systems in the starting point?

The proportionality principle is an outgrowth of the general principle of proportionality: UCITS-CMGs shall implement the regulatory requirements in their remuneration systems in a manner and to an extent that is appropriate to their size, their internal organization, and the scope and complexity of their business. It enables the individual UCITS KVG to implement the requirements independently and in line with requirements. Independent implementation must be carried out on the basis of an individual risk assessment. It must observe the purpose of the regulatory requirements, which is essentially to manage the risk of (identified) employees through monetary behavioral incentives. The UCITS Directive provides various design leeway for the needs-based implementation, which focuses on an individual design of the payment of variable remuneration of identified employees, in particular with reference to the regulatory requirements on the (i) Compensation in Instruments, (ii) Blocking Period, (iii) Deferral and (iv) retrospective risk assessment and associated malus regulations.

The risk assessment must be documented transparently in order to explain the specific implementation decision to the auditor and the financial supervisory authority, among others.

2 What is the scope of the proportionality principle in AIF-KVGen?

According to ESMA’s pronouncements in the ESMA Guideline, AIF-CVGs may completely waive the implementation of individual regulatory requirements in the remuneration systems of identified employees if they can plausibly justify that the implementation is not necessary with regard to the purpose of the regulatory requirements. Specifically, they may refrain from implementing the aforementioned requirements for the payment of variable compensation, as well as from establishing a compensation committee. In practice, the AIF-KVGs have made use of these structuring options in different ways. Individual KVGs have comprehensively waived the implementation of the aforementioned requirements; this has sometimes involved a great deal of effort in the plausible justification of the deselection.

3 What is the scope of the proportionality principle for UCITS KVGs according to the UCITS guidelines?

The UCITS guidelines do not contain any explicit statements on a waiver of the implementation of regulatory requirements. ESMA justifies this approach – which is more defensive than the pronouncements in the AIF Directive – by stating that it had to observe the further guiding principle of close cooperation with the EBA enshrined in the UCITS Directive when filling out the content of the UCITS Guidelines and would permit the waiver of the implementation of individual regulatory requirements in coordination with the EBA. In its guidelines on the regulatory requirements of CRD IV (2013/36(EU) on remuneration systems in credit institutions and financial services undertakings (institutions), the EBA rejected a waiver of the implementation of individual regulatory requirements in accordance with the current legal situation and called on the legislator to provide legal clarification. The European Commission has responded to this request with a proposal to supplement CRD IV published on November 23, 2016. The proposal provides, among other things, that institutions with total assets of no more than EUR 5 billion may waive a deferral for the variable remuneration of employees identified as risk takers as well as the granting of part of the variable remuneration in instruments. The proposal to supplement CRD IV is currently in the legislative process.

Prior to the European Commission’s proposal, ESMA had already stated in a further announcement of March 31, 2016 that it would not (or no longer) explicitly recommend the waiver of the implementation of individual regulatory requirements deemed permissible in the AIF Guideline until a statutory modification had been made.

4. How should the current status of the proportionality principle be treated in practice at UCITS KVGs?

In its announcement of March 31, 2016 on its position on the possible waiver of the implementation of individual regulatory requirements, ESMA stated that it had alternatively considered the announcement of a comprehensive implementation of the regulatory requirements of the AIF Directive and the UCITS Directive; however, it ultimately rejected this consideration with a view to the principle of proportionality. This statement of ESMA does not make an application of the proportionality principle with the possibility of waiving the implementation of individual requirements of the UCITS Directive inadmissible from the outset; rather, the concretely determined remuneration parameters are to be determined in accordance with the assessment criteria specified in Art. 14a, 14b of the UCITS Directive and the concrete (non-) implementation of individual regulatory requirements is to be assessed in a transparent and comprehensible manner in appropriate documentation. UCITS KVGs can take the relevant parameters into account accordingly in the concept for implementing the regulatory requirements.

Outlook

The CRD IV amendment is expected to enter into force in the fourth quarter of 2017 at the earliest. It is to be expected that EBA and ESMA will each adapt their guidelines with regard to the waiver of individual regulatory requirements after the entry into force. We will keep you up to date on further developments with our Client Alert.