Saturday, October 16, 2010

UK FSA Senior Official Describes Impact of Remuneration Code on Hedge Funds

The proposed revision of the UK Remuneration Code contains two key general principles impacting hedge fund advisers, said Dan Waters, FSA Director of Asset Management at a recent seminar. The first principle requires that the remuneration policy of a hedge fund advisory firm promote effective risk management and not encourage excessive risk-taking. The second key general principle requires that a firm’s remuneration policy include measures to avoid conflicts of interest. The FSA intends to implement some earlier revisions to the EU Capital Requirements Directive (CRD) by amending its Remuneration Code. The time pressure is great because the UK must implement the new CRD by January 1, 2011.

In designing a framework that would apply the Code’s risk management principle in the context of hedge fund adviser remuneration policy, the FSA official said that an important factor would be the extent to which the tolerated risk of the hedge fund in question results in it having a systemic presence in the market and whether the risks arising from such a presence could be effectively dealt with through the use of macro prudential tools. Thus, the FSA must fully understand and consider the characteristics of the different firms serving the asset management sector, and of the funds which they manage, in determining the precise practical application of this principle. Generally, he conceded, the Code’s proportionality approach will reflect the general characterization that most asset managers do not currently have a systemic presence in the market through the funds that they manage.

The second key principle in the Remuneration Code requires that a firm’s remuneration policy include measures to avoid conflicts of interest. According to the Director, in the wider context of investor protection there are legitimate regulatory concerns regarding the distortions that could result from remuneration structures. Such distortions could lead to the misalignment or conflict of the interests of investors and those of asset managers.

In designing the application of this principle to asset managers, an important factor would be the extent to which the activities of individuals or the remuneration structures of a firm directly or indirectly result in distortions in the alignment of the interests of investors and those of asset managers. The considerable variance in the way which conflicts of interest can occur, and the breadth of the controls that can be used to manage and mitigate them, calls into question the extent to which the specific or arbitrary application of the more detailed requirements in the CRD will serve to deliver appropriate regulatory outcomes in all cases across the diverse population of firms to which the CRD remuneration rules apply.

Distortions in the interests of investors and asset managers can arise in instances where remuneration structures are unrelated to the investment period of a fund, its performance during that period and where variable remuneration is a significant component of total remuneration. The CRD proposes a hard requirement to defer at least 40 percent of variable remuneration over at least a three year period. The FSA is concerned that in the case of asset managers such a hard-edged requirement does not reflect the specificities of different types of funds, for instance those where the investment period of the fund is greater than or less than three years.

It is for this reason that the FSA decided not to propose a rigid approach to those elements of the CRD remuneration principles that are relevant in the design of remuneration structures for asset managers. Instead, the FSA proposes to apply some elements of the Code proportionately and in some cases on a comply or explain basis, including the nature of remuneration payment, deferral of performance related remuneration, such as bonuses, and performance adjustment of those awards. These are largely features that the FSA found were already present in many asset manager remuneration arrangements that the authority considered in the course of its consultation last year on extending the scope of the Remuneration Code.

In the view of Director Waters, this approach in the proposal reflects the diversity of the funds and fund managers operating across the sector and also, in the context of the overarching principle of avoiding conflicts of interest, reflects that in some instances such remuneration structures may serve to mitigate these conflicts but in other instances can exacerbate them.