Securities Regulation
& Law Report
REPORT
VOL. 43, NO. 28
JULY 11, 2011
E X E C U T I V E C O M P E N S AT I O N
Federal Regulators Propose Rule Addressing
Incentive-Based Compensation Arrangements for Financial Firms
n March 30, 2011, seven federal financial regulators1 (each, an ‘‘Agency,’’ and collectively, the
‘‘Agencies’’) published a proposed rule (the ‘‘Proposed Rule’’)2 to implement Section 956 of the DoddFrank Wall Street Reform and Consumer Protection Act
(the ‘‘Act’’).
Section 956 of the Act requires the Agencies 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. Under Section 956, the regulations also must require covered financial institutions to disclose the structures of their
incentive-based compensation arrangements in a manner sufficient for the Agencies to determine whether the
foregoing prohibitions are being properly implemented.
Section 956 defines ‘‘covered financial institutions’’
to include a broad range of financial institutions that
have $1 billion or more in total consolidated assets, including bank holding companies, national banks, savings and loans, credit unions, investment advisers and
registered broker-dealers. The Proposed Rule further
O
BY JAMES E. EARLE
AND
MARK D. PERLOW
Jim Earle and Mark Perlow are Partners at
K&L Gates, LLP.
Jim Earle’s practice focuses on 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 servicecompanies with global operations.
Mark Perlow’s practice focuses on investment
management and securities law. He regularly
represents mutual funds, hedge fund managers, investment advisers, fund boards of directors, and broker-dealers on a variety of regulatory and transactional matters on a broad
range of traditional and novel matters.
COPYRIGHT 姝 2011 BY THE BUREAU OF NATIONAL AFFAIRS, INC.
1
The seven federal agencies are: the U.S. Securities and
Exchange Commission (‘‘SEC’’); the Office of the Comptroller
of the Currency, Treasury (‘‘OCC’’); the Board of Governors of
the Federal Reserve System (‘‘Board’’); the Federal Deposit Insurance Corporation (‘‘FDIC’’); the Office of Thrift Supervision, Treasury (‘‘OTS’’); the National Credit Union Administration (‘‘NCUA’’); and the Federal Housing Finance Agency
(‘‘FHFA’’).
2
The Proposed Rule is available at http://www.occ.gov/
news-issuances/news-releases/2011/nr-ia-2011-37a.pdf.
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expands this definition to also cover certain U.S. operations of foreign banks.
Section 956 requires the Agencies to ensure that their
proposed regulations (i) are comparable to the safety
and soundness standards applicable to insured depository institutions under Section 39 of the Federal Deposit
Insurance Act (the ‘‘FDIA’’) and (ii) take into consideration the compensation standards described in FDIA
Section 39(c).
While many banking institutions recently have been
subjected to guidance on sound incentive compensation
policies adopted by certain Federal banking agencies
(the ‘‘Banking Agency Guidance’’),3 Section 956 and
the Proposed Rule (if adopted) apply to a broader range
of financial institutions. The Proposed Rule, however,
would supplement, not replace, other rules on compensation practices (including the Banking Agency Guidance).
A forty-five day comment period ended on May 31,
2011. Following the comment period, the Agencies
should adopt a final rule, which is expected to become
effective six months after its publication in the Federal
Register. However, given the number of issues raised by
the comment letters, we believe it likely that the effective date for the final rule will not occur until sometime
in 2012.
The scope of the Proposed Rule is potentially very
broad. The Agencies collectively estimate that there are
over 1,600 covered financial institutions that will be
subject to the Proposed Rule. Moreover, the Proposed
Rule generally follows a principles-based approach to
rulemaking and includes a number of critical undefined
terms. Much of the actual impact will therefore depend
on how each Agency chooses to enforce its rules.
Summary of the Proposed Rule
Scope.
The Proposed Rule would apply to any ‘‘covered financial institution’’ that has ‘‘total consolidated assets’’
of $1 billion or more and that offers an ‘‘incentive-based
compensation’’ arrangement to a ‘‘covered person’’ (essentially, directors, officers, employees and principal
shareholders). Certain requirements only would apply
to ‘‘larger covered financial institutions,’’ which in general are covered financial institutions with $50 billion or
more in total consolidated assets. We provide additional
details on these highlighted defined terms later in this
article.
Two Key Prohibitions.
The Proposed Rule would prohibit a covered financial institution from having incentive-based compensation arrangements that may encourage inappropriate
risks either (i) by providing ‘‘excessive compensation’’
to covered persons, or (ii) that could lead to a material
financial loss for the covered financial institution.
A. Prohibition Regarding Excessive Compensation.
As required under Section 956 of the Act, the Proposed
Rule would include standards for determining whether
an incentive-based compensation arrangement provides ‘‘excessive compensation.’’ These standards
would be comparable to, and based on, the ‘‘safety and
3
Guidance on Sound Incentive Compensation Policies, 75
FR 36395 (Jun. 25, 2010), adopted by the OCC, Board, FDIC,
and OTS.
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soundness’’ standards established under FDIA Section
39. Specifically, compensation for a covered person
would be considered excessive when amounts paid are
unreasonable or disproportionate to, among other
items, the amount, nature, quality, and scope of services performed by the covered person. In making such
a determination, an Agency would consider, among
other matters:
s the combined value of all cash and non-cash benefits provided to the covered person;
s the financial condition of the covered financial institution;
s comparable compensation practices at comparable institutions;
s for post-employment benefits, the projected total
cost and benefit to the covered financial institution; and
s 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. Prohibition Regarding Material Financial Loss.
The Proposed Rule would implement the prohibition on
incentive compensation that encourages inappropriate
risks that could lead to material financial loss largely
through the standards in the Banking Agency Guidance
regarding sound incentive compensation practices.
Consistent with the Banking Agency Guidance, this
prohibition would apply to a subset of all covered persons, made up of the following three groups:
s Senior Management: Executive officers and other
covered persons who are responsible for oversight of
the covered financial institution’s firm-wide activities or
material business lines;
s Other Individual Risk-Takers: Other individual
covered persons, including non-executive employees,
whose activities may expose the covered financial institution to a material financial loss (e.g., traders with
large position limits relative to the covered financial institution’s overall risk tolerance); and
s Risk-Taking Groups: Groups of covered persons
who are subject to the same or similar incentive-based
compensation arrangements and who, in the aggregate,
could expose the covered financial institution to a material financial loss, even if no individual covered person in the group could expose the covered financial 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).
To avoid inappropriate risks that can lead to a material financial loss, the covered financial institution
would have to comply with three key risk management
principles related to the design and governance of
incentive-based compensation: (i) balanced design, (ii)
independent risk management controls and (iii) strong
governance.
s Balanced Design: Incentive-based compensation
arrangements at a covered financial institution should
balance risk and financial rewards in a manner that
does not provide covered persons with incentives to
take inappropriate risks that could lead to material financial loss at the covered financial institution, taking
into consideration the full range of risks associated with
a covered person’s activities and the time horizon over
which those risks may be realized. Like the Banking
Agency Guidance, the Proposed Rule generally does
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not mandate a specific, ‘‘one size fits all’’ design-based
approach to meet this requirement (other than certain
minimum deferral requirements for larger covered financial institutions discussed further below). Instead,
the Proposed Rule identifies four primary methods to
make compensation more sensitive to risk (while noting
that other methods for achieving balance are likely to
be developed in the coming years):
—Risk Adjustment of Awards: The covered financial
institution adjusts the amount of the person’s incentivebased compensation 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 covered financial 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 covered financial 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 covered financial 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.
s Independent Risk Management Controls. A covered financial institution’s risk management processes
and internal controls should reinforce and support the
development and maintenance of balanced incentivebased compensation arrangements, in particular by (i)
adopting strong controls governing its processes for designing, implementing and monitoring incentive-based
compensation arrangements, and (ii) ensuring that riskmanagement personnel have an appropriate role in the
institution’s processes for designing, monitoring and
assessing incentive-based compensation arrangements.
These risk-management personnel should operate independently from the business(es) they support. For example,
compensation
arrangements
for
riskmanagement personnel should not be tied to the business unit results.
s Strong Corporate Governance. As the body with
ultimate responsibility for ensuring that the covered financial institution’s incentive compensation arrangements are appropriately balanced, the board of directors of a covered financial institution should actively
oversee incentive-based compensation arrangements,
for example, by reviewing and approving the overall
goals and purposes of the covered financial institution’s
incentive-based compensation system and ensuring its
consistency with the institution’s overall risk tolerance.
Proposed Procedural Requirements
Given the attention on risk management practices relating to compensation arrangements over the last several years in the wake of the 2008-2009 financial crisis,
many covered financial institutions may find that their
incentive-based compensation arrangements already
substantially comply with the two proposed prohibitions described above. The Proposed Rule, however,
also would include two new procedural requirements
that could take significantly more effort to comply with:
(i) the requirement to file an annual report with the apSECURITIES REGULATION & LAW REPORT
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plicable Agency, and (ii) the requirement to adopt written policies and procedures designed to ensure compliance with the two prohibitions.
Annual Report. Although each Agency will develop
its own form and procedures related to the annual report that a covered financial institution would need to
file, the Proposed Rule would require the annual report,
at a minimum, to include the following information:
s a clear narrative description of the components of
the covered financial institution’s incentive-based compensation arrangements applicable to covered persons
and specifying the types of covered persons to which
they apply;
s a succinct description of the covered financial institution’s policies and procedures governing its
incentive-based compensation arrangements;
s for larger covered financial institutions, a succinct description of any specific incentive compensation
policies and procedures for the institution’s executive
officers, and other covered persons who the board (or
committee of the board) determines individually have
the ability to expose the institution to possible losses
that are substantial in relation to the institution’s size,
capital, or overall risk tolerance; and
s the specific reasons the covered financial institution believes the structure of its incentive-based compensation plan (i) does not provide covered persons
with excessive compensation, and (ii) does not provide
covered persons with incentives to engage in behavior
that is likely to cause the covered financial institution to
suffer a material financial loss.
The proposing release notes that the disclosures being sought are intended to ensure that covered financial
institutions provide the Agencies with a streamlined set
of materials that will permit them to effectively identify
and address any areas of concern. The annual report
would not require disclosure of individual compensation for any particular covered person. The proposing
release also notes that the Agencies generally would
maintain the confidentiality of the information submitted to the Agencies, and the information would be nonpublic to the extent permitted by law, including the
Freedom of Information Act (which has exemptions for
trade secrets and reports provided to regulators). Finally, the proposing release states that the volume and
detail of information provided annually by a covered financial institution should be commensurate with the
size and complexity of the institution and the scope and
nature of its incentive-based compensation arrangements. The volume and detail of information provided
by a large, complex institution that uses incentivebased arrangements to a significant degree likely would
be substantially greater than that submitted by a
smaller institution that only has a few incentive-based
compensation arrangements or arrangements that affect only a limited number of covered persons.
Policies and Procedures. The Proposed Rule would
impose the following requirements regarding the policies and procedures that the board (or committee) of
each covered financial institution would have to adopt:
s The policies and procedures would, at a minimum, have to be reasonably designed to address the
two key prohibitions described above;
s Risk management, risk oversight, and internal
control personnel would be required to (i) be involved
in all phases of the process for designing incentivebased compensation arrangements and (ii) have reBNA
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sponsibility for ongoing assessment of incentive-based
compensation policies to help ensure that the covered
financial institution’s processes remain up-to-date and
effective relative to its incentive compensation practices;
s The policies and procedures would have to provide that one or more individuals who are independent
from a covered person (where practicable) will monitor
incentive-based compensation awards to that covered
person. This oversight should include a review of the
risks taken and actual risk outcomes to determine
whether incentive-based compensation payments are
reduced to reflect adverse risk outcomes or high levels
of risk taken. To be considered independent under the
Proposed Rule, the group or person providing the oversight would have to have a separate reporting line to senior management from the covered person who is creating the risks so as to help ensure that the analysis of
risk is unbiased;
s The policies and procedures should be designed
to ensure that the covered financial institution’s board
(or committee of the board) receives data and analysis
from management and other sources sufficient to allow
it to assess whether the overall design and performance
of the firm’s incentive-based compensation arrangements are consistent with Section 956 of the Act. The
scope and nature of the data and analysis should be appropriate to the size and complexity of the covered financial institution and its use of incentive-based compensation;
s The policies and procedures would have to provide that each covered financial institution maintains
sufficient documentation of the institution’s processes
for establishing, implementing, modifying, and monitoring incentive-based compensation arrangements sufficient to allow the applicable Agency to determine the
institution’s compliance with the Proposed Rule. Given
that the determinations that would be made regarding
incentive-based compensation are fact-specific, the proposing release notes that effective documentation of the
covered financial institution’s policies, procedures and
actions related to incentive-based compensation would
be essential both to help promote the risk-based discipline that Section 956 of the Act seeks to foster in covered financial institutions, and to facilitate meaningful
oversight and examination. In this context, the Agencies would expect the documentation maintained by a
covered financial institution under the Proposed Rule to
include, but not be limited to:
—a copy of the covered financial institution’s
incentive-based compensation arrangement(s) or
plan(s)
—the names and titles of individuals covered by such
arrangement(s) or plan(s)
—a record of the incentive-based compensation
awards made under the arrangement(s) or plan(s)
—records reflecting the persons or units involved in
the approval and ongoing monitoring of the arrangement(s) or plan(s);
s Where a covered financial institution uses deferral of incentive-based compensation, the policies and
procedures would have to provide for the following:
— that the amount and time period for the deferrals
are appropriate with respect to (i) the duties and responsibilities of the covered persons, (ii) the risks associated with those duties and responsibilities and (iii) the
size and complexity of the covered financial institution
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— that the deferrals be subject to adjustments for actual losses or other measures or aspects of performance
that are realized or become better known only during
the deferral period. Risk management personnel are expected to play a substantial role in identifying and
evaluating risks that become better known with the passage of time;
s Policies and procedures would have to subject
any incentive-based compensation arrangement to a
corporate governance framework that provides for ongoing oversight by the board (or committee of the
board); and
s In addition, the proposing release notes that the
use of certain hedging strategies by covered persons
who receive deferred incentives in the form of equitybased awards could significantly diminish the effectiveness of the deferrals and undermine the underlying purpose of the policies and procedures. The Proposed Rule
notes that the Agencies are therefore considering
whether a covered financial institution’s policies and
procedures should be required to specifically include
limits on personal hedging strategies.
Additional Requirements for Larger Covered Financial Institutions
In addition to the prohibitions and procedural requirements described above, the Proposed Rule would
impose two additional requirements on incentive-based
compensation arrangements at larger covered financial
institutions: (i) a mandatory 50% deferral of incentivebased compensation for executive officers and (ii)
board oversight of incentive-based compensation for
certain risk-taking employees who are not executive officers.
Mandatory Deferrals. The Proposed Rule would establish a deferral requirement for larger covered financial institutions. At these institutions, at least 50% of annual incentive-based compensation of an executive officer would have to be deferred over a period of at least
three years. Deferred amounts paid also would be subject to adjustment for actual losses or other measures or
aspects of performance that are realized or become better known during the deferral period. In the proposing
release, the Agencies asserted that, because decisions
of executive officers have a significant impact on a
larger covered financial institution and often involve
substantial strategic or other risks that are difficult to
measure and address with front-end risk adjustment
measures, incentive-based compensation arrangements
for executive officers at larger covered financial institutions likely would be better balanced if they involve the
deferral of a substantial portion of the executives’ incentive compensation over a multi-year period in a way
that reduces the amount received in the event of poor
performance over a longer period of time.
The Proposed Rule would provide a larger covered financial institution with flexibility on how to release or
allow vesting of deferred amounts subject to these deferral requirements (e.g., a lump sum at the conclusion
of the deferral period or pro rata for each year in such
period), provided that such deferred amount may not be
released or vest more quickly than in pro rata increments for each year of the deferral period. For example,
a deferral amount of $300,000 over three years could
not be released more quickly than $100,000 per year
over such period.
Special Review and Approval Requirements for
Other Designated Individuals. The Proposed Rule
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would require that, at a larger covered financial institution, the board (or committee of the board) take the following three actions relating to those covered persons
(other than executive officers) that individually have
the ability to expose the institution to possible losses
that are substantial in relation to the institution’s size,
capital, or overall risk tolerance (for example, traders
with large position limits relative to the institution’s
overall risk tolerance):
s identify those individuals;
s approve the incentive-based compensation arrangements for those individuals, based on a determination that each arrangement, including the method of
payment, effectively balances the financial rewards to
the employee and the range and time horizon of risks
associated with the employee’s activities, and
s maintain documentation of this approval.
Evasion
The Proposed Rule would prohibit a covered financial institution from evading the restrictions of the rule
Federal Regulator
Federal Reserve
FDIC
NCUA
OCC
OTS
SEC
FHFA
The following provides additional detail on certain of
the key definitions under the Proposed Rule.
A ‘‘covered financial institution’’ means each of the
following entities with total consolidated assets of $1
billion or more (other than the listed entities regulated
by the FHFA, which are covered simply by reason of being designated):
- Bank holding company- State member bank- State-licensed uninsured branch or
agency of a foreign bank- U.S. operations of a foreign bank that is treated as a bank
holding company
- State nonmember bank- Insured U.S. branch of a foreign bank
- Federally insured credit union- Credit union eligible to make application to become an insured credit union
- National bank- Federal branch or agency of a foreign bank
- Savings and loan holding company- Savings association
- Broker-dealer registered under Section 15 of the Securities Exchange Act of 1934,
as amended (the ‘‘Exchange Act’’)- Investment adviser, as such term is defined in
Section 202(a)(11) of the Investment Advisers Act of 1940, as amended (the ‘‘Advisers Act’’), regardless of whether the adviser is registered under the Advisers Act
- Fannie Mae- Freddie Mac- Federal Home Loan Bank- Federal Home Loan Bank
System’s Office of Finance
Federal Regulator
SECURITIES REGULATION & LAW REPORT
Key Definitions
Covered Financial Institutions
The definition generally tracks the definition set forth
in Section 956 of the Act, except that the Proposed Rule
would expand the definition, pursuant to delegated authority under the Act, to include the uninsured
branches, agencies and certain other U.S. operations of
foreign banking organizations, and the Federal Home
Loan Banks.
Federal Reserve
by doing any act or thing indirectly, or through or by
any other person, that would be unlawful for the covered institution to do directly. This anti-evasion provision is designed to prevent covered financial institutions from, for example, making substantial numbers of
its covered employees independent contractors for the
purpose of evading this subpart (although the Proposed
Rule stresses that bona fide independent contractor relationships of covered financial institutions are not intended to be disrupted).
‘‘Total consolidated assets’’ is generally based on a
rolling four-year average of reported assets, although in
the case of a broker-dealer or investment adviser, the
Proposed Rule would use a one-year ‘‘snap shot.’’ The
following chart provides additional details:
Basis for Determining Total Consolidated Assets
- For a bank holding company, average of the company’s four most recent Consolidated Financial Statements for Bank Holding Companies- For a state member bank
or a state-licensed uninsured branch or agency of a foreign bank, average of the
total assets reported in the bank’s four most recent Call Reports- For the U.S. operations of a foreign bank that is treated as a bank holding company, as determined
by the Federal reserve- Includes any subsidiary of the entity
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FDIC
- For a state nonmember bank, average of the total assets reported in the bank’s
four most recent Consolidated Reports of Condition and Income- For the insured
U.S. branch of a foreign bank, average of the total assets reported in the branch’s
four most recent Reports of Assets and Liabilities of U.S. Branches and Agencies
of Foreign Banks
- Average of the total assets reported in the credit union’s four most recent 5300
Call Reports
- For a national bank, average of the total assets reported in the bank’s four most
recent Call Reports- For the Federal branch or agency of a foreign bank, average
of the total assets reported in the entity’s four most recent Reports of Assets and
Liabilities of U.S. Branches and Agencies of Foreign Banks
- Average of the entity’s four most recent Thrift Financial Reports
- For a broker-dealer, total assets reported in the firm’s most recent year-end audited Consolidated Statement of Financial Condition- For an investment adviser,
total assets shown on the balance sheet for the adviser’s most recent fiscal year endNOTE: For an investment adviser, the amount is not based on assets under management, thereby excluding a large number of advisers that otherwise could have
been swept into the Proposed Rule’s scope
- N/A – each of the entities is included simply by designation
NCUA
OCC
OTS
SEC
FHFA
‘‘Incentive-based compensation’’ is defined broadly
to mean any variable compensation that serves as an incentive for performance, regardless of whether compensation takes the form of cash, equity awards or
other property.
‘‘Compensation’’ also is defined broadly to mean all
direct and indirect payments, fees or benefits, both cash
and non-cash, awarded to, granted to, or earned by or
for the benefit of, any covered person in exchange for
services rendered to the covered financial institution.
‘‘Covered person’’ means, with respect to a covered
financial institution, any of its employees, and each of
the following:
s An ‘‘executive officer’’ of the covered financial institution, defined as any person who holds the title or
performs the function (regardless of title, salary or compensation) of one or more of the following: president,
chief executive officer, executive chairman, chief oper-
Requirement
Applies To
Prohibition Regarding Excessive Compensation
Prohibition Regarding Material Financial Loss
Mandatory Deferrals for Larger Covered Financial
Institutions
Special Review and Approval Requirements for
Larger Covered Financial Institutions
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ating officer, chief financial officer, chief investment officer, chief lending officer, chief legal officer, chief risk
officer, or head of a major business line.
s A ‘‘director’’ of the covered financial institution,
defined as a member of the board of directors of the
covered financial institution or of a board or committee
performing a similar function to a board of directors.
s A ‘‘principal shareholder’’ of the covered financial institution, defined as an individual that directly or
indirectly, or acting through or in concert with one or
more persons, owns, controls, or has the power to vote
10 percent or more of any class of voting securities of a
covered financial institution. Shares owned or controlled by a member of an individual’s immediate family are considered to be held by the individual.
The following chart illustrates how the various requirements under the Proposed Rule would apply to
various sub-groups of covered persons:
- All covered persons (i.e., all employees, executive officers, directors and principal shareholders)
- Executive officers and other persons who are responsible for
oversight of the covered financial institution’s firm-wide activities
or material business lines - Other individual risk takers (e.g., traders with large position limits relative to the covered financial institution’s overall risk tolerance)- Groups of risk takers in similar
incentive plans (e.g., loan officers who, as a group, originate loans
that account for a material amount of the covered financial institution’s credit risk)
- Executive officers
- Employees (other than executive officers) who individually have
the ability to expose the institution to possible losses that are substantial in relation to the institution’s size, capital, or overall risk
tolerance (for example, traders with large position limits relative to
the institution’s overall risk tolerance)
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Analysis
The sheer vagueness and generality of most of the
operative terms in the Proposed Rule means that, if
implemented as proposed, there could be considerable
uncertainty about the scope of the rule during implementation, unless and until regulatory or industry standards develop. The following highlights a number of the
key issues the Proposed Rule raises.
s The Proposed Rule relies on qualitative concepts
and judgments to regulate a subject matter that is inherently quantitative. While the principles-based nature of
the Proposed Rule is welcome, the Proposed Rule does
not provide sufficient guidance to covered financial institutions to determine whether their incentive compensation plans are sufficiently ‘‘balanced’’ – it is not clear,
for example, what the appropriate degree of ‘‘risk adjustment’’ or ‘‘reduced sensitivity to short-term performance’’ would be for any compensation package, or
what the appropriate ‘‘deferral of payment’’ or ‘‘longer
performance period’’ would be. A financial institution
that is more conservative in interpreting and applying
these terms runs the risk of offering less competitive
compensation and losing personnel to competitors. For
these reasons, a number of comment letters asked the
Agencies to provide guidance through detailed case examples particular to each relevant regulated industry.
s Consistent application of the Proposed Rule
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. The banking regulators have started
this process through the implementation of the Banking
Agency Guidance, but it is not clear that the SEC has
the same experience or resources to evaluate management practices as do the banking regulators.
s The entity-by-entity approach to determining
which entities are ‘‘covered financial institutions’’ could
create confusion and multiple layers of regulation, especially given that the Federal Reserve’s definition
picks up all subsidiaries. For example, a bank holding
company with broker-dealer and investment adviser
subsidiaries, each with assets of $1 billion or more,
could be required to file multiple annual reports, adopt
separate policies and procedures, etc. Some comment
letters suggested that the final rule require a single
‘‘lead’’ regulator in these circumstances based on the
‘‘highest level’’ entity within the controlled group.
s If the different regulators do not coordinate sufficiently, there is a real risk that some financial industries
will develop compensation practices that the regulators
in other sectors deem unacceptable, which could introduce regulatory arbitrage on compensation practices –
over time, talent could migrate to those industries
whose regulators allow more favorable compensation
packages. Thus, the Proposed Rule could introduce
more systemic risk into the financial system.
s Many of the comment letters criticized the ‘‘onesize-fits-all’’ approach to mandating deferrals of annual
incentive-based compensation for larger covered financial institutions. This requirement, which does not come
from the text of the Act, creates numerous interpretive
issues not clearly addressed by the Proposed Rule, such
as (i) what counts as ‘‘annual’’ incentive-based compensation that is subject to the 50% mandatory deferral,
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(ii) what constitutes a ‘‘deferral’’ of that compensation,
(iii) assuming equity awards are part of the mandatory
deferral, how should they be valued for this purpose,
and (iv) what kinds of adjustments will satisfy the requirement that deferrals be subject to ‘‘actual losses or
other measures or aspects of performance that are realized or become better known during the deferral period.’’ As an example, a number of financial services
companies have begun to grant long-term incentive
awards that become earned based on performance over
a multi-year period. Under the Proposed Rule, it is unclear whether such awards are part of ‘‘annual’’ incentive compensation that can count towards the deferral
requirement, or whether the performance-based vesting
requirements (which in some cases may result in either
increases or decreases to the award based on performance results) will satisfy the requirement that the
award be subject to adjustment ‘‘for losses or other
measures or aspects of performance.’’
s The above comments possibly illustrate a much
larger problem with the Proposed Rule. There is an inherent tension between consistency and fairness, on the
one hand, and flexibility in adapting the rules to different companies and industries, on the other. It is not
clear that the Proposed Rule, or indeed any attempt to
regulate incentive compensation, can get the balance
right: the Agencies run the risk that their attempts to
enforce consistency would limit covered financial institutions’ ability to adapt to quickly changing competitive
circumstances and that their attempts to be flexible will
provide a regulatory advantage to some firms over others.
s The mandatory deferral requirement also raises
potential accounting and tax challenges. As some comment letters observed, assuming the deferral requirement is met using equity-based awards, subjecting
those awards to discretionary adjustments can lead to
adverse accounting consequences – i.e., ‘‘mark-tomarket’’ liability accounting rather than ‘‘fixed’’ sharebased accounting. Mandatory deferrals also might create challenges in complying with the rules applicable to
nonqualified deferred compensation plans under Internal Revenue Code Section 409A.
s Many comment letters worried about ‘‘unintended consequences’’ that could result from an overly
prescriptive approach to the regulation of compensation. For example, some covered financial institutions
could choose to shift total compensation away from
incentive-based programs and into compensation that is
tied less to performance, such as salary or retirement
benefits. For example, a number of banks under the
Troubled Asset Relief Program (‘‘TARP’’) significantly
increased salaries as a way to avoid many of the TARP
executive compensation rules aimed at limiting bonus
pay. A rule that results in compensation becoming less
sensitive to performance runs contrary to the goal that
executive pay should be linked to performance – a goal
found elsewhere in the Act (such as the ‘‘say on pay’’
requirements of Section 951).
s Greater clarity is needed about how the prohibition against ‘‘excessive’’ compensation would be enforced by the Agencies, especially given that this prohibition applies to all employees (not just risk-takers) and
seemingly applies to all compensation (not just
incentive-based compensation). The open-ended nature
of this prohibition could lead to the Agencies micromanaging otherwise routine business decisions. For exBNA
7-11-11
8
ample, a covered financial institution trying to hire a
new information systems manager (presumably, not a
‘‘risk-taker’’) might have to worry if it needed to pay
‘‘above market’’ to get the right person for the job.
s Greater clarity is needed around the definition of
‘‘incentive-based compensation.’’ For example, any
compensation granted in the form of equity arguably
could count as ‘‘incentive-based compensation’’ under
the definition. Financial services companies sometimes
structure equity buyouts and sign-on bonuses for key
new hires in the form of equity awards, or grant equitybased awards intended primarily to retain key employees. Arguably, those types of awards should not constitute ‘‘incentive-based compensation.’’ In any event,
clarity is needed to make sure that covered financial institutions properly identify, design and govern the applicable programs.
s To the extent that the Agencies use compensation
packages at competing firms in evaluating a covered financial institution’s incentive compensation (as seems
likely), the Proposed Rule could have an anticompetitive effect. This approach could lead the Agencies and thus regulated firms to conclude that more favorable compensation practices than their competitors’
are ‘‘excessive,’’ thereby impeding their ability to compete for talent on the basis of incentive compensation.
Action Steps
Although there are a number of open issues and
much will depend on how the Agencies choose to interpret and enforce the final rules, there are a number of
action steps that covered financial institutions can currently consider to possibly better position themselves if
the Proposed Rule is adopted as proposed:
s Determine whether the company is in fact a ‘‘covered financial institution,’’ whether there may be multiple covered financial institutions within the controlled
group and whether any of such entities are ‘‘larger covered financial institutions.’’
s Tentatively identify the categories of covered persons within the organization, broken into groups, including (i) executive officers, (ii) other individual risk
takers (e.g., traders with large position limits relative to
the covered financial institution’s overall risk tolerance), (iii) groups of risk takers in similar incentive
plans (e.g., loan officers who, as a group, originate
loans that account for a material amount of the covered
financial institution’s credit risk), and (iv) for larger
covered financial institutions, employees (other than
executive officers) who individually have the ability to
expose the institution to possible losses that are substantial in relation to the institution’s size, capital, or
overall risk tolerance.
s Identify the incentive-based compensation plans
applicable to covered persons.
s For each of those incentive-based compensation
plans, consider whether those plans could result in ‘‘excessive compensation’’ based on the standards set forth
in the Proposed Rule (i.e., establish that the incentivebased compensation will not result in payments that are
‘‘unreasonable or disproportionate to the services performed’’).
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s Commence reviewing the design of incentivebased compensation arrangements to establish that
they appropriately balance risk and financial rewards in
a manner that does not provide covered persons with
incentives to take inappropriate risks. In addition, take
a look at current approaches to deferring incentive
awards and whether deferred awards are subject to appropriate prospective adjustments for future performance and compliance with risk policies.
s Consider whether risk and other key control partners (such as audit, finance, human resources, legal,
etc.) have appropriate roles in the design and administration of incentive-based compensation plans, and
whether those key control partners operate independently from the businesses they support.
s Consider ways in which the effectiveness of
incentive-based compensation plans from a risk management perspective can be prospectively tested on the
front end and monitored on the back end. The prospective testing and retrospective monitoring of the effectiveness of incentive-based compensation plans to balance risk-taking behaviors with compensation outcomes has been a focus in the regulatory review of
compensation practices at ‘‘large, complex, banking organizations’’ under the Banking Agency Guidance.
s
Review current governance structures for
incentive-based compensation arrangements – e.g.,
those responsible for approving design, the funding of
pools, the allocation of individual awards, etc. It may be
appropriate to employ multiple levels of governance to
ensure that the most relevant level of management is
making incentive award decisions, e.g., having the
Board-level compensation committee act on executive
officers and certain other key risk takers, but have a
management-level body act on risk takers at lower levels.
s Consider what forms of documentation are maintained regarding governance activities, including documentation regarding the exercise of discretion or the
implementation of clawbacks.
s Begin to consider how all of this activity may be
encompassed by a set of written policies and procedures.
The Agencies face a difficult task in implementing
the Proposed Rule because there is so much diversity in
the businesses and practices of covered financial institutions. As the numerous comment letters point out, the
Proposed Rule raises a large number of complicated issues; if the Agencies take them seriously, it might take
them an extended period of time to formulate appropriate final rules, and even more time and care to apply
them with the appropriate degree of consistency and
flexibility.
Reproduced with permission from Securities
Regulation & Law Report, 43 SRLR 1425,
07/11/2011. Copyright 娀 2011 by The Bureau of
National Affairs, Inc. (800-372-1033) http://
www.bna.com
COPYRIGHT 姝 2011 BY THE BUREAU OF NATIONAL AFFAIRS, INC.
SRLR
ISSN 0037-0665