On June 21, 2010, the Office of the Comptroller of the Currency (“OCC”), the Federal Deposit Insurance Corporation (“FDIC”), the Office of Thrift Supervision (“OTS”) and the Board of Governors of the Federal Reserve System (“Federal Reserve,” and collectively referred to as the “Bank Regulators”) jointly issued guidance concerning incentive compensation policies of each Bank Regulator’s constituent financial institutions (the “Compensation Guidance”). The Compensation Guidance was a follow-up to, and result of, comments on the compensation guidance issued by the Federal Reserve in October 2009.
Compensation arrangements are critical to successful management of financial institutions and serve several objectives, including attracting skilled employees, promoting employee retention and providing retirement security for employees. The Bank Regulators recognize this. The Bank Regulators also recognize, however, that certain compensation arrangements may lead employees to take aggressive or unnecessary risks that are inconsistent with sound banking practices, especially when the return for that risk-taking is in the form of higher potential compensation.
The Bank Regulators’ view is that flawed incentive compensation practices were one of the many factors that led to the collapse of the financial system that began in 2007 and continues to some degree to this day. Accordingly, the Bank Regulators believe that financial institutions should reexamine compensation practices with an eye toward better alignment of the interests of employees with the soundness of the financial institution. The traditional approach taken by many financial institutions in first seeking to align the interests of employees and shareholders is perceived by Bank Regulators as not always sufficient to address the safety and soundness of the financial institution. This is primarily because the “safety net” provided by the Bank Regulators (through the examination process and resultant authority to impose administrative action) may lead shareholders to tolerate a greater degree of risk that is inconsistent with safety and soundness standards. Thus, the guidance seeks to separate shareholders’ view of compensation practices from the Bank Regulators’ view of compensation practices.
While the Compensation Guidance avoids mandates, structured standards and various threshold limits, it does provide a basic policy framework within which financial institutions would operate with respect to incentive compensation arrangements. This article will briefly discuss to whom the Compensation Guidance applies, to what types of compensation arrangements the Compensation Guidance applies, and the corporate governance and risk-management processes that the Compensation Guidance requires. This article concludes with some suggested “next steps” that financial institutions should take with respect to the Compensation Guidance.
To Whom Does the Compensation Guidance Apply?
The Compensation Guidance applies to all banking organizations supervised by the Bank Regulators, including national banks, state member banks, state nonmember banks, savings associations, bank holding companies, thrift holding companies, and so on. The Compensation Guidance applies regardless of the size of the financial institution, although there are certain provisions and guidelines that apply only to “large complex banking organizations,” which are the largest and most complex financial institutions regulated by the Bank Regulators. More specific to this article, the Bank Regulators do recognize that the Compensation Guidance will generally have less impact on small financial institutions, such as the typical community bank, which are normally less complex and make less use of incentive compensation arrangements. Nevertheless, the Compensation Guidance does apply, and smaller financial institutions should take action to ensure compliance with its provisions and guidelines.
The Compensation Guidance applies to employees who, either individually or as part of a group, have the ability to expose the financial institution to material amounts of risk. The type of risks include credit, market, liquidity, operational, legal, compliance and reputational. Accordingly, the Compensation Guidance applies to employees other than senior executive officers. The employees subject to the Compensation Guidance are referred to as “covered employees.” Whether an employee or a group of employees has the ability to expose the financial institution to material amounts of risk is a “facts and circumstances” determination, but the Compensation Guidance does provide some direction by stating that such employees are those whose activities are material to the financial institution or are material to a business line or unit within the financial institution. Types of employees or categories of employees that might fall outside the scope of the Compensation Guidance would likely include tellers, bookkeepers, couriers, data processing personnel and similar positions. Conversely, employees who do not originate business or approve transactions could still expose a financial institution to material risk in some circumstances.
Consequently, the Compensation Guidance does not provide a blanket exception for any employee or group of employee, but instead suggests that a “facts and circumstances” determination should be applied to each employee within the financial institution to determine whether such employee is a “covered employee” under the Compensation Guidance. The Board Compensation Committee will need to determine the “covered employees” and document why any employee or category of employee was not designated.
To What Types of Arrangements Does the Compensation Guidance Apply?
The Compensation Guidance is fairly (and intentionally) vague with respect to the types of incentive compensation arrangements to which the Compensation Guidance applies. The Compensation Guidance does not limit the forms of incentive compensation arrangements that may be entered into by financial institutions. It does not state what is and what is not an acceptable incentive compensation arrangement. It also clearly states that the Compensation Guidance does not apply to arrangements, like 401(k) retirement plans with employer contributions based upon salary levels, that are based solely upon the employees’ level or compensation and that do not vary based upon employee performance or the financial institution’s performance. Based upon this guideline, the Compensation Guidance would likely also not apply to profit-sharing plans, employee stock ownership plans or similar retirement arrangements. Whether the Compensation Guidance applies to salary continuation arrangements, supplemental executive retirement plans or similar nonqualified deferred compensation arrangements is unknown, but it likely does not, absent some incentive feature within the agreement. The Compensation Guidance also notes that incentive compensation arrangements that provide for awards based upon overall financial institution performance are unlikely to provide employees, other than senior executives and others who have the ability to materially affect overall financial institution performance, with risk-taking incentives.
The Compensation Guidance does, however, specifically address one type of compensation arrangement—the “golden parachute” payment. For this purpose, a “golden parachute” payment is any payment to an employee upon departure from the financial institution or in connection with a change in control of the financial institution. The Compensation Guidance requires that financial institutions carefully consider such payments and how such payments may potentially affect risk-taking behavior of employees (typically senior executives). The Bank Regulators’ view is that arrangements that provide for guaranteed payments upon departure from or in connection with a sale of the financial institution, regardless of performance, may neutralize any balancing features that such arrangements may have to preclude risk-taking. While not expressly prohibited, it is clear that typical “golden parachute” payments tend to be viewed unfavorably by Bank Regulators.
What Does the Compensation Guidance Require?
After carefully reviewing comments received on the October 2009 compensation guidance issued by the Federal Reserve, the Bank Regulators adopted the final Compensation Guidance in June 2010, which is similar to the October 2009 guidance. There are three key principles in the Compensation Guidance concerning incentive compensation arrangements:
- such arrangements should provide employees incentives that balance risk and financial results in a manner that does not encourage employees to expose the financial institution to imprudent risks;
- such arrangements should be compatible with effective controls and risk management; and
- such arrangements should be supported by strong corporate governance with effective and active oversight by the financial institution’s board of directors.
Balanced Incentive Compensation Arrangements. The first principle of the Compensation Guidance is that incentive compensation arrangements should provide employees incentives that balance risks and rewards in a manner designed to discourage imprudent or excessive risk-taking. Incentive compensation that may be available to employees should consider, and be adjusted for, the risks and losses—and gains—associated with applicable employees’ activities. In other words, the greater the incentive to take risks, the greater the need for offsetting protections or disincentives. While the Compensation Guidance does not specifically set forth how this balancing technique should occur, it does suggest four methods that might make incentive compensation arrangements more sensitive to risk. Those methods are: (a) risk adjustment of awards (i.e., downward adjustment if risks are excessive), (b) deferral of payment, (c) longer performance periods and (d) reduced sensitivity to short-term performance. A typical disincentive would be a “clawback” feature providing that incentive payments may be reduced if negative results are experienced. Financial institutions should note that these methods are not exclusive, and one may be combined with another to achieve the desired result. Further, methods used at one financial institution, or even for one employee within a single financial institution, may not be suitable for another. The financial institution should use a broad view when designing its incentive compensation arrangements, and should ensure that the arrangements are consistent with safety and soundness principles.
The underlying point of this first principle is that incentive compensation arrangements should be balanced, in that the arrangements contain not only incentives for performance but also “negative” incentives for taking excessive and imprudent risks.
Compatibility With Effective Controls and Risk Management. The second tenet in the Compensation Guidance is that a financial institution’s risk-management processes and internal control procedures should reinforce and support the development and maintenance of balanced incentive compensation arrangements. In other words, financial institutions should:
- have appropriate controls to ensure that processes for achieving balance are followed;
- ensure that appropriate personnel, such as risk-management personnel, have input on the design and assessment of incentive compensation arrangements; and
- monitor incentive compensation awards, risk taken and actual risk outcomes to determine whether the incentive compensation arrangements and awards are properly balanced vis-à-vis risk exposure.
With respect to internal controls and risk management, the Compensation Guidance recognizes that monitoring methods and processes used by a financial institution should be commensurate with its size and complexity, the understanding being that smaller financial institutions may be able to satisfy this principle through normal management processes.
The underlying point of this second principle is to monitor and review the results of incentive compensation arrangements to make sure that the first principle of balance is attained and maintained.
Strong Corporate Governance. The final principle in the Compensation Guidance is that incentive compensation arrangements should be supported by strong corporate governance, including active and effective oversight by the financial institution’s board of directors. It is the ultimate responsibility of the financial institution’s board of directors that incentive compensation arrangements are appropriately balanced, effectively monitored and reviewed, and are within the principles of safety and soundness. In that regard, the Compensation Guidance notes that boards of directors should receive data and analysis from management and other sources (compensation consultants, accountants, attorneys, etc.) to sufficiently enable the board of directors to review and assess the overall design and actual performance of the incentive compensation arrangement in light of safety and soundness principles. Further, boards of directors should have sufficient expertise and knowledge on compensation and risk-management issues, whether through directors on the board or through access to appropriate consultants outside of the board.
In addition to corporate governance at the board level, the Compensation Guidance mandates that a financial institution’s disclosure practices should support safe and sound incentive compensation arrangements. The institution should disclose to its shareholders sufficient information concerning its incentive compensation arrangements and related risk-management, control and corporate governance processes to enable shareholders to monitor and, where appropriate, take action to restrain the potential for such arrangements causing employees to take excessive or imprudent risks. The challenge in this regard is that the Compensation Guidance does not impose specific disclosure requirements on financial institutions. Rather, the scope and level of disclosure should be tailored to the nature and complexity of the organization and its incentive compensation arrangements. Some hint is provided, however, in that financial institutions should attempt to comply with the incentive compensation disclosure requirements under federal securities laws.
What Should You Do Right Now?
Make no mistake, the Bank Regulators are serious about the Compensation Guidance. To that point, one of the most important concepts to take from the Compensation Guidance is that examinations performed by Bank Regulators will incorporate the Compensation Guidance, and financial institutions’ compliance with the Compensation Guidance, into future safety and soundness examinations.
In fact, this process has already begun. The Compensation Guidance has been mentioned in a few recent examination exit interviews. Accordingly, boards of directors and management of financial institutions should act quickly to inventory any type of compensation arrangement that may fall within the parameters of the Compensation Guidance. Financial institutions should then work closely with their compensation consultants, accountants and attorneys, preferably those with knowledge of tax law, corporate governance law, employment law and benefits law, as well as the requirements of the Compensation Guidance, to (a) review the arrangements and, where necessary, amend them to incorporate certain of the concepts within the Compensation Guidance, (b) review the financial institution’s internal risk-management and control processes with respect to compensation matters and (c) ensure that the financial institution has proper corporate governance processes to meet the requirements of the Compensation Guidance. Further, this entire process should be well documented for regulatory review during the examination process. In fact, it may be advisable to conduct certain of these processes at least twice per year. This process will undoubtedly involve a multidisciplinary approach, and financial institutions should be prepared, at least initially, for increased regulatory costs in that regard.
The Compensation Guidance is intentionally vague, and contains no specific “recipe” as to how a financial institution should comply with it. There are numerous ingredients. Our team of financial institution and benefits lawyers are more than happy to work with bankers to audit existing plans and agreements and to help devise a program to ensure compliance with the Compensation Guidance.