On June 21, 2010, the Board of Governors of the Federal Reserve System, the
Office of the Comptroller of the Currency, the Federal Deposit Insurance
Corporation, and the Office of Thrift Supervision (collectively, the Agencies)
final guidance for reforming incentive compensation practices throughout
the banking industry.
The guidance was originally proposed in October 2009 by the Federal Reserve,
and as adopted, will apply to all banking organizations under the supervision of
the Agencies. The guidance is effective immediately.
Three Key Principles
Like the proposed guidance, the final guidance sets forth three key
principles on which incentive compensation arrangements (ICAs) at a banking
organization should be based. All ICAs should:
- Provide employees incentives that appropriately
balance risk and reward in a manner that does not encourage employees to
expose their organizations to imprudent risk;
- Be compatible with effective controls and risk-management; and
- Be supported by strong corporate governance, including active and
effective oversight by the organization’s board of directors.
Scope & Applicability
For purposes of the guidance, incentive compensation is defined as any
current or potential compensation that is tied to achievement of one or more
specific metrics (e.g., a level of sales, revenue, or income). It does not
include base salary, awards that vest solely based on service and the passage of
time, or arrangements (such as qualified retirement plans) to the extent
benefits are accrued based on salary and not performance metrics.
The guidance only applies to ICAs for certain covered employees, including:
- Senior executives (i.e. “executive officers”
under Federal Reserve rules and “named executive officers” under SEC proxy
- Other employees responsible for oversight of the banking organization’s
firm-wide activities or of material business lines;
- Employees (including non-executives) who may expose the organization to
material amounts of risk (such as traders with large position limits); and
- Groups of employees who are subject to the same or similar incentive
compensation arrangements and who, in the aggregate, may expose the
organization to material risk (such as loan officers who, as a group,
originate loans that account for material amounts of the organization’s
overall credit risk).
Tellers, bookkeepers, couriers and data processing personnel
will generally be exempt from the requirements.
The guidance emphasizes that the time and effort needed to comply with the
requirements will vary depending on the size of the organization and the number
and complexity of its ICAs. Large banking organizations (LBOs) are expected to
devote substantial resources to – and have systematic and formalized processes
and procedures for – complying with the requirements, including regular,
multi-level reviews of ICAs with both backward-looking assessments of how well
the ICAs are performing and forward-looking analyses of how the ICAs could
potentially encourage different types of risk-taking behavior. The policies and
procedures of smaller banking organizations may be less extensive, detailed and
formalized than those of LBOs.
First Principle: Balance
The guidance specifically endorses the use of four design features to help
ensure that ICAs appropriately balance risk and reward: (1) risk adjustment of
incentive payouts (i.e., the riskier the activity on which the award is based,
the lower the payout relative to less risky activities); (2) deferral of payment
with potential clawbacks for performance or risk outcomes; (3) use of longer
performance periods; and (4) reduced leverage for short-term performance
measures (i.e., the higher the short-term performance threshold, the slower the
rate at which an incentive payment is earned).
The guidance specifically recommends that incentive compensation for senior
executives at LBOs be structured to involve deferral of a substantial portion of
the executive’s incentive compensation over a multi-year period, substantial use
of multi-year performance periods, and payment of a significant portion of the
incentive compensation in the form of equity-based instruments that vest over
In addition, although not banning the arrangements outright, the final
guidance specifically frowns on severance and golden parachute arrangements that
could result in large additional payments without regard to risk outcomes, and
on “golden handshake” agreements that make up for forfeited incentive
compensation an employee leaves behind when he or she moves to another firm.
Second Principle: Controls
The final guidance requires banking organizations to have strong controls to
ensure that their processes for establishing balanced ICAs are followed,
including appropriate input from risk-management personnel into the design and
implementation of ICAs. These risk-management personnel are expected to have
appropriate skill sets and experience, and to be compensated based on their
functions rather than the financial results or performance of their business
Third Principle: Governance
The final guidance requires a banking organization’s board of directors (or
appropriate committee thereof, such as the compensation committee) to actively
oversee the design and implementation of the organization’s ICAs, including to
directly approve all ICAs for senior executives.
Members of the board or the committee responsible for this function are
expected to have levels of expertise and experience in risk-management at
financial institutions, either individually or collectively, that is appropriate
for the size of the organization and the complexity of its ICAs. Banking
organizations (whether or not publicly traded) are expected to provide
disclosure concerning their ICAs and risk-management processes to their
shareholders, for senior executives as well as other covered employees. For
publicly traded organizations, this may extend beyond what is currently called
for under similar SEC disclosure rules.
Current Enforcement Efforts
The Agencies have announced special supervisory initiatives to review the ICA
practices at regulated banking organizations, with the Federal Reserve acting as
the lead monitor, in addition to the Agencies’ regular safety and soundness
reviews (which will include review of ICAs as well).
In the press release announcing the final guidance, the Agencies listed four
areas in which they feel that banking organizations had been deficient: (1)
inability to identify which employees could expose the organizations to material
risk; (2) inability to fully capture the risks involved with ICAs, and failure
to apply risk-adjustment methods to enough employees; (3) taking a
“one-size-fits-all” approach to deferred compensation arrangements, and failing
to tailor the deferral arrangements according to the type or duration of risk;
and (4) lack of adequate mechanisms to evaluate whether established practices
are successful in balancing risk. Banking organizations should expect the
Agencies to follow up on these four points in future reviews.
Implications for Companies Outside the Banking Industry
Although the guidance only applies to regulated banking organizations, the
three key principles announced in the guidance can be easily translated by
shareholder groups or regulatory bodies to ICA practices at companies outside
the banking industry as well.
Financial service companies (such as investment advisers, broker-dealers, and
insurance companies) on the periphery of the regulated group should pay
particular attention to the guidance and its implications for their own ICA
policies, as the guidance may come to be viewed as containing best practices for
a wider group of financial service entities. Even non-financial companies –
particularly public companies where ICAs contribute significantly to senior
executive compensation and which must make detailed public disclosure regarding
these ICAs – should consider how the themes and concepts in the guidance may
apply to their own arrangements.
For more information on the new guidelines and their implications, please
contact any member of our
Compensation Practice Group.