On 13 October 2008, the Financial Services Authority (FSA) wrote to the chief executive officers of various banks and building societies setting out details of the FSA’s work on remuneration structures and its proposals that organisations should now focus on structures that do not reward short-term risk.

The FSA does not intend to become involved in setting remuneration levels and accepts that this is a matter for the relevant boards; however, its view is that boards should ensure that they have effective structures in place to set remuneration policies and monitor remuneration levels throughout the organisation. Remuneration policies and individual awards above a certain level should be controlled by a remuneration committee with a majority of non-executive directors. Departments such as human resources and risk and compliance should also have a strong and independent role in setting compensation levels.

Although the FSA acknowledges that remuneration policies will vary between organisations and between different levels of staff, and that they will continue to need to reflect varying factors such as the nature of the business and the culture of the institution, it intends to set out some high-level criteria against which organisations can assess their own internal remuneration policies (see box “FSA’s current thinking on bonuses”).

The FSA is currently urging all organisations (not just in the trading and investment banking areas) to review their remuneration policies in light of market developments and to take immediate action to remedy these if necessary. Organisations will be expected to avoid or to start changing policies that do not comply with the FSA’s guidelines, and to set timetables to implement performance-adjusted and deferred compensation arrangements.

The FSA intends to visit recipients of the letter before the end of 2008 to review internal practices. It will ultimately publish its findings about remuneration structures in the financial services sector in anonymised form.

Organisations should start reviewing their remuneration structures using the FSA guidelines. However, they should be aware of their existing obligations to honour current bonuses and not be tempted to make changes to bonus schemes that might end up falling foul of employment law (for background, see feature article “Bonus payments: avoiding the pitfalls”, www.practicallaw.com/4-102-2551).

There are two main types of bonus schemes that need to be considered in this context:

Contractual bonus schemes. An organisation that denies its employees bonuses to which they are contractually entitled will be exposed to the risk of claims for breach of contract, constructive unfair dismissal and/or wrongful dismissal and potentially (depending on the circumstances) discrimination or other claims.

It may not be possible for organisations to avoid their contractual obligations to make bonus payments simply by terminating the employment of eligible employees. If an organisation does terminate the employment of an eligible employee when the bonus is due, or almost due, for payment, it will need to have an alternative, potentially fair reason for doing so, and will need to follow a fair procedure to reduce the risk of exposure to claims.

Discretionary bonus schemes. An organisation that operates a discretionary bonus scheme and has exercised its discretion in the same manner, consistently, over a period of time, may have given rise to contractual entitlements through custom and practice. The scheme itself may also stipulate factors that must be taken into account when exercising discretion; for example, the organisation’s performance and/or the individual employee’s performance. If these entitlements are denied, this will expose the organisation to claims.

All organisations are obliged not to exercise their discretion in an irrational, perverse or arbitrary manner. They must exercise their discretion objectively, rationally and in good faith. An organisation that fails to do so will be exposed to the risk of claims (for background, see News brief “Discretionary bonuses: the tide is turning”, www.practicallaw.com/8-206-3973).

Good practice. As a matter of good practice, organisations should record and be transparent about the reasons for their decisions to award, or not to award, bonus payments and the value of those bonus payments, whether those decisions are taken under a contractual or discretionary bonus scheme.

Organisations wishing to change their contractual bonus scheme should do so, as far as possible, in accordance with its terms. The terms may include an express right to make changes to the scheme, or may be widely drawn enough for changes to be made in any event. If this is not possible, an organisation should try to obtain its employees’ consent to the proposed changes.

Alternatively, an organisation may unilaterally change the bonus scheme and seek to rely on the employees’ subsequent conduct to establish implied agreement to the changes. This may expose the organisation to the risk of claims, but these risks may be minimal if the prospects of employee objection are low.

It is possible for an organisation to seek to terminate and re-engage its employees on terms and conditions that incorporate the changes to the bonus scheme. However, depending on the number of employees involved, this may be a burdensome administrative task requiring either compliance with the statutory dispute resolution procedures or collective consultation with appropriate representatives. It may also expose the organisation to the risk of claims, although this risk would be minimised by serving adequate notice, ensuring that there is a potentially fair reason for the dismissal and following a fair procedure.

Consultation with specially appointed information and consultation bodies may, for some organisations, be required.

Organisations should ensure that any new schemes are:

Further thought may now also need to be given to new ways of attracting, retaining and incentivising individuals.

It remains to be seen how the FSA’s review will continue, what the final guidelines will be, how the FSA will enforce these guidelines and how organisations and their employees will react to the resulting changes.