On February 4, 2011, a group of government agencies who are charged with enforcing laws relating to financial institutions (including the Securities and Exchange Commission, the Office of the Comptroller of the Currency, the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision and the National Credit Union Administration) issued a proposed rule relating to the enforcement of the Dodd-Frank Act, which directed the agencies to rein in executive pay as a result of the financial crisis that occurred during the last several years. This proposal has received a lot of publicity, as it provides for the deferral of incentive-based executive pay for executives at large financial institutions (defined as those with over $50 billion in assets).
However, the proposal contains provisions that would impact incentive compensation practices at many other financial institutions – those with over $1 billion in assets. The gist of these proposals is that additional disclosure of incentive programs needs to be made and that the agencies are coming closer to a definition of what a program has to contain to not be viewed as ‘risky’. Let’s examine each area more closely.
Additional disclosure needed:
The proposal wants the covered financial institutions to submit an annual report to its regulator which discloses the structure on an incentive-based program. The report would contain:
- A discussion of the programs and the type of participants
- A description of the financial institution’s policies and procedures governing these incentive programs
- A listing of any material changes to the programs since the prior report
- The specific reasons why the financial institution believes that the incentive programs do not cause employees to engage in risky behavior and does not provide these employees with excessive compensation
The last bullet, above, will be troubling to those institutions who instinctively believe that their programs are safe and their pay levels are not excessive—some type of analysis will need to be made to prove to the regulators that a ‘gut feel’ is not the standard of review.
The proposal addresses the standards that an incentive program must meet so that the agencies would not view the program as one that could lead to a material financial loss to the financial institution. The proposal emphasizes three areas of concern:
- The program itself has to balance risk and financial rewards, by using some mechanism that makes sure that payments are not being made until it is clear that the ‘risk’ has passed—perhaps by deferring payments or making awards based on longer-term actions (more than one year). The proposal suggests that incentive programs need to be tailored to each participant, to reflect that person’s activities and the impact of that person on the financial institution.
- The program must be compatible with effective controls and risk management. Financial institutions should create appropriate policies and procedures supporting these incentive programs to promote compliance and accountability with these rules. Risk management, risk oversight and internal control personnel should be involved in the design and administration of the programs, and that these people should be independent (from an internal reporting standpoint) of the employees who benefit under the program.
- The program is supported by strong corporate governance—the board of directors (or at least a committee of the board) needs to be involved, monitoring and reporting of program results needs to be conducted on a regular basis, and that the procedures and reports are documented.
Many institutions, particularly smaller ones, will struggle with these proposals. The institution may not be large enough to be able to adequately separate participants from the internal monitors; the board may need to be brought more up to speed on compensation based risk; and, key employees may rebel at having the receipt of their incentive compensation dramatically changed.
This is a proposal, and comments are being accepted through mid-March. You can access the 77 page proposal at this link: http://www.fdic.gov/news/board/2011rule2.pdf
For more information on this topic, post a comment below or contact our Compensation & Benefits Advisory Services Group at 440-449-6800.