Disincentivizing Incentives – The Changing World of Banker and Broker Compensation

June 13, 2016Articles

Like a large shoe dropping from the Dodd-Frank basket, the federal financial institution regulatory agencies have jointly issued proposed regulations, implementing Section 956, aimed at reining in incentive-based compensation for senior executive officers and significant risk-takers (covered persons) of covered institutions, which was perceived to be a cause of the 2008 financial crisis. Covered institutions mainly include depository institutions, holding companies, registered broker-dealers, credit unions, nondepository trust companies, Edge and Agreement Corporations and certain foreign bank branches and agencies and foreign banking organizations. Because the lengthy regulatory proposal will take time and focus to digest and implement, the agencies propose a delayed compliance date about 18 months after publication of the final regulations, and incentive-based compensation plans with a performance period beginning before the compliance date would not be covered. The deadline for public comment is July 22, 2016.

Discouragement of inappropriate risks
As an overarching theme, the proposed regulations would prohibit covered institutions from establishing or maintaining any form of incentive-based compensation program, plan or arrangement that provides covered persons with excessive compensation, fees or benefits, as defined, or that encourages them to take inappropriate risks that could lead to material financial loss. However, the agencies are not attempting to dictate a one-size-fits-all approach, expecting, rather, that incentive-based compensation arrangements will be tailored to the size, complexity, risk tolerance and business model of each covered institution.

Balancing risk and reward
In exercising supervisory oversight, the agencies would evaluate how an institution integrates incentive-based compensation into its risk-management systems and hold it responsible for achieving an appropriate balance between risk and reward. An incentive-based compensation arrangement would achieve an appropriate risk-reward balance only if it (i) included financial and non-financial measures of performance that are relevant to a covered person’s role and to the type of business in which the covered person is engaged and that are appropriately weighted to reflect risk-taking; (ii) allowed non-financial measures of performance to override financial measures when appropriate; and (iii) subjected to adjustment any amounts to be awarded under the arrangement that reflect actual losses, inappropriate risks taken, compliance deficiencies or other measures or aspects of financial and non-financial performance.

Excessive compensation
Central to the structure of the proposed regulations is the concept of excessive compensation. Simply put, excessive compensation refers to payments that are unreasonable or disproportionate to the value of the services performed by a covered person. What is reasonable and proportionate would be measured by several factors, including (1) the combined value of all compensation, fees or benefits; (2) the compensation history of the covered person; (3) the financial condition of the covered institution; (4) compensation practices at comparable covered institutions; (5) the projected total cost and benefit to the covered institution of post-employment benefits; and (6) any connection between the covered person and any fraudulent act, breach of trust or insider abuse.

Who is targeted?
Deciphering the proposed regulations is best approached through the defined terms, starting with those covered by the provisions. “Covered persons” include employees, directors and principal (i.e., 10 percent equity interest) shareholders. “Covered institutions” are assigned to one of three categories – Level 1 (assets above $250 billion), Level 2 (assets between $50 billion and $250 billion), and Level 3 (assets between $1 billion and $50 billion).

Level 3 (smaller) Institutions
Since the agencies concentrate their concerns on Level 1 and Level 2 institutions, Level 3 institutions escape the most burdensome and intricate provisions. Subject only to the fundamentals, a Level 3 institution must structure its incentive-based compensation arrangements to avoid excessive compensation, avoid encouraging inappropriate risks that could lead to material financial loss, ensure direct board oversight and maintain seven-year records that document compliance. Importantly, a Level 3 institution above $10 billion with complex operations or compensation practices can be required to comply with Level 2 requirements at the discretion of its primary federal supervisor.

Level 1 and Level 2 (larger) Institutions
To fully understand who is targeted, Level 1 and Level 2 institutions must understand two key terms. A “senior executive officer” is singled out for special attention and includes all policy-level officers. The term also extends to heads of major business lines or control functions, even when their activities are not designed to generate revenue, such as human resources. More complicated is the definition of “significant risk-taker,” who is someone at a Level 1 or Level 2 institution whose income is at least one-third incentive-based, and who has the ability to expose the institution to certain levels of financial loss. That ability is determined through one of two methods – the “relative compensation test” and the “exposure test.” The relative compensation test compares a covered person’s annual base salary and incentive-based compensation to other covered persons working for the same covered institution and its affiliate covered institutions in order to determine whether the individual is among the top five percent (Level 1) or two percent (Level 2), depending on the institution’s size, of highest compensated covered persons in the consolidated organization. The exposure test identifies covered persons who have authority to commit or expose at least 0.5 percent of the capital of the covered institution or an affiliate covered institution.

What is targeted?
To understand what is targeted, a grasp of definitions is even more critical. “Incentive-based compensation” means any variable compensation, fees or benefits that serve as an incentive or reward for performance. Not targeted, however, are benefits paid for reasons other than to induce performance, such as signing or hiring bonuses, retention payments or bonuses for maintaining professional certification. Also not targeted are medical insurance, use of a company car and similar fringe benefits, and arrangements based on fixed compensation, regardless of an employee’s performance, such as employer contributions to a 401(k) retirement savings plan based on a fixed percentage of salary, including an employer match of the employee-designated tax-deferred amount. While most pensions will not count as incentive-based compensation, some may have features that meet the definition.

Incentive-based compensation is compartmentalized by the proposed regulations within four key defined terms. First, an “incentive-based compensation plan” is a document setting forth terms and conditions governing the opportunity for and delivery of incentive-based compensation payments to covered persons. Second, an “incentive-based compensation program” houses incentive-based compensation plans and is a covered institution’s framework governing incentive-based compensation practices. Third, a “long-term incentive plan” provides incentive-based compensation based on a performance period of at least three years, and fourth, “qualifying incentive-based compensation” is the amount awarded to a covered person for a particular performance period other than under a long-term incentive plan.

Rigorous special limitations are placed on incentive-based compensation at Level 1 and Level 2 covered institutions. For all covered persons (not just senior executive officers and significant risk-takers), hedging arrangements would be prohibited if they protect against suffering the negative financial impact of a decrease in value of any award. Further, the proposed regulations would strictly limit the amount by which incentive-based compensation for senior executive officers and significant risk-takers could exceed the target amounts for performance measure goals established at the beginning of the performance period.

Risk management through deferral, downward adjustment, forfeiture and clawback
For Level 1 and Level 2 covered institutions, deferral of incentive-based compensation is planted at the core of effective risk management. In order to expose risk-takers to the consequences of their risk decisions over time, the agencies have determined that meaningful portions of incentive-based compensation must be deferred and placed at risk of reduction or recovery. The number of years required for deferral and the percentage of incentive-based compensation that must be deferred vary depending on the institution’s Level, the nature of the payment (i.e., qualifying incentive-based compensation vs. long-term incentive plan), and the status of the covered person (i.e., senior executive officer vs. significant risk-taker).

Again, in this context, definitions serve as guideposts for compliance and can best be understood chronologically. For Level 1 and Level 2 covered institutions, during the Performance Period, incentive-based compensation is expected to be awarded on the basis of actual performance, with deficient performance leading to downward adjustment before the award is made. Deferral Period means the “look-back’ period that follows a covered person’s performance period and allows time for the consequences of risk-taking decisions made during the performance period to become apparent. During the deferral period, for Level 1 and Level 2 covered institutions, after the award is made but before incentive-based compensation has fully vested, the award will be subject to forfeiture if financial loss or other adverse consequences warrant. Timing of vesting is rigidly limited, with acceleration prohibited except for death or disability.

When adverse consequences surface after vesting, Level 1 and Level 2 covered institutions would be required to provide for a clawback to recover any portion of incentive-based compensation already paid. This requirement could overlap with the existing clawback provisions of the Sarbanes-Oxley Act (SOX), which require CEOs and CFOs to disgorge incentive-based compensation for the 12-month period following issuance of financial statements if it is later determined that a restatement is required as a result of misconduct. It will also overlap a rule proposed by the Securities and Exchange Commission (SEC) last summer, implementing Section 954 of Dodd-Frank requiring a listed company to adopt a clawback policy that would permit recovery of incentive-based compensation paid to current and former executive officers during the three fiscal years preceding the date on which the company is required to prepare an accounting restatement to correct a material error. The regulations implementing Section 956 proposed by the federal financial institution regulatory agencies, which includes the SEC, would reach a wider array of covered persons and would require a covered institution to reserve the right to recover incentive-based compensation for seven years from the date when incentive-based compensation vests, potentially leaving amounts subject to deferred vesting at risk for 10 years or longer. The overlap between the three regulatory schemes underlines the need for the agencies to rationalize the proposed clawback rules with the SOX clawback requirements.

Board oversight, recordkeeping and disclosure
With their effectiveness reliant on strengthened corporate governance, the proposed regulations would directly impact a board’s responsibilities. The board or a board committee would be required to conduct more extensive oversight of the institution’s incentive-based compensation program; approve incentive-based compensation arrangements for senior executive officers, including award amounts and payouts; and approve material exceptions or adjustments to incentive-based compensation policies or arrangements for senior executive officers. To assist the board in carrying out these responsibilities, a Level 1 or Level 2 institution would be required to ensure that its compensation committee is composed solely of directors who are not senior executive officers. Working in tandem with the risk management function, including the risk and audit committees, the compensation committee would have a mandate to assess the effectiveness of risk measures and adjustments used to balance incentive-based compensation arrangements. It would report directly to the board or senior management, excluding any covered persons within the ambit of its monitoring responsibilities.

Additionally, the proposed regulations would require every covered institution to document the structure and compliance of its incentive-based compensation arrangements annually. A covered institution would have to maintain those records for at least seven years and disclose them upon request to its primary federal supervisor.

Although there is no absolute certainty that any particular proposed provisions will find their way into final regulations, we believe it is fair to assume that most will survive without substantial modification. Accordingly, as a preparatory measure, financial institutions should examine where they and their subsidiaries fit within the new Dodd-Frank regulatory scheme. Further, they should begin to consider the extent to which their compensation structures and functions will need to be adjusted to comply with the new Dodd-Frank mandates, including alignment with other applicable compensation rules.

If you have questions regarding the proposed revisions, please contact your Dinsmore attorney.