By Francis X. Grady
On March 30, 2011, all Federal bank regulators jointly released proposed rules with respect to incentive-based compensation arrangements for banks with $1 billion or more in assets. Issued under the authority of Section 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), the proposed rules would align the U.S. more closely with international compensation standards by:
- Prohibiting incentive-based compensation arrangements that would encourage inappropriate risks by banks providing excessive compensation;
- Prohibiting incentive-based compensation arrangements for covered persons that would expose the institution to inappropriate risks by providing compensation that could lead to a material financial loss;
- Requiring policies and procedures for incentive-based compensation arrangements that are commensurate with the size and complexity of the institution; and
- Requiring annual reports on incentive compensation.
The rules explicitly apply to all banks with assets of $1 billion or more. All “covered” financial institutions will be required to annually report incentive compensation arrangements to their primary Federal bank regulator within 90 days of the fiscal year end.
If issued in final form as proposed, the final rules will be burdensome. However, successful banks will not only comply with the rules but, with the right assistance, use them to gain a competitive advantage over less nimble competitors. Good incentive plans support short and long-term business goals, and the rewards of well-designed plans support shareholder and executive success.
Section 956 of the Dodd-Frank Act requires that the Federal banking agencies jointly adopt measures that:
- Require the “covered financial institutions” to disclose to their appropriate Federal regulator the structure of their incentive-based compensation arrangements so the regulator can determine whether such compensation is excessive or could lead to material financial loss to the bank; and
- Prohibit any type of incentive-based compensation that the regulators determine encourages inappropriate risk by providing excessive compensation or that could lead to material financial loss to the covered bank.
The seven agencies involved in the joint rulemaking process include the Office of the Comptroller of the Currency, the Federal Reserve Board, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision, the National Credit Union Administration, the Securities and Exchange Commission, and the Federal Housing Finance Agency.
Proposed Rules on Incentive-Based Compensation
The proposed rules, which would apply to banks, brokers, dealers or investment advisers with assets of at least $1 billion, contain three elements:
(1) Annual Reporting About Incentive-Based Compensation Arrangements Under the proposed rules, a bank with assets of $1 billion or more would be required to file annually with its appropriate Federal bank regulator a report describing the firm’s incentive-based compensation arrangements. The information that would be required to be submitted would include, but not be limited to:
- A narrative description of the components of the bank’s incentive-based compensation arrangements;
- A succinct description of the bank’s policies and procedures governing its incentive-based compensation arrangements; and
- A statement of the specific reasons as to why the bank believes the structure of its incentive-based compensation arrangements will help prevent the bank from suffering a material financial loss or does not provide covered persons with excessive compensation.
For purposes of the proposed rules, the term “incentive-based compensation” is defined broadly to include any variable compensation that serves as an incentive for performance. Whether the form of payment is cash, an equity award, or other property does not affect whether compensation meets the definition of “incentive-based compensation.” Compensation would not be incentive-based if it is awarded solely for, and payment is tied solely to, continued employment (e.g., salary). Incentive-based compensation includes direct and indirect payments, fees and benefits, payments or benefits pursuant to an employment contract, compensation or benefit agreement, fee arrangement, perquisite, stock option plan, post-employment, or other compensatory arrangement.
(2) Prohibition on Encouraging Inappropriate Risk
(a) General Prohibitions
The proposed rules apply to executive officers, employees, directors, or principal shareholders – “covered persons” – at a covered financial institution. Under those rules, a covered financial institution would be prohibited from establishing or maintaining an incentive-based compensation arrangement that encourages inappropriate risks by providing covered persons with excessive compensation, or that could lead to material financial loss. Incentive-based compensation for a covered person would be excessive when amounts paid are unreasonable or disproportionate to, among other things, the amount, nature, quality, and scope of services performed by the covered person. In making such a determination, the proposed rules indicate that the agencies will consider:
- The combined value of all cash and non-cash benefits provided to the covered person;
- The compensation history of the covered person and other individuals with comparable expertise at the covered financial institution;
- The financial condition of the covered financial institution;
- Comparable compensation practices at comparable institutions, based upon such factors as asset size, geographic location, and the complexity of the institution’s operations and assets;
- For postemployment benefits, the projected total cost and benefit to the covered financial institution; and
- Any connection between the individual and any fraudulent act or omission, breach of trust or fiduciary duty, or insider abuse with regard to the covered financial institution.
(b) Incentive Compensation
The proposal states that incentive-based compensation arrangements would be deemed not to encourage inappropriate risk if they meet vague standards established under Section 39(c) of the Federal Deposit Insurance Act and guidance issued by Federal bank regulators in June 2010 setting forth principles for incentive compensation standards. The incentive-based compensation arrangement would not encourage inappropriate risk if the arrangement:
- Balances risk and financial rewards, for example by using deferral of payments, risk adjustment of awards, reduced sensitivity to short-term performance, or longer performance periods;
- Is compatible with effective controls and risk management; and
- Is supported by strong corporate governance.
The incentive compensation rules on establishing or maintaining any type of incentive compensation arrangements that could lead to a material loss to the financial institution includes groups of persons who are subject to the same or similar incentive compensation arrangements and who, in the aggregate, could expose the institution to a material financial loss (e.g., loan officers who, as a group, originate loans that account for a material amount of the covered financial institution’s credit risk).
Because the Dodd-Frank Act rules on incentive-based compensation represent principlesbased regulation, not rules-based supervision, the regulations’ lack of specificity leads to nebulous standards that will be enforced through examiner leverage. When it comes to incentive-based compensation, the basis for a board’s judgment has to be documented. If the board does not document the process, the bank examiner can question the results. The financial
health of a bank will play a big part in compensation-focused exams. If the bank regulator has a safety and soundness concern with a bank and then finds that the bank is paying compensation at the upper end of the scale for similar sized institutions, that institution will be at more risk for having the incentive compensation arrangement challenged.
(3) Establishing Policies and Procedures
A covered financial institution would be barred from establishing an incentive-based compensation arrangement unless the arrangement has been adopted under policies and procedures developed and maintained by the institution and approved by its board of directors. A foundation to ensure an effective pay-for-performance relationship is to
actually model and monitor the relationship. This is an area where many banks fall short.
By documenting scenario analyses, banks can show the rationale for rewards that result from these programs. While not common practice, the board record of incentive compensation approval should reflect consideration of the following:
- The complete range of compensation that would result from programs in aggregate under various performance scenarios;
- Relate the long-term award values received by executives to company performance relative to peers/industry over multiple years; and
- Monitor the level of equity/ownership by executives, employees and board members so that levels of ownership are sufficient to ensure their alignment with shareholders.
Because assessment of executive compensation is now part of the management evaluation in the CAMELS safety and soundness examination, the policies and procedures that promote compliance with the rules should:
- Provide data to the board or compensation committee from management or outside sources sufficient to allow the board or compensation committee to assess if the overall design and performance of the incentive compensation arrangements are consistent with Section 956 of the Dodd-Frank Act; and
- Maintain sufficient documentation regarding the establishment, implementation, modification and monitoring of incentive compensation arrangements to determine compliance with Section 956 of the Dodd-Frank Act.
Although the requirements under the proposed rule are not anticipated to become effective until late this year or early next year, it is not too early for financial institutions to begin to prepare for the requirements. We recommend that banks take the following actions:
- Inventory the compensatory arrangements of all covered persons to identify those that would constitute “incentive-based compensation”;
- For those arrangements that would constitute incentive-based compensation, begin compiling the information required to analyze the factors under Section 39(c) of the Federal Deposit Insurance Act that would be used to determine whether the compensation could be deemed “excessive”;
- Determine the subset of covered persons and groups of covered persons who would be covered by the prohibition on incentive-based compensation that could lead to material financial loss;
- Review the compensation committee’s charter and consider revising the compensation committee charter to ensure that the charter scope includes the approval of incentivebased compensation arrangements of applicable non-executive officers;
- Create a plan for implementing or revising policies and procedures governing the award of incentive-based compensation;
- Determine the appropriate risk-management, risk-oversight and internal-control personnel to be involved in the process of designing incentive-based compensation arrangements and assessing incentive-based compensation policies; and
- Consider the process required to prepare the annual report that would be submitted to the appropriate Federal bank regulator.