Class 2 investment firms: remuneration requirements

Key takeaways:

Under the Investment Firms Directive (IFD), only Class 2 firms are subject to the remuneration requirements outlined in the directive. Class 1 firms follow the Capital Requirements Regulation (CRR) and Capital Requirements Directive (CRD), while Class 3 firms, which are Small and Non-Interconnected (SNI) firms, are governed by MiFID regulations.

Article 30 of the IFD provides the framework for Class 2 investment firms to develop and implement remuneration policies for various staff categories, including senior management, risk takers, and control functions. Key principles include:

• Proportionality: Remuneration policies should reflect the firm's size and complexity.
• Gender neutrality: Policies must ensure gender equality.
• Sound risk management: Remuneration should align with the firm’s risk management, long-term goals, and overall strategy.
• Avoiding conflicts of interest: Remuneration must be structured to avoid conflicts and ensure independence for control functions.
• Fixed vs variable pay: There should be a clear distinction between fixed and variable remuneration, with the fixed component forming a significant portion of total compensation.

Variable remuneration

The IFD mandates that variable remuneration must be performance-based, considering individual, unit, and overall firm results. Financial and non-financial criteria should be evaluated over a multi-year period. Importantly, variable remuneration should not compromise the firm's capital stability and guaranteed variable pay is limited to new staff in their first year under certain conditions. Payments for early contract termination should reflect performance and not reward failure, while remuneration packages from previous contracts should align with the firm's long-term interests. Performance measurement for variable pay should consider all types of risks and capital costs. Additionally, the allocation of variable pay within the firm should also consider current and future risks. A minimum of 50% of variable remuneration must consist of:

1. Shares or equivalent ownership interests (subject to the legal structure of the investment firm).
2. Share-linked instruments or equivalent non-cash instruments (subject to the legal structure of the investment firm).
3. Additional Tier 1 or Tier 2 instruments or other instruments convertible to Common Equity Tier 1 instruments or written down and reflect the credit quality of the investment firm as a going concern.
4. Non-cash instruments which reflect the instruments of the portfolios managed.

At least 40% of variable remuneration must be deferred (can be raised to at least 60%) over a three-to-five-year period depending on the business activities of the investment firm.

These payout rules do not apply to firms with average on and off balance sheet assets of less than €100 million over the previous four financial years, or to individuals whose variable remuneration does not exceed €50,000 or more than 25% of their annual remuneration. Member states may raise the €100 million threshold if they meet the criteria outlined in Article 32(5) of the IFD or lower it under Article 32(6).

Additi onal important aspects

Remuneration Committee:

As per EBA/GL/2021/13 an investment firm with on and off‐balance-sheet assets valued on average at more than EUR 100 million over the four-year period immediately preceding the given financial year must establish a remuneration committee. This committee must consist of members of the management body that do not have any executive function and employee representatives, where applicable. The remuneration committee is responsible for preparing decisions on remuneration for key management and staff and advising on the creation of a gender-neutral remuneration policy. It oversees and ensures compliance with this policy, regularly updating it as necessary. The committee reviews the appointment of external remuneration consultants and ensures shareholders receive adequate information about remuneration practices. It ensures the remuneration system accounts for risks and aligns with the firm's business strategy and corporate values. Additionally, the committee assesses performance targets and the need for adjustments, including malus and clawback arrangements, and tests how remuneration policies respond to various scenarios to validate the criteria used for awards and risk adjustments.

Risk adjustments – Malus and Clawback

As outlined in EBA/GL/2021/13, Malus or clawback arrangements are ex-post risk adjustment mechanisms that allow firms to adjust the remuneration of identified staff. Criteria for assessment include:

1. Misconduct or serious error.
2. Downturn in financial performance.
3. Significant failures of risk management.
4. Increases in the firm’s economic or regulatory capital requirements.
5. Regulatory sanctions

How can we help?

At Forvis Mazars, our Prudential Risk experts understand that regulations remain a pivotal driver for the strategic priorities of financial institutions. We specialise in helping clients within the financial services sector to navigate the intricate web of regulations. By working closely with our clients, we identify their regulatory responsibilities and develop comprehensive strategies for full compliance.