The Background
Everyone in banking knows that the cap on bankers’ remuneration is nearly in effect. But last month, it was announced that the UK had launched a legal challenge in the European Union Court of Justice against the remuneration cap introduced by the capital requirements directive “CRD IV”.

The cap is to apply to European-headquartered groups, European subsidiaries of non-European groups and global staff of European banks from 2014. It affects European banks operating in Hong Kong. The challenge focuses on the cap’s legal basis, but also challenges its extra-territorial effect and lack of proper consultation and impact assessment. The challenge makes clear the UK believes that real improvements in the alignment of bankers’ pay with risk and performance have already been made, and that the cap may undo this by forcing banks to raise salaries, and therefore fixed costs, making it harder to reduce pay rates when profits are falling.

The Case
The key remuneration provision of CRD IV is that bonuses of “Identified Staff” will be capped at one times the staff member’s annual fixed remuneration (including basic salary and other non-variable benefits and allowances), although this can be doubled with shareholder approval. Identified Staff are usually senior managers and risk-takers, but the definition is widened significantly under the new rules, raising the number of staff subject to the cap.

The new rules identify 14 criteria capable of bringing a staff member within the definition of Identified Staff. All but two of them are absolute, such that if any one of them is met, the staff member must be treated as Identified Staff with no further consideration as to whether or not the individual has a material impact on the bank’s risk profile.

The Response
The Prudential Regulation Authority and the Financial Conduct Authority have announced the proposed approach to the UK implementation of the cap. While consultation documents give much more certainty as to which banks, building societies and investment firms will (and will not) be subject to the cap, consultation documents do not deal with how it will apply in practice, and many key issues remain unresolved. Banks and building societies generally must apply it across their entire group, while investment firms will generally be permitted to disapply it (subject to exceptions).

Undoubtedly, the market response to the cap will include a rise in base salaries. But, given the number of associated drawbacks – that is to say, it de-links pay and performance and raises the bank’s fixed cost base – affected banks in Asia should be aware of the options available to mitigate the effect.

Banks must create an overall package that is attractive to the best staff so that they continue to hire, reward and retain key personnel. This includes considering alternative remuneration mechanisms that seek to maintain remuneration at competitive levels, while improving and maximising the retentive effect of the staff members’ overall employment package, particularly elements that may have been overlooked as a result of a previous focus on bonus levels.

Employers may consider offering affected employees extra cash or equity-based fixed allowances – which would not form part of the basic salary – to limit pension costs and costs incurred in the event of departure.

Alternatively, banks may consider reviewing contract elements such as pension and health cover, holiday entitlements and alternative working arrangements, which may be key in creating a competitive overall package.

Over and above changes to remunerations structures is the possibility of changes to the structure of the banks, to remove them from the CRD IV provisions’ jurisdictional remit.

Although the UK’s challenge may ultimately result in the cap being overturned, it remains to be seen whether that will be the case. The issue may not be resolved before the next remuneration round. Firms may have to implement the provisions in the interim. European banks in the SAR must continue preparing a response, including flexibility to cater for various outcomes.

Herbert Smith Freehills has 2,800 lawyers and 460 partners in over 20 offices globally. It advises on dispute resolution and employment, among other areas.

Gareth Thomas is head of the Hong Kong commercial litigation team and responsible for the Greater China employment practice.

Helen Beech is a senior member of the Hong Kong employment practice and has a wide range of experience in employment matters.

The information contained in this article should not be relied on as legal advice and should not be regarded as a substitute for detailed advice in individual cases. If advice concerning individual problems or other expert assistance is required, the service of a competent professional adviser should be sought.