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5 NOV 2009
Proposed Federal Reserve guidance on incentive compensation policies of financial institutions
FINANCIAL CRISIS RESPONSE ALERT
On October 22, 2009, the Federal Reserve Board (Federal Reserve), issued a proposal (the Proposal), designed to assure that the incentive compensation policies of financial institutions subject to its supervision do not threaten the safety and soundness of said firms. To read this Proposal, please click here >> The Proposal was issued against a backdrop of criticism of many of the compensation policies that prevailed at banking institutions during the worst of the financial crisis in 2008 and early 2009, and was a counterpoint to the decision also announced on the same date by Kenneth Feinberg, the Special Master for TARP Executive Compensation, in which he severely curtailed and restructured the compensation arrangements for the 25 most senior and highly compensated executives at the seven firms that received exceptional TARP assistance. Most significantly, Special Master Feinberg rejected cash bonuses for the executives at these seven firms that were based on short-term performance, insisting that company stock be issued in their place and that such stock awards be held over a multiple year period to ascertain long-term success for the policies being implemented by the executives. Annual cash salaries were limited by the Special Master to $500,000 for over 90 percent of the executives involved, and total compensation awards were cut on average by an amount equal to approximately 50 percent. Limitations on the ability to sell restricted stock otherwise received as awards were tightened in the Special Master’s plan, and caps were imposed on expense reimbursements, “golden parachute” payments and supplemental executive retirement plans. Overview of the Proposal and Comparison with the Feinberg Determination. Unlike Special Master Feinberg’s decisions, the principles set forth by the Federal Reserve in the Proposal do not impose strict percentage or monetary limits on the amount and nature of incentive compensation to be received by senior banking officials. Instead, the Proposal solicits comments from interested members of the banking community (due by November 27, 2009) on key aspects of the compensation process and also announces two separate supervisory initiatives, focusing respectively on large, complex financial firms and on smaller, community banks. The Proposal does share certain policy principles with the recommendations established by Special Master Feinberg in the TARP context, attempting to reward long-term success over short-term performance as a general goal, and enshrining the following three overall considerations to guide, in broad terms, the establishment of specific incentive compensation
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practices at the firms in question: Incentives should not encourage “excessive” risk-taking; Incentives should be compatible with effective controls and risk management; and Incentives should be supported by strong corporate governance, including active and effective board of director oversight. We turn below to a detailed consideration of these issues. Avoidance of “Excessive” Risk-Taking. A touchstone for the Federal Reserve’s guidance, as noted above, is to avoid too formulaic an approach to incentive compensation, since, as the Federal Reserve notes in the “Questions and Answers” related to the Proposal, “one size does not fit all.” Rather, the central focus of the Federal Reserve’s concerns is in scrutinizing discrete institutional policies in this area against standards that are designed to foster the long-term well being of the firm in question, while discouraging risk outcomes that may engender possibly adverse effects on the organization. In this regard, the time horizon to be considered must be sufficiently long to address the likelihood of countervailing consequences that may flow from a particular business decision, and reliable quantitative measures must be developed and applied to balance the award of compensation, and the timing of such payments, against the risks and concerns related to the business decisions and practices giving rise to the compensation award. In some cases, payments should be deferred, or be subjected to “clawback,” to tie the payment of the award in question to the longer-term risks involved. Sensitivity must be recognized in consideration of the fact that equity awards (including restricted stock or options), may be more effective in restraining the activities of higher level rather than lower level employees, as these more junior officials may not believe that their actions will materially affect the organization’s stock price. Finally, “golden parachute” and other deferred termination arrangements need to be monitored and scrutinized carefully, under the provisions of the Proposal, to assure that excessive risk-taking, in light of the employee’s overall incentive compensation arrangements, is not facilitated. Compatibility with Effective Controls and Risk-Management. In addition to sound risk-taking quantification and assessment methodologies, banking organizations must establish appropriate controls to assure the development and maintenance of balanced incentive and compensation arrangements. Strong controls, including compliance policies, procedures and enforcement systems, need to be in place to ensure that avoidance is not taking place by key employees of the risk-weighing standards described above. Regular internal reviews need to be conducted by a firm’s audit, compliance, risk management, legal and other control personnel, with results reported to senior management as well as to the board of directors of the banking institution in question, to verify compliance with the incentive compensation criteria established for the firm. Risk management and compliance personnel should be included in the design and implementation of compensation policies to make certain that procedures are carefully calibrated. In addition, the independence of such control officials must be protected and safeguarded within each institution to keep certain the accuracy and soundness of the judgments involved. Strong Corporate Governance. The Federal Reserve, in its Proposal, clearly designates the board of directors of a particular firm as the ultimate and active overseer of incentive compensation arrangements. The board must supervise and monitor the development of the policies and practices involved, the overall goals and purposes established and their execution in a manner that is balanced and consistent with safety and soundness. Data and reviews on the incentive compensation awards under review must be received by the board from management, in order to gauge whether particular
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incentive compensation arrangements may be encouraging excessive risk-taking. Periodic reports should also be prepared on a backwards-looking basis to determine the effects of such compensation arrangements as correlated with the original risk-taking judgments. The board must also stay aware of developments in the applicable marketplace of comparable compensation arrangements, to determine whether the individual firm for which the board is responsible is applying standards and practices consistent with those of cohorts in its field. Much of the day-to-day work involved should be undertaken by a compensation committee of the board of directors, authorized to hire such consultants and advisors, including attorneys and experts, as may be helpful, all with the primary goal of reducing the institution’s ultimate risk. Supervisory Initiatives. As already noted, the Federal Reserve announced, as a central recommendation of the Proposal, two separate supervisory initiatives designed to monitor the industry’s progress toward the implementation of effective compensation arrangements, and structured to identify best practices and advance the state of business methodologies in this field. These initiatives consist of: A review of large, complex banking organizations (LCBOs), to be conducted on a “horizontal” basis of these institutions across the affected grouping of these firms, and focusing on specific reviews of the actual incentive compensation arrangements in question to assure their conformity with adequate risk management and assessment standards, as well as an analysis of awards and payments to ascertain that they do not pose a threat to the safety and soundness of the pertinent organization; and A study of community and regional banks to make certain that these non-LCBO organizations have adequate risk management and control frameworks in place, as well as incentive compensation policies and standards, that are consistent with the complexity and size of the institution being monitored. Comments. Given the richness and diversity of experience on the subject of incentive compensation, and the inherently particularistic nature of the judgments and standards involved, the Federal Reserve is soliciting comments from interested parties, to be received, as noted, on or before November 27, 2009, on the Proposal in question, and on the following broad range of topics: The overall viability, efficacy and utility of the Proposal under consideration, in light of its stated purpose of rendering more safe and sound financial institutions while stimulating effective employee performance and goal-setting; Whether the proposed collection of information is necessary for the proper performance of the Federal Reserve’s functions, and its practical effect on the firms and entities involved; The accuracy of the Federal Reserve’s estimate of the burden of the proposed information collection, including the cost of compliance; Ways to enhance the quality, usefulness and clarity of the information to be collected; and Methods to minimize the burden of information collection on respondents, including through the use of automated collection techniques. The Federal Reserve will assess and revise its Proposal in light of comments received, and will also continue to collaborate with multilateral organizations such as the Group of Twenty and the Financial Stability Board, in the on-going development and refinement of the policies and recommendations in question.
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Next Steps. For those firms affected by the scope of the Proposal and facing the prospects of collaborating with the regulators on those supervisory initiatives already announced, the opportunity to comment on the nature of the recommendations and on the burdens potentially involved in these initiatives will be of great importance in guiding the regulators in a more efficient and constructive formulation of the rules and programs involved. The Federal Reserve has made clear its intention, as set forth in various sections of the Proposal, to be guided by the responses received, particularly on matters relating to cost and difficulty of application of the norms and standards as set forth in this guidance. What is clear is that, in addition to ongoing interpretations and rulings to be received from the Federal Reserve and other banking regulators, the topic of restricting executive compensation will continue to be a highly controversial and charged subject, reflecting the input of further determinations by Special Master Feinberg in the context of TARP recipients, as well as the outcome of the legislative process. In this regard it should be noted that Senator Christopher Dodd (D. Conn.), who chairs the Senate Banking Committee, has recently indicated his intention to introduce comprehensive financial services reform legislation designed to complement and expend the bill on these matters working its way through the House Financial Services Committee and the full House of Representatives. Expected in mid-November, the Dodd bill has been announced as covering consumer regulation, systemic risk supervision and consolidated banking regulatory authority. It is expected that provisions dealing with overall restrictions on executive compensation at affected financial firms will also be a part of this proposed legislation, particularly in light of Senator Dodd’s interest in this subject, as evidenced by his authorship in the stimulus legislation passed by the Congress in February of this year of an amendment that provided the jurisdictional basis for Special Master Feinberg’s recommendations and decisions concerning TARP recipients. Our firm will continue to monitor and advise on these developments, keeping in mind that the ultimate disposition of the politically sensitive topic of executive compensation may need to await further resolution of these overlapping regulatory, executive and legislative developments before final clarity is ultimately achieved.
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