NEWS ANALYSIS - EU bonus regulation with teeth

By Ramyar Moghadassi, Moghadassi & Associates Following warnings about further regulation of the financial services sector, the EU has stepped up calls to revamp bonus structures, including hedge funds. The US may not be far behind.

In an effort to "promote" and "secure" sound risk management, the European Commission published a draft directive on alternative investment fund managers.

The commission made two recommendations regarding incentive schemes in financial services companies. The first is that directors' remuneration should be "clearly linked to performance and not a reward for failure". The second is that "incentives should be aligned with long-term, firm-wide profitability".

These recommendations could be given effect as early as June, when Internal Market and Services Commissioner Charlie McCreevy intends to publish amendments to the existing Capital Requirements Directive. This would enable EU member states to impose sanctions on financial institutions that operate remuneration policies posing an "unacceptable risk". The sanctions could include a requirement that organisations hold additional capital.

The proposed measures apply to financial institutions with an office in the EU as well as subsidiaries of EU-based entities. Whether the US will follow with equally tough restrictions is not yet known.

In the US, the financial services sector has recently been subjected to significant government scrutiny. President Barrack Obama has pointed the finger of blame at hedge funds for Chrysler's bankruptcy filing (a "small group of speculators" were said to have blocked a negotiated restructuring of Chrysler's £4.7 billion ($6.9 billion) debt by refusing to swap it for $2 billion in cash).

The US House of Representatives has passed measures imposing a 90% tax on bonuses paid to executives at banks bailed out by the government. If there is any impetus to regulate hedge fund bonuses in the US, it could be strengthened by the EU precedent.

On both sides of the Atlantic, for now, existing contractual bonus structures are enforceable and valid from an employment law standpoint. They would remain until the proposed regulations take effect. So freely negotiated hedge fund incentive schemes in the UK and the US could continue until laws in each jurisdiction require something different. Even then, any disputes regarding incentive schemes in existence prior to the effective date of the new measures would generally be resolved with reference to the law in force at the time the parties agreed to their terms.

Risk-friendly bonus schemes are still legally valid, even if some may consider them inadvisable.

Some hedge funds remain steadfast in their resolve to maintain all aspects of the compensation status quo. Others, whether to temper the impact of imminent regulation, reassure risk-weary clients, or control fund managers' expectations, have already revamped their incentive schemes to fall in line with a combination of some or all of the components of the potential new regime, where bonuses are performance-linked, capped at a percentage of total pay and/or deferred over time.

It is possible the wave of bonus regulation may lose much of its gusto by the time it reaches London or New York. While waiting, hedge funds on both sides of the Atlantic may at the very least want to look at and re-examine incentive schemes before regulations demand it.