Banking bonuses: The future of buyouts

A year after they started consulting, the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA) still don't know what to do about buyouts in the financial services sector.

Having started off with four options in their consultation paper back in July 2014, in a recent policy paper (June 2015) they have now narrowed this down to two options (see below) they wish to consider further, but with no signs of when a final determination will be made.

To be fair to the regulators, the issue is a thorny one and answers don’t exactly leap off the page.

The problem, in a nutshell, is this: for bankers who are material risk takers (of whom there are now many), a significant portion of any bonuses are now paid out over a number of years (shortly to be three, five or seven years, depending upon the banker’s seniority). By paying out a large portion of bonuses over a number of years, the bank can retain a right to reduce any unpaid portion should it become aware of circumstances that merit doing so.

This is in addition to any post-payment claw-back period, during which the bank may require repayment of any paid bonus in the event it discovers grounds for doing so.

And, if the banker resigns to take another job, any unpaid portions of bonuses can also lapse. In its July 2014 consultation paper, the FCA referred to the ‘widespread practice whereby firms cancel the unvested bonus awards of staff who are leaving one firm to join a competitor’.

One knock-on effect of this is that in order to recruit a banker who will lose part of his or her bonus awards, a new employer will often agree to compensate the banker for any loss. Regulators require such buyout awards to be paid in portions which match the vesting terms of the lost award from the old employer, so there is no immediate windfall for the employee. So far, so good.

But there is a subtle problem with this system: by jumping ship and getting a buyout, an employee leaves behind any potential trouble at their old bank that may (had they not changed jobs) result in their unvested bonus amounts being reduced by way of a malus adjustment.

This ability to potentially dodge a bullet is something the regulators have never been overly keen on. However, fixing it is proving a tough nut to crack.

When they opened their consultation a year ago, the PRA and the FCA suggested four options to deal with this issue.

The first option is to ban buyout awards from new employers completely. In presenting this option, the regulators accepted that this could place UK firms at a serious competitive disadvantage compared to those overseas. Not surprisingly, it has now been rejected completely.

The second option would be to stop an employee’s old firm from cancelling his or her bonus instalments just because the employee changes jobs. Again, firms were generally against this option and the regulators now appear to have also dropped it.

That leaves two final options the PRA say are worth exploring further – however, it is not pinning their colours to the mast just yet. The options are:

• Requiring that any buy-out award offered by a new employer must somehow be subject to a potential 'malus' reduction by the new employer or the regulator, if anything comes out of the woodwork at the old employer. In other words, get the new employer or the regulator to do the old employer's dirty work. Such a solution is neat, but has the obvious practical drawback of requiring a degree of information sharing that may not be welcome in practice, especially not between competitor businesses; and
• Not regulating buy-outs at all, instead strengthening existing claw-back rules to ensure that any departing employee has received sufficient vested bonus payments that may be subject to future repayment to guarantee the employee toes the line. Another neat solution in theory, but in practice it can only work if an individual has received sufficient paid bonus awards which may be clawed-back to act as a reasonable disincentive against bad behaviour.

Neither of the two remaining options are perfect solutions to the problem, but therein lies the rub – there aren’t any clever, perfect solutions. And, as the FCA itself put it in July last year, it is particularly difficult to regulate bonuses in the domestic financial services market when ‘properly addressing buy-outs would require international agreement which … is desirable, but unlikely’. SJ

Darren Isaacs is a partner at GQ Employment Law