Consultation on the German Securities Institutions Remuneration Ordinance (WpIVergV) - Part I

On 19 October 2022, the German Federal Financial Supervisory Authority (BaFin) submitted a new and revised draft of a German Investment Firms Remuneration Ordinance (Wertpapierinstitutsvergütungsverordnung - WpIVergV) to the German Investment Firm Act (Wertpapierinstitutsgesetz – WpIG)  for consultation (07/2022). This is intended to specify and flesh out the requirements of Directive (EU) 2019/2034) on the supervision of investment firms (also referred to as Investment Firm Directive - IFD) on remuneration systems for medium-sized investment firms.

This article deals with the main features of the draft WpIVergV. Amendments and changes made in relation to the original consultation version (Consultation 04/2021) to the current consultation version can be found in the continuation of this article.

Objective of the WpIVergV

Essentially, the aim is to link the remuneration policy of an investment firm to its ongoing and long-term growth as well as its economic success. By way of the draft WpIVergV, the German Federal Financial Supervisory Authority (BaFin) aims to ensure that an investment firm aligns its remuneration policy and practices with the business strategy and long-term interests of the institution, considering its business and risk strategy and risk profile. Remuneration is intended to create incentives for prudent risk-taking and in particular not set incentives for excessive risk-taking or unfair sales practices.

The past has shown (keyword: 2008 financial crisis - high bonuses, hardly any restrictions on compensation in the event risks materialise, inter alia due to short-term strategies) that a compensation policy which rewards short-term success without containing a lack of sanctions in the event of ongoing damages caused by risky practices, create incentives too compelling for decision-makers seeking to achieve short-term profits in order to benefit financially. This risk shall be limited by the WpIVergV and its provisions on remuneration policy.

This is in line with the Institution Remuneration Ordinance (Institutsvergütungsverordnung - IVV), which has been in existence since 2010 and regulates the remuneration of institutions under the German Banking Act (Kreditwesengesetz – KWG). The regulatory structure and contents are largely the same. Some provisions, such as the provision on the remuneration control committee, are even identical in wording. However, there are also differences. In some places, the IVV is more extensive. For example, in contrast to the IVV, the draft WpIVergV does not contain any provisions for a compensation officer or a disclosure obligation.

Main concern and scope of WpIVergV

The draft WpIVergV is characterized by its risk-based approach. For investment firms, it is of importance to align their internal compensation structures with their own risk profile.

The draft WpIVergV only applies to medium-sized investment firms and parent entities. The IVV therefore no longer applies to these. However, the IVV continues to apply to large investment firms. In addition, the draft WpIVergV does also not apply to small investment firms. However, these must comply with the requirements of the stipulations set out in the Minimum Requirements for Compliance (MaComp) MaComp (BT 8) when setting up their internal remuneration structures.

The draft WpIVergV covers managing directors and all employees whose professional activities have a material impact on the risk profile of the investment firm or the assets it manages (so-called risk takers). Investment firms are responsible for identifying internally which employees qualify as risk takers.

Compensation policy and practice

Consultation draft 07/2022 continues to distinguish between fixed and variable compensation. The clear separation between fixed and variable compensation is explicitly emphasized in the law as a criterion for an appropriate compensation system. The draft WpIVergV sets out in detail what qualifies as fixed compensation. Variable compensation is defined as everything that is not part of the fixed compensation. In principle, if it is not possible to clearly allocate a component to the fixed compensation category on the basis of the criteria contained in the ordinance, it should be regarded as variable remuneration. Variable compensation includes, for example, retirement benefits, retention bonuses and severance payments, although severance payments may occasionally be disregarded when calculating the ratio of fixed to variable compensation.

It is of paramount importance for investment firms to allocate compensation components to either fixed or variable compensation. Their remuneration policy should set out clear, objective, predetermined and transparent criteria for allocating all remuneration components to either the fixed remuneration category or the variable remuneration category.

The compensation systems and the compensation parameters on which they are based must be reviewed by the investment firms at least once a year as part of a central and independent internal audit to ensure that they are appropriate, and particularly that they are consistent with the business and risk strategies. This requirement is almost identical to the requirements of the IVV. Only the requirement for a central and independent internal audit is new.

The provisions of the draft WpIVergV intend to create an appropriate relationship between the variable and fixed components of total compensation by means of the compensation policy. When setting the ratio, investment firms should take into account that a performance-based variable component may have a positive impact on "risk sharing" and provide incentives for prudent risk-taking behaviour in line with the investment firm’s risk appetite , while an unbalanced variable compensation component may have adverse effects under certain circumstances. The higher the potential variable compensation compared to fixed compensation, the stronger the incentive to perform at the level required to achieve it, and, hence, the greater the associated risks may be. Investment firms should consider that employees may become accustomed to and therefore expect to receive significant variable compensation. If the fixed component is too low compared to the variable compensation, it may be difficult for an investment firm to reduce or eliminate variable compensation in a weak fiscal year. In this context, it is important to note that the payment of variable compensation must not jeopardize adequate capital resources at any time.

The amount of variable compensation is to be measured on the basis of the individual performance of the risk taker, the business area and the institution as a whole. The performance measurement must cover a period of several years. The assessment period must be at least 12 months. In addition, the performance measurement methods and performance criteria must be clearly defined. The specifications for retrospective risk adjustment are also of central importance. In this context, BaFin has responded to criticism of Consultation 04/2021. In all comments on Consultation 04/2021, the proposal emerged to apply the ex-post risk adjustment rules only to variable compensation exceeding a certain threshold. Based on such a regulation in the IVV, a threshold of EUR 50,000 was proposed in all comments. BaFin has followed this suggestion in its new draft regulation. An ex-post risk adjustment below this value will no longer be made. This implements the IFD, preserves the principle of proportionality and avoids unnecessarily high administrative costs.

Negative performance contributions by a risk taker and a negative overall performance of the significant institution must have a diminishing effect on the variable compensation and, in serious cases, even lead to the complete loss of the variable compensation.

Malus, Clawback & Deferrals

The draft WpIVergV contains various ex-ante and ex post risk adjustment mechanisms. On the one hand, the regulation clearly stipulates the minimum percentage amount of variable compensation that must be retained (deferral). In case no subsequent adjustment is required, the retained compensation may only be paid in a period of 3 - 5 years (minimum deferral period).

In addition, the draft WpIVergV provides for malus (agreement under which an institution can reduce variable compensation retrospectively) and clawback agreements (agreement under which a risk taker must repay an amount paid in the past to the investment firm). These are explicit ex-post risk adjustment mechanisms where the investment firm itself adjusts the compensation of the identified employee based on these mechanisms (e.g., by reducing the cash compensation granted or reducing the number or value of instruments granted). The draft WpIVergV provides that institutions must be able to reclaim 100% of the variable remuneration, without prejudice to the general principles of national labor or contract law.

Prohibition of hedging

Ex-ante and ex-post risk adjustment are elementary components of an appropriate compensation policy. The practice of making an adjustment to the amount paid to a risk taker, e.g. by applying malus and clawback agreements, must therefore remain in place and must not be circumvented. Otherwise, the objectives of the WpIVergV would be threatened. To guarantee this, it is therefore impermissible to conclude contracts with third parties that compensate for possible reductions through deductions when malus or clawback provisions take effect. Such contracts are void. Adherence to this requirement is to be monitored by internal compliance departments.

Conclusion

The draft WpIVergV creates independent requirements for medium-sized investment firms and parent companies with regard to the compensation structures to be set up in their own companies. 

Affected investment firms that were previously subject to the requirements of the IVV and the KWG should familiarize themselves with possible differences compared to the previously applicable regulations in order to implement the new requirements as quickly as possible and avoid violations. The development of the final version of the WpIVergV should therefore be followed closely.

Our Finance & Financial Regulation team is closely following the further development of the WpIVergV and will keep you up-to-date with further website articles.

With the kind assistance of Christopher Schmieder, LL.M (Boston University) (research assistant), Bird & Bird Frankfurt am Main - Finance & Financial Regulation.