ESMA Publishes Final UCITS Remuneration Guidelines

On 31 March 2016, the European Securities and Markets Authority (“ESMA”) published its final report

on Guidelines on Sound Remuneration Policies under the UCITS Directive and AIFMD (the

“Guidelines”). The publication of the report follows a public consultation relating to the Guidelines

launched by ESMA in July 2015 (the “Consultation”). The Guidelines are intended to provide clarity

on the requirements under the UCITS Directive for management companies when establishing and

applying a remuneration policy for key staff and will apply to UCITS management companies from

1 January 2017, subject to the transitional provisions stated within the Guidelines (see further below).

The most significant change to the draft version of the Guidelines consulted upon in July 2015 is that

the final Guidelines do not offer any guidance as to whether the application of the proportionality

principle may result in certain specific requirements of the pay-out process being dis-applied in full

(that is, the requirements on variable remuneration in instruments, retention, deferral and ex-post

incorporation of risk for variable remuneration). This does not mean, however, that ESMA has

determined that certain remuneration requirements may not be dis-applied. Alongside the publication

of the Guidelines, ESMA has published a letter to the European Commission, European Parliament

and the Council of the European Union (the “Letter”) making it clear that it believes that the

proportionality principle should continue to apply so as to enable management companies to dis-apply

specific requirements of the pay-out process and suggesting that legislative change may be necessary

to provide clarity in this area.

The Proportionality Issue

The proportionality provisions in the UCITS Directive and the Alternative Investment Fund Managers

Directive (“AIFMD”) require management companies and AIFMs to comply with the remuneration

principles “in a way and to the extent that is appropriate to their size, internal organisation and the

nature, scope and complexity of their activities”. In a departure from the earlier draft version of the

Guidelines, which was the subject of the July 2015 Consultation, the Guidelines do not provide

guidance on the possibility of the proportionality principle operating to dis-apply certain specific

requirements of the pay-out process.

In drafting the Guidelines, ESMA was required to cooperate closely with the European Banking

Authority (“EBA”) in order to ensure consistency with the requirements developed for credit institutions

and other financial services sectors and also to align the Guidelines to the extent possible with the

equivalent guidelines issued under the AIFMD. The ESMA Consultation had proposed an

interpretation of the provisions on proportionality in the UCITS Directive which would permit the dis-

application of the requirements on the pay-out process in certain circumstances on an exceptional

basis, consistent with the approach adopted under the AIFMD equivalent guidelines.

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This proposed approach, however, differed to that of the EBA’s March 2015 consultation paper on

remuneration guidelines under CRD IV and the final version of those guidelines published in

December 2015. In its March 2015 consultation paper, the EBA stated “the preliminary assessment of

the EBA is that a full waiver of the application of even a limited set of remuneration principles for

smaller and non-complex institutions would not be in line with CRD.” The final EBA guidelines are

silent on the possibility of dis-applying any of the CRD IV remuneration requirements but were

accompanied by an opinion of the EBA suggesting changes to the CRD to clarify that certain

provisions on variable remuneration do not apply to certain firms and / or their staff. ESMA’s approach

in the final Guidelines in not providing guidance regarding the possible dis-application of certain

remuneration requirements is therefore consistent with that adopted by the EBA in its final

remuneration guidelines under the CRD.

However, this does not mean that ESMA believes that entities in the fund management sector should

be subject to the same remuneration rules as credit institutions. In the Letter sent by ESMA to the EU

law-making institutions on 31 March 2016, ESMA draws particular attention to the differences between

the two sectors, noting in particular that:

“Fund managers operate according to an agency model and do not accept deposits or deal on

their own account. As a consequence, fund managers, unlike credit institutions, do not issue

liabilities to fund investors. Fund investors have a claim on the investment portfolio which is

ring-fenced from the fund manager. Fund managers manage a portfolio of securities on behalf

of a fund, in the interest of the investors in such fund, under an investment mandate. Their

discretion on how to dispose of the assets in the relevant portfolio is constrained by the

investment objectives and specific limits and restrictions set out in the investment management

mandate and in specific product regulation (e.g. UCITS concentration limits). ESMA recalls that

remuneration rules under the UCITS Directive and the AIFMD are aimed to align the interests

of, including the risks taken by, the fund managers with those of the investors of the funds that

they manage.

Given the nature of activities of fund managers, and the variety of funds they manage and

strategies they implement for those funds, it is appropriate to recognise the possibility to tailor

the rules on the pay-out process of variable remuneration when these do not, in the specific

circumstances, achieve the goal of aligning the interests of the fund manager’s staff.”

ESMA notes that recent work and legal analysis has called into question the existing understanding

that the proportionality provisions set out in the UCITS Directive and the AIFMD may lead to a result

where:

(a) under specific circumstances, the requirements of the pay-out process are not applied; or

(b) it is possible to apply lower thresholds whenever minimum quantitative thresholds are set

for the pay-out requirements (for example, the requirement to defer at least 40% of variable

remuneration).

ESMA states in its Letter that it considers that the scenarios under (a) and (b) should remain possible

in certain situations and that further legal clarity on this possibility could be beneficial to all interested

parties.

ESMA provides a number of examples in the Letter of circumstances in which it believes it should be

possible to tailor the rules on the pay-out process and concludes that it would be inappropriate for the

following fund managers to be subject in all circumstances to the requirements of the pay-out process:

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smaller fund managers (in terms of balance sheet or size of assets under management);

fund managers with simpler internal organisation or nature of activities; or

fund managers whose scope and complexity of activities is more limited.

The ESMA Letter also states that it would be disproportionate to apply the requirements to relatively

small amounts of variable remuneration and to apply certain requirements to certain staff when this

would not result in an effective alignment of interests between the staff and the investors in the funds.

Application to Delegates

ESMA has provided in the Guidelines that the remuneration principles should apply to delegates of the

management company. This had been expected, notwithstanding that the provisions in relation to the

application to delegates had been included in the recitals to the UCITS V Directive, rather than in the

substantive provisions of the Directive. It also reflects that approach which had been taken by ESMA

in the context of the AIFMD.

However, ESMA goes on to acknowledge in the Letter that there may be cases where the application

of the pay-out process rules to the staff of the delegate would not be proportionate and would not

achieve the outcome of aligning the delegates’ staff interests with those of the investors in the UCITS.

It also acknowledges the risk that the unwillingness of delegates outside the EEA to be subject to

some requirements which they consider disproportionate, could prevent access of EU management

companies to certain investment strategies. It remains to be seen whether the additional clarifications

on proportionality requested by ESMA in the Letter might extend to delegates but we believe that the

factors mentioned by ESMA above should be regarded as relevant for management companies when

considering the application of the Guidelines to their delegates.

Other Changes to the Draft Guidelines

ESMA has introduced the following changes to the draft Guidelines in response to the feedback

received on its Consultation:

the application date of the Guidelines has been amended from 18 March 2016 to 1 January

2017;

transitional provisions have been introduced in respect of the rules on variable remuneration

(see below);

the wording relating to management companies being part of a group has been amended to

clarify that non-UCITS or non-AIF sectoral prudential supervisors of group entities do not have

a discretion to decide which set of sectoral rules should prevail;

the guidance relating to payment in instruments has been amended to state that, where it is

appropriate to ensure the better alignment of interests with investors, it may be possible to

remunerate identified staff with non-cash instruments whose performance is correlated with

the performance of the portfolios that they manage, provided that these instruments feature

equally effective incentives as any of the instruments referred to in the UCITS Directive (units

of the UCITS concerned, equivalent ownership interests, or share-linked instruments); and

in relation to the requirement to pay at least 50% of variable remuneration in instruments

unless the management of UCITS accounts for less than 50% of the total portfolio managed

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by the management company, the wording has been amended to state that the 50% threshold

should be based on the total net asset value of all the UCITS managed by the management

company and the total portfolio managed should be the portfolios collectively and individually

managed under its authorisation under the UCITS Directive and its authorisation under the

AIFMD, if any.

Next Steps and Transitional Provisions

The Guidelines will now be translated into the official languages of the EU and the final texts will be

published on the ESMA website. National competent authorities must inform ESMA within two months

of publication of the translations on the ESMA website whether they intend to comply with the

Guidelines. We expect the Central Bank of Ireland to comply with the Guidelines. The Guidelines will

apply from 1 January 2017.

The Guidelines state that the guidance on the rules on variable remuneration should apply for the

calculation of payments relating to new awards of variable remuneration for identified staff for the first

full performance period after 1 January 2017. For example, a management company whose

accounting period ends on 31 December 2016 should apply the guidance on the rules on variable

remuneration to the calculation of payments relating to the 2017 accounting period. However, a

management company whose accounting period ends on 30 November 2016 may be in a position

where the provisions in relation to variable remuneration will only apply for the accounting period

commencing 1 December 2017. This is a welcome clarification given the ambiguity on this issue in

ESMA’s recent Q&A relating to the update of fund documentation to reflect the UCITS V requirements.

Comment

While ESMA’s views on the application of proportionality as expressed in the Letter are welcome, it is

unfortunate that there is no clear guidance on this issue and the current position is somewhat unclear.

In the absence of legislative amendment at European level, or clarification at member state level, by 1

January 2017, it may be necessary for the relevant management company to make its own

assessment as to application of the proportionality principle. In doing so, we believe it would be

appropriate for management companies to have regard to ESMA’s views in the Letter regarding the

circumstances in which a UCITS management company may rely upon proportionality.

The equivalent remuneration guidelines under the AIFMD currently provide that the pay-out process

rules may be dis-applied in certain circumstances and ESMA has stated that the AIFMD remuneration

guidelines will not be amended to bring them into line with the UCITS Guidelines pending clarification

on the application of the proportionality principle.

The delay in the application of the Guidelines from March 2016 to 1 January 2017 and the transitional

provisions with respect to the application of the guidance on the variable remuneration rules are

positive developments. It remains to be seen whether there will be further legislative change, as

advocated for by ESMA, to clarify the proportionality issue or whether national regulators will seek to

clarify the issue at member state level. We will keep our clients updated regarding further

developments.

ESMA’s final report on the UCITS remuneration guidelines may be accessed here. The ESMA Letter

to the EU law-making institutions may be accessed here.

Please get in touch with your usual Asset Management and Investment Funds Group contact or any of

the contacts listed in this publication should you require further information in relation to the material

referred to in this update.

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Full details of the Asset Management and Investment Funds Group, together with further updates,

articles and briefing notes written by members of the Asset Management and Investment Funds team,

can be accessed at www.matheson.com.

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