VOL. 24, NO. 3
AUTUMN 2011
BENEFITS LAW
JOURNAL
Executive Compensation
Global Update on Regulation
of Compensation for Financial
Services Companies
Ian Fraser and James E. Earle
W
ere flaws in bank compensation practices a leading cause of
the global economic crisis of 2008–2009? Reasonable people
can debate the answer to this question, but the fact is that banking
regulators have taken concrete actions in the wake of the 2008–2009
crisis that could significantly change the way compensation is paid in
the financial services sector across the world.
The leading criticism of pre-crisis compensation practices at banks
has been that there was too much focus on annual cash bonuses that
encouraged excessive risk taking by over-rewarding short-term results
to the detriment of the long-term safety and soundness of banking
institutions. Actions by global regulators have focused on fundamentally changing all aspects of these compensation practices, and the
changes will likely have lasting effects. The regulatory changes appear
I an Fraser is a partner in the London office of K&L Gates LLP who advises on the design, drafting, and implementation of director/employee
equity and cash incentive arrangements and the legal and regulatory
implications of operating them in the UK and internationally. James
E. Earle is a partner in the Charlotte offices of K&L Gates. Mr. Earle’s
practice involves counseling publicly traded companies and other complex employers on matters related to executive compensation. Clients
include financial services companies, hedge funds, large national retailers, manufacturers, and service-companies with global operations.
Executive Compensation
to be creating new “best practices” that may also have long-term effects
in other industry sectors. On the other hand, the new regulations are
creating additional challenges for global businesses due to increased
compliance and reporting obligations and inconsistent implementation
across multiple regulatory regimes. This article explores the current
global landscape of compensation regulations for financial services
companies, including the common source of guiding principles issued
by the Financial Stability Board, as well as the way those principles are
being implemented in Europe, the United States, and beyond.
Background to Global Regulation
In the wake of the financial crisis, the “Group of Twenty” Finance
Ministers (often referred to as the G-20) created the Financial Stability
Board (FSB) by expanding the pre-existing Financial Stability Forum
(an advisory group established in 1999 to promote financial stability
through international information exchange and cooperation). The
new FSB included all G-20 countries, Spain and the European
Commission. The FSB published a set of Principles for Sound
Compensation Practices which were endorsed by the G-20 at its
summit meeting in London in April 2009,1 and then went on to publish a set of Implementation Standards which were endorsed by the
G-20 at its summit meeting in Pittsburgh in September 2009.2 The FSB
Principles and Implementation Standards are outlined below. While
they are not in themselves binding on financial services regulators in
any individual country, they effectively form the basis of global regulation of compensation in the banking sector.
In addition to this, the Basel Committee on Banking Supervision
(BCBS), a committee of the Bank for International Settlements (the
global banking body based in Basel, Switzerland), has incorporated
the FSB Principles and Implementation Standards into the Basel
Accords (Pillar 2).3 Again, while the Basel Accords are not binding
on individual country regulators, they form the basis of international regulation in the banking sector, thereby increasing the status of
the FSB Principles as the basis of global regulation. The BCBS has
also issued a Compensation Principles and Standards Assessment
Methodology, which provides commentary and guidance on the FSB
Principles and Implementation Standards and analyzes the (recently
completed) Methodologies for Risk and Performance Alignment
of Remuneration. These Methodologies provide non-prescriptive
guidelines for incorporating risk adjustment into compensation
policies operated by firms in the financial services sector.4
In response to these new guidelines, financial services regulators
in many countries have taken steps to implement regulations based
on the FSB Principles and Implementation Standards. In addition, the
European Union (EU) has issued mandatory rules through the Third
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Capital Requirements Directive, which contains prescriptive regulations that arguably go beyond the FSB requirements. Regulators in
EU Member States were required to implement these new regulations
from January 1, 2011 (see below).
Financial Stability Board Compensation Principles
The FSB Principles and Implementation Standards are intended to
provide a framework for operating compensation policies and practices that are consistent with and promote effective risk management.
FSB Principle
FSB Implementation
Standard
Topics Covered
1 and 2
1
• Governance structures and processes, including
oversight and periodic review of compensation
policies by an independent remuneration
committee
3
2
• Involvement of independent control function
staff in incentive compensation decisions
• Separating compensation decisions for
independent control function staff from the
performance of the business areas they support
4
3 and 4
• Effective alignment of compensation with
prudent risk taking through risk adjustments
that take into account all types of risk
6
5, 6(a), 11, 12,
and 14
• Determination of bonus pools
• Payment of variable compensation in the form of
deferred equity
• Prohibitions on multiyear guarantee payments,
severance payments that may reward failure,
and employee hedging strategies that could
undermine clawback or malus arrangements
6
6(b), 7, and 9(a)
•
•
Mandatory deferral for senior employees and
risk-takers of 40 to 60 percent of variable pay,
with a minimum three year vesting period (and
vesting no faster than pro rata on an annual
basis)
Mandatory clawback of unvested amounts in
the event of poor performance of the firm or
business line
7
8 and 9(b)
• Mix of compensation
• Requires at least 50 percent of variable
compensation to be provided in shares or “sharelike instruments”
8
3(b), 10, 13, 16,
17, 18, and 19
•
•
9
15
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•
Effective supervisory oversight of compensation
policies
Requires national regulatory authorities to
review compensation policies and actively
intervene where necessary
Public disclosure to enable stakeholders to
evaluate a firm’s compliance with the Principles
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The following chart provides an overview of the FSB Principles and
Implementation Standards:
These Principles and Standards establish the themes that the various
global regulatory bodies have addressed in their regulatory actions. As
the next several sections show, however, the regulators have adopted
these themes with varying degrees of focus and flexibility.
Implementation of FSB Principles
in the European Union
As noted above, the EU’s Third Capital Requirements Directive
(CRD3) requires EU Member States to implement compensation
principles based on the FSB Principles with effect from January 1,
2011.5 These requirements are backed by regulatory guidance
issued by the Committee of European Banking Supervisors (CEBS),
now renamed the European Banking Authority.6 The EU rules
broadly mirror the FSB Principles, but are stricter in three key
respects:
1. The structures required for delivery of variable compensation are more prescriptive in that 50 percent of both upfront
and deferred variable compensation must be comprised of
shares or share-like instruments;
2. The CRD3 rules apply to all financial services businesses that
are subject to CRD, which includes not only all banks and
other deposit-taking institutions, but also many broker-dealers, asset managers, hedge funds, and private equity funds;
and
3. Mandatory public disclosure rules apply to all CRD firms,
with a first disclosure required in 2011.
One of the key principles of CRD3 is that firms should apply the
principles in a proportionate way, i.e., in a manner appropriate to
their size and internal organization, as well as the nature, scope,
and complexity of their business activities. Generally, EU regulators are enforcing the strictest requirements on large, complex businesses, and more relaxed requirements for less systemically important
businesses.
It is also worth noting that the CRD3 rules are a minimum standard
that must be adopted by all EU countries. Local regulators may adopt
stricter rules if they wish and some have issued additional guidance
setting out their interpretation of the CRD3 rules. For example, the
UK’s Financial Services Authority has implemented extensive rules
and guidance through its Remuneration Code, which was updated in
late 2010 to reflect the CRD3 rules.7
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Implementation of FSB Principles in the United States
Guidance on Sound Incentive Compensation Policies
In June 2010, US banking regulators adopted the “Guidance on
Sound Incentive Compensation Policies” (the Agency Guidance).8 The
Agency Guidance states that it is intended to be consistent with the
FSB Principles and Implementation Standards.
The Agency Guidance applies to a broad range of banking institutions, regardless of size, including US bank holding companies,
national banks, state member banks, state nonmember banks, savings
associations, savings and loan holding companies, and US operations of foreign banks with a branch, agency, or commercial lending
company in the United States. The Agency Guidance also applies to
potentially a broad range of employees, including:
•
Senior executives;
•
Other non-executive employees who may expose the institution to material amounts of risk (such as traders with large
position limits relative to the institution’s risk appetite); and
•
Groups of non-executive employees in similar incentive
compensation plans who collectively may expose the institution to material amounts of risk (such as mortgage loan
officers).
The Agency Guidance requires these covered institutions to comply with three key risk management principles related to the design
and governance of incentive-based compensation:
1. Balanced design;
2. Independent risk management controls; and
3. Strong governance.
The following provides additional detail on these three key principles:
Balanced Design
Incentive-based compensation arrangements at a covered financial institution should balance risk and financial results in a manner
that does not encourage employees to expose their organizations to
imprudent risks. The Agency Guidance identifies four primary methods to make compensation more sensitive to risk:
•
Risk adjustment of awards. The institution adjusts the amount
of the covered person’s incentive-based compensation
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award based on quantitative or qualitative measures that
take into account the risk the covered person’s activities
pose to the covered financial institution.
•
Deferral of payment. The institution delays the actual payout
of an award to a covered person significantly beyond the
end of the performance period, and the amounts paid are
adjusted for actual losses or other aspects of performance
that become clear only during the deferral period.
•
Longer performance periods. The institution extends the
time period covered by the performance measures used in
determining a covered person’s award.
•
Reduced sensitivity to short-term performance. The institution reduces the rate at which awards increase as a covered
person achieves higher levels of the relevant performance
measure(s) used in the person’s incentive-based compensation arrangement.
Independent Risk Management Controls
A covered institution’s risk-management processes and internal controls should reinforce and support the development and maintenance
of balanced incentive compensation arrangements. For example,
risk-management personnel should have an active role in designing
and assessing the effectiveness of incentive compensation programs.
These risk-management personnel should operate independently
from the businesses they support. Compensation arrangements for
risk-management personnel should not be tied to the business unit
results.
Strong Corporate Governance
Covered institutions should have strong and effective corporate
governance to help ensure sound compensation practices, including
active and effective oversight by the board of directors.
Importantly, the Agency Guidance does not impose specific compensation caps or mandate specific compensation designs. The Agency
Guidance also explicitly recognizes that these principles should be
proportionately applied to smaller, less complex institutions that rely
to a lesser degree on incentive compensation. The heavier burdens,
especially as to processes and procedures, are likely to fall on larger,
more complex institutions. In that regard, even before the Agency
Guidance had been finalized, a number of larger, more complex
institutions were subjected to a broad review of their compensation practices by bank regulators. It appears that the agencies may
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be intending to compel the larger institutions to change their practices in order to enable those changes to “trickle down” to smaller
institutions.
Dodd-Frank Act Section 956
Section 956 of the Dodd-Frank Wall Street Reform and Consumer
Protection Act (the Act)9 requires various US regulatory agencies10 to
issue joint regulations that prohibit “covered financial institutions”
from entering into incentive-based compensation arrangements that
encourage inappropriate risks, either because they provide certain
covered persons of the covered financial institutions with excessive
compensation, or because they could lead to material financial loss
to the covered financial institution. On March 31, 2011, the agencies issued proposed rules under Section 956.11 A comment period
for the proposed rules closed on May 31, 2011. Following the comment period, the agencies will adopt a final rule which is expected
to become effective six months after its publication in the Federal
Register. A rule-making calendar posted be the SEC on July 29, 2011,
does not anticipate adoption of final rules until January–June 2012,
meaning that the likely effective date is not earlier than the latter half
of 2012.12
Section 956 and the proposed rules go well beyond the Agency
Guidance in a number of important respects:
•
Section 956 applies to a broad range of financial services
companies with $1 billion or more in total assets, including banks, savings and loans, credit unions, investment
advisors, broker-dealers, and other institutions. The agencies collectively estimate that there are over 1,600 covered
financial institutions that will be subject to the proposed
rules.
•
Section 956 imposes two prohibitions on incentive compensation arrangements at covered financial institutions:
1. Prohibition on excessive compensation. This prohibition
applies to all directors, officers and employees of the
institution (i.e., not just risk-takers). Whether compensation is excessive is determined by reference to a list of
factors, such as comparable compensation practices at
competitors, the financial condition of the institution,
other elements of the compensation package, etc.
2. Prohibition regarding material financial loss. The proposed rules largely adopt the Agency Guidance as the
standard for enforcing this prohibition.
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•
Section 956 includes two new procedural requirements for
covered financial institutions:
1. Annual report. Covered financial institutions must provide their regulator with an annual report that demonstrates their compliance with the two prohibitions.
2. Policies and procedures. Covered financial institutions must adopt written policies and procedures that
meet certain minimum standards, that are reasonably
designed to address the two prohibitions described
above, and that provide for appropriate levels of oversight and documentation.
•
Finally, for “larger” covered financial institutions (those with
$50 billion or more in assets), the proposed rules go beyond
the statutory requirements of Section 956 in two important
respects:
1. Mandatory deferrals for executives. At least 50 percent of
“annual” incentive compensation for executive officers
must be deferred over a period of at least three years;
and
2. Board oversight for certain
The board of directors of
vide more direct oversight
compensation arrangements
risk-takers.
non-executive risk-takers.
the institution must prowith respect to incentive
for certain non-executive
Section 956 and the proposed rules present a number of challenges. The sheer vagueness and generality of most of the operative
terms in the proposed rules means that, if implemented as proposed,
there will be considerable uncertainty about the scope of the rules
during implementation and unless and until regulatory or industry
standards develop. Consistent application of the proposed rules
across agencies poses a significant challenge. To achieve consistency, each agency would have to actively examine, disseminate,
and police industry compensation practices, which would require
considerable resources and the exercise of a high degree of judgment by agency staff.
Implementation of the FSB Principles
in Other Countries
The FSB has published the results of a survey it carried out and
submitted to the G-20 Summit in November 2010, analyzing the progress of implementation of general regulatory reform in the banking
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sector.13 This survey indicates that the following countries have made
progress in implementing the FSB Principles:
Argentina, Australia, Brazil, Canada, China, France, Germany,
Hong Kong, India, Indonesia, Italy, Japan, Mexico, Netherlands,
Republic of Korea, Russia, Saudi Arabia, Singapore, South
Africa, Spain, Switzerland, Turkey, UK, US and the EU.
However, the review also indicates that not all countries have rules
and implementation standards that meet the FSB’s standards. The FSB
has stated that it will continue to carry out Peer Reviews with the
intention of achieving common standards for all countries that have
significant financial centers.
Conclusion
The actions by regulators across the globe to implement the FSB’s
Principles represent a significant new level of regulatory oversight of
compensation programs. The FSB’s Principles are not, however, being
implemented in a totally consistent manner across jurisdictions. As an
example, EU member states are generally viewed as having adopted
the strictest requirements, with mandatory deferral percentages for all
“Identified Employees” (broadly, senior employees and risk-takers),
the required use of equity awards for a portion of both immediate
and deferred awards, and post-vesting holding period requirements
for all equity awards.
In contrast, some commentators have criticized the United States for
being slow to implement the FSB Principles on a comprehensive basis
and for being less prescriptive in its requirements. US industry groups
counter by strongly cautioning against “one-size-fits-all” approaches to
regulating compensation, such as mandatory deferrals and minimum
vesting requirements applied broadly.
To date, the focus has largely been on the delivery of incentive
compensation and how that may need to be varied to meet regulatory requirements in specific countries or regions (such as the EU).
However, we expect that the next major focus will be on public disclosure obligations.
The FSB’s Implementation Standard 15 requires extensive compensation disclosure for all risk-takers and across all lines of business.
However, non-EU countries do not generally have disclosure obligations which extend beyond the proxy/annual financial statement disclosures for senior executives.
In the EU, Implementation Standard 15 forms the basis of the disclosure requirements under the EU’s CRD3 rules, so financial services
firms operating in the EU already have public disclosure obligations
which they must meet before December 31, 2011. However, the
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disclosure requirements present new challenges for non-EU headquartered groups that operate in the EU, because local requirements
are significantly more demanding than home country regulations.
Furthermore, the BCBS carried out a consultation exercise in late 2010
which proposed disclosure obligations with an even greater level of
detail than Implementation Standard 15. Although the BCBS’s final
proposals have not yet been released, it is possible that regulators
could require even more extensive disclosure of compensation information in the future.
Regulation of compensation policies in the financial services sector
is growing and is here to stay, and firms have generally responded by
adjusting policies and processes and engaging with their regulators.
Given the range of regulatory approaches evolving out of the FSB’s
Principles, financial services firms with global operations are increasingly concerned about the compliance challenges of operating global
compensation policies. It is helpful that the FSB Principles have been
effectively adopted as a global standard for regulation in this area, but
international business would benefit from regulators taking a more
consistent approach to implementation and interpretation.
Notes
1. FSF Principles for Sound Compensation Practices, available at www.
financialstabilityboard.org/publications/r_0904b.pdf.
2. FSF Principles for Sound Compensation Practices: Implementation Standards, available at www.financialstabilityboard.org/publications/r_090925c.pdf.
3. The BCBS provides a forum for regular cooperation on banking supervisory matters and, although it does not in itself have power to implement or enforce its policies and standards, its principles on banking regulation have been endorsed by the
G-20 and form the basis of international thinking on regulation. The Basel II Accord
created the framework of three pillars: Pillar 1 relates to capital adequacy, Pillar 2 to
supervisory review processes, and Pillar 3 to market discipline, including disclosure.
For more information, see http://www.bis.org/list/bcbs/index.htm.
4. Compensation Principles and Standards Assessment Methodology January 2010,
available at http://www.bis.org/pub/bcbs166.htm and Range of Methodologies for Risk
and Performance Alignment of Remuneration, May 2011, available at http://www.bis.
org/pub/bcbs194.htm.
5. CRD3: Directive 2010/76/EU of the European Parliament and of the Council of
24 Nov. 2010 amending Directives 2006/48/EC and 2006/49/EC as regards capital
requirements for the trading book and for re-securitisations, and the supervisory
review of remuneration policies.
6. CEBS Guidelines on Remuneration Policies and Practices, 10 Dec. 2010, available
at http://www.eba.europa.eu/Publications/Standards-Guidelines.aspx.
7. FSA Remuneration Code: PS10/20 “Revising the Remuneration Code,” December
2010, available at http://www.fsa.gov.uk/papers/Library/Communication/PR/2010/180.
shtml.
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8. Guidance on Sound Incentive Compensation Policies, 75 FR 36395 (Jun. 25, 2010),
adopted by the Office of the Comptroller of the Currency, Treasury, the Board of
Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation
and the Office of Thrift Supervision; available at http://www.federalreserve.gov/
newsevents/press/bcreg/bcreg20100621a1.pdf.
9. The Dodd-Frank Wall Street Reform and Consumer Protection Act (Pub. L. No.
111-203, enacted July 21, 2010).
10. The seven federal agencies are: the US Securities and Exchange Commission;
the Office of the Comptroller of the Currency, Treasury; the Board of Governors of
the Federal Reserve System; the Federal Deposit Insurance Corporation; the Office
of Thrift Supervision, Treasury; the National Credit Union Administration; and the
Federal Housing Finance Agency.
11. The proposed rules are available at http://www.occ.gov/news-issuances/
news-releases/2011/nr-ia-2011-37a.pdf.
12. See “Implementing Dodd-Frank Wall Street Reform and Consumer Protection Act—
Upcoming Activity,” at http//:www.sec.gov/spotlight/dodd-frank/dfactivity-upcoming.
shtml#07-12-12.
13. The survey was conducted by the FSB Implementation Monitoring Network and
is generally correct as of Sept. 2010, although some responses contain more recent
updates. The responses were published in Apr. 2011 and are collected at http://www.
financialstabilityboard.org/publications/r_101111b.htm.
Reprinted from Benefits Law Journal Autumn 2011, Volume 24,
Number 3, pages 75-85, with permission from Aspen Publishers, Inc.,
Wolters Kluwer Law & Business, New York, NY, 1-800-638-8437,
www.aspenpublishers.com
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