Federal Banking Agencies Release Final Guidance on “Sound Incentive Compensation Policies”

June 29, 2010

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) adopted 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:

  1. Provide employees incentives that appropriately balance risk and reward in a manner that does not encourage employees to expose their organizations to imprudent risk;
  2. Be compatible with effective controls and risk-management; and
  3. 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:

  1. Senior executives (i.e. “executive officers” under Federal Reserve rules and “named executive officers” under SEC proxy reporting rules);
  2. Other employees responsible for oversight of the banking organization’s firm-wide activities or of material business lines;
  3. Employees (including non-executives) who may expose the organization to material amounts of risk (such as traders with large position limits); and
  4. 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.

Scaled Compliance

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 multiple years.

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 unit.

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 Executive Compensation Practice Group.