"Regulators Get Banks to Rein In Bonus Pay" read the headline on an article on page 1 of The Wall Street Journal last Tuesday. This article is among the first to shed light on a significant problem that has been developing behind the scenes for companies in the financial services area and their advisers.*
Dodd-Frank Act Section 956 "Enhanced Disclosure and Reporting of Compensation Arrangements" has been overlooked by much of corporate America (and all of the media). First, it only applied to large financial services companies, so more than 90% of corporate America can ignore it (for now, but see below). Second, like so many of the provisions of Dodd-Frank, Section 956 will not be fully effective until regulations are issued. Dodd-Frank required the Fed, SEC, OCC, FDIC, NCU, FHFA, and OTS,** to prescribe regulations or guidelines on Section 956 not later than 9 months after the date of enactment.
However, Section 956 has already led to significant changes in the way financial services companies pay their executives and management employees, which may become even more dramatic if and when the final regulations are issued. Section 956 requires a covered financial institution to disclose to the appropriate Federal regulator the structures of all incentive-based compensation arrangements offered by such covered financial institutions sufficient to determine whether the compensation structure provides officers, directors, and employees with "excessive compensation, fees, or benefits" or could lead to material financial loss to the covered financial institution.
In spring 2011, the seven federal agencies issued proposed rules for Section 956, which were both overreaching and unworkable. We (and numerous others) submitted detailed comments on the proposed rules in May 2011 – and that is the last anyone has heard of these rules.
However, the seven agencies did adopt the "Interagency Guidance on Sound Incentive Compensation Policies" in 2010. Also in 2010, the Fed embarked on a project known as the Horizontal Review of Practices at Large Banking Organizations (the "Horizontal Review") under which it thoroughly reviewed the incentive compensation practices at 25 large, complex banking organizations ("LCBOs").
Because the Horizontal Review process took place behind closed doors between the Fed and each institution, what the rest of corporate America (and investors and their advisor) did not necessarily see was that the Fed was strongly urging financial institutions to make their compensation programs less likely to create risk . . . by making the performance targets easier for officers and employees to achieve!
Now the secret is out, thanks to The Wall Street Journal. The article quotes Carol Bowie of ISS nicely summarizing the issue: "There is some tension between the Fed's focus, which is on risk mitigation, and the focus of investors." On the one hand, financial services companies, like all other public companies, are facing enormous pressure from investors and their advisors to pay for performance and on the other hand you have the key federal regulator telling them not to so.
More on this issue as it develops, but I was glad to see that the media and the investor community have spotted this issue. I tried to make this point myself in testimony before the Senate Banking Subcommittee on Financial Institutions and Consumer Protection. (But my own family doesn't listen to me, so I don't know why I thought the Senate would.)
*Inasmuch as last week I blogged on an issue featured on page 1 of The Wall Street Journal, it may seem to readers as though all I do is read the paper for blog ideas, but I assure you this is just a coincidence.
**The Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, the Board of Directors of the Federal Deposit Insurance Corporation, the Director of the Office of Thrift Supervision, the National Credit Union Administration Board, the Securities and Exchange Commission, the Federal Housing Finance Agency