2. Contents
1 Introduction
2 The risk of rewards: How did
we get here?
4 The FDIC’s proposed regulations
11 Understanding the proposed
regulations in context
12 Proposed methodology for
compliance
15 Action steps: Top 10 tips
3. Introduction
Many believe that excessive executive compensation and
flawed incentive compensation practices can be at least
partially blamed for the imprudent risk-taking that helped
spark the economic crisis. Financial institutions face more
scrutiny from regulators and the general public than ever
before particularly when it comes to executive and incentive
pay. In response, the president signed the Dodd-Frank Wall
Street Reform and Consumer Protection Act (Dodd-Frank
Act) into law on July 21, 2010. Among the Dodd-Frank Act’s
many provisions are new rules for incentive compensation.
On Feb. 7, 2011, the Federal Deposit Insurance Corporation
(FDIC) proposed a number of regulations for implementing
compensation provisions in the Dodd-Frank Act. The FDIC’s
proposed regulations reach beyond banks and will affect a
range of financial services firms, including broker-dealers and
investment advisers. The purpose of this white paper is to
review the historical background leading up to the FDIC’s
recent proposals, as well as to provide insight and analysis both
from a compliance perspective and in light of the trends and
issues surrounding executive compensation in the financial
services industry.
Financial institutions face more scrutiny from regulators and the general public
than ever before particularly when it comes to executive and incentive pay.
Beyond banks: New incentive compensation rules reach entire industry 1
4. The risk of rewards:
How did we get here?
Most of the principles and plan design features (e.g., mandatory The events, laws, regulations and related documents listed
deferrals, risk-adjusted awards and longer-term performance below serve as milestones marking the increases in regulatory
periods) outlined in recent reports and statements in the scrutiny of executive and incentive-based compensation in the
United Kingdom have been incorporated in newly proposed U.S. and global banking system. This process began with the
and released incentive-based compensation rules in the United financial crisis in the fall of 2008 and continued as follows:
States. For instance, a recent history of incentive compensation
policies and practices in the financial services industry can
be found in A review of corporate governance in UK banks
and other financial industry entities.1 This report, prepared
by Sir David Walker and published on July 16, 2009, was
commissioned by then-Prime Minister Gordon Brown in
response to the economic crisis. In August 2009, the UK’s
Financial Services Authority published Policy Statement 09/15,
Reforming remuneration practices in financial services.2 This
exhaustive policy statement presented new principles and a
complex structure for designing, implementing and controlling
compensation (remuneration) arrangements.
1
Walker, Sir David. A review of corporate governance in UK banks and other financial industry entities. Originally published July 16, 2009. webarchive.nationalarchives.gov.uk/+/
http://www.hm-treasury.gov.uk/d/walker_review_261109.pdf.
2
Financial Services Authority. Policy Statement 09/15, Reforming remuneration practices in financial services, August 2009, www.fsa.gov.uk/pubs/policy/ps09_15.pdf.
2 Beyond banks: New incentive compensation rules reach entire industry
5. Date Event Description
Oct. 3, 2008 The Emergency Economic Stabilization Act Created three new programs: auctions for troubled assets, direct capital purchases (CPP), and
interventions to prevent the failure of systemically significant institutions. Compensation effects
include enhanced clawbacks, new limits on tax deductibility, prohibitions on golden parachutes,
and prohibitions on incentives for unnecessary and excessive risks.
Feb. 17, 2009 The American Recovery and Reinvestment Act Established compensation caps; clawbacks; restrictions on incentive pay; and prohibitions on
golden parachute payments, luxury expenditures, and unnecessary or excessive risks.
April 2, 2009 Principles from the Financial Stability Board The Group of Twenty (G-20) issued these principles for sound incentive compensation practices.
June 10, 2009 The U.S. Treasury’s five principles regarding Timothy Geithner emphasized the importance of risk and time horizons and sound risk
compensation management. Geithner also called for a review of golden parachutes and supplemental
executive retirement plans (SERPs) and for greater transparency and accountability.
July 16, 2009 A review of corporate governance in UK banks Discussed the global financial market meltdown and its relationship to compensation.
and other financial industry entities Recommended drastic reforms in executive compensation and corporate governance.
August 2009 Financial Services Authority Policy Statement This vehicle for sweeping regulatory reform established mandatory deferrals, specific design
09/15, Reforming remuneration practices in rules for equity pay, a code of conduct for compensation consultants, strong governance
financial services requirements, and limits on compensation.
Oct. 27, 2009 The Federal Reserve Board’s proposed The Federal Reserve Board (FRB) identified four methods to be used when designing plans:
guidance on incentive compensation plans deferral of payment, a longer performance period, risk-based adjustment of rewards, and
reduced sensitivity to short-term performance.
Dec. 16, 2009 SEC’s Final Rule, Proxy Disclosure The Final Rule requires SEC registrants to disclose compensation policies and procedures as
Enhancements they relate to risk management to the extent that risks arising from a registrant’s compensation
policies and procedures are reasonably likely to have a material adverse affect on the
registrant.
June 21, 2010 Guidance on Sound Incentive The federal banking regulators issued final guidance on sound incentive compensation policies.
Compensation Policies This guidance included a discussion of tying rewards to longer-term performance.
July 21, 2010 The Dodd-Frank Wall Street Reform and The Dodd-Frank Act outlined new rules for incentive compensation, including clawbacks and say-
Consumer Protection Act on-pay provisions.
Feb. 7, 2011 Proposed rulemaking to implement Section Section 956 prohibits incentive-based compensation that encourages inappropriate risk-taking by
956 of the Dodd-Frank Act covered financial institutions and that is deemed to be excessive or may lead to material losses.
Beyond banks: New incentive compensation rules reach entire industry 3
6. The FDIC’s proposed regulations
Overview We’ll focus specifically on Section 956, which requires that
A number of the provisions in the Dodd-Frank Act address agencies issue regulations or guidelines with respect to incentive-
corporate governance and executive compensation issues. based compensation practices at covered financial institutions.
Other relevant sections include:
971 — Proxy access authority The SEC has been granted authority to adopt rules for including the names of shareholder board
nominees in proxy solicitation materials.
951 — Say-on-pay The Dodd-Frank Act mandates a say-on-pay vote for shareholders on the compensation of the issuer’s
named executive officers.
957 — Broker discretionary voting Stock exchanges must prohibit brokers from voting customer shares without receiving voting
instructions.
952 — Compensation committee and adviser independence The SEC must direct national securities exchanges to require member companies to satisfy heightened
independence standards similar to those that apply to audit committees.
972 — Disclosure of board leadership The SEC must issue rules for filers to disclose the reasoning behind establishing the same or different
roles for the chairman and the CEO.
953 — Additional executive compensation disclosures This is a requirement for public companies to explain the pay-for-performance relationship and to
disclose the ratio of CEO pay to the median compensation for all employees.
954 — Clawback of incentive compensation This provision requires all public companies to establish and enforce an incentive compensation
clawback requirement for current and former employees.
955 — Hedging by employees and directors The SEC is directed to issue rules requiring companies to disclose policies on whether employees or
directors are permitted to hedge their stock-based compensation.
956 — Compensation structures of financial institutions Financial institutions with assets of $1 billion or more must disclose the structure of all incentive
compensation arrangements.
4 Beyond banks: New incentive compensation rules reach entire industry
7. Key implementation dates Covered financial institution (CFI) — Defined to include any
The notice of proposed regulation called for a comment period of the following types of institutions that have $1 billion or more
of 45 days beginning Feb. 7, 2011. Following the comment in assets:
period, the final regulations will be published in the Federal • A depository institution or depository institution holding
Register. The final regulations will become effective six months company, as such terms are defined in Section 3 of the
following publication in the Federal Register. Federal Deposit Insurance Act (FDIA)
• A broker-dealer registered under Section 15 of the Securities
Definitions Exchange Act of 1934
The following definitions were used to clarify the new rules: • A credit union, as described in Section 19(b)(1)(A)(iv) of the
Federal Reserve Act
Compensation — Defined as all direct and indirect payments, • An investment adviser, as such term is defined in Section
fees or benefits, both cash and noncash, awarded to, granted to, 202(a)(11) of the Investment Advisers Act of 1940
or earned by or for the benefit of any covered person in exchange • The Federal National Mortgage Association (Fannie Mae)
for services rendered to the covered financial institution. This • The Federal Home Loan Mortgage Corporation (Freddie
would include payments or benefits pursuant to an employment Mac)
contract, compensation or benefit agreements, fee arrangements, • Any other financial institution that the appropriate federal
perquisites, stock option plans, postemployment benefits, regulators, jointly, by rule, determine should be treated as a
or other compensatory arrangements. For credit unions, the CFI for these purposes
definition of compensation specifically excludes reimbursement
for reasonable and proper costs incurred by covered persons As the last item above implies, these rules are designed
in carrying out official credit union business; provision of to cover a broad range of financial institutions, as well as to
reasonable health, accident and related types of personal address compensation arrangements that extend beyond those
insurance protection; and indemnification. included in the Dodd-Frank Act. The uninsured branches and
agencies of a foreign bank, as well as the other U.S. operations of
foreign banking organizations that are treated as bank holding
companies pursuant to Section 8(a) of the International Banking
Act of 1978, will be considered CFIs. The Federal Home Loan
Banks with assets of more than $1 billion and the FHLBanks
Office of Finance will also be subject to the proposed rules.
Beyond banks: New incentive compensation rules reach entire industry 5
8. Covered person — A covered person is any executive officer, Executive officer — Defined as any person who holds the
employee, director or principal shareholder of a CFI. No specific title or performs the function (regardless of title, salary or
categories of employees are excluded from the scope of the compensation) of one or more of the following positions:
proposed rules. Certain prohibitions apply only to a subset of president, CEO, executive chairman, chief operating officer,
covered persons. For federal credit unions, only one director, if CFO, chief investment officer, chief lending officer, chief legal
any, may be considered a covered person, since under Federal officer, chief risk officer, or head of a major business line.
Credit Union Act and National Credit Union Administration In addition, directors and boards of directors are defined
(NCUA) regulations, only one director may be compensated as as board members or boards performing a similar function. A
an officer of the board. principal shareholder owns at least 10 percent of the voting
securities of the financial institution. Total consolidated assets
Incentive-based compensation — Defined as any variable must generally be $1 billion or more for the institution to qualify
compensation that serves as an incentive for performance. The as a CFI under the proposed rules.
form of payment, whether it is cash, an equity award, or other
property, does not affect whether the compensation meets the
definition of incentive-based compensation. There are several
types of compensation that do not fall within the scope of this
definition, including:
• compensation that is awarded solely for, and the payment of
which is solely tied to, continued employment (e.g., salary);
• compensation arrangements that provide rewards solely
for activities or behaviors that do not involve risk-taking
(e.g., payments made solely for achieving a higher level of
education or maintaining a professional certification);
• compensation arrangements that are determined based solely
on the employee’s level of fixed compensation and do not vary
based on one or more performance metrics (e.g., employer
contributions to a 401(k) retirement savings plan computed
using a fixed percentage of an employee’s salary); and
• dividends paid and appreciation realized on stock or other
equity instruments that are owned outright by a covered
person. However, stock or other equity instruments awarded
to a covered employee under a contract, arrangement, plan
or benefit would not be considered owned outright while
subject to any vesting or deferral arrangement (irrespective of
whether such deferral is mandatory).
6 Beyond banks: New incentive compensation rules reach entire industry
9. Prohibitions Inappropriate risks that may lead to a material financial loss
The proposed rules specify two prohibitions for covered The proposed rules prohibit any CFI from establishing or
persons at CFIs: maintaining any incentive-based compensation arrangement or
• establishing or maintaining any incentive-based any feature of any arrangement that encourages a covered person
compensation arrangements that encourage covered persons to expose the financial institution to inappropriate risks that could
to expose the institution to inappropriate risks by providing lead to a material financial loss. The provision acknowledges the
excessive compensation, and requirement in Section 956 of the Dodd-Frank Act mandating
• establishing or maintaining any incentive-based such prohibition. Further, the proposed rules clarify that Section
compensation arrangements that encourage inappropriate 39 of the FDIA does not include standards to determine whether
risks that could lead to a material financial loss. compensation arrangements may encourage inappropriate risks
that could lead to a material financial loss. However, these rules
In addressing whether an institution provides excessive point to existing supervisory guidance that addresses incentive-
compensation, the proposed rules refer to compensation based compensation, such as the Principles for Sound Incentive
standards established under Section 39 of the FDIA and expand Compensation Practices and, as mentioned earlier, the related
upon them. Under the proposed rules, compensation for a principles adopted by the Financial Stability Board.
covered person is considered excessive when amounts paid are Specifically, the prohibition will apply only to those
unreasonable or disproportionate to, among other things, the incentive-based compensation arrangements for individual
amount, nature, quality or scope of services performed by the covered persons or groups of covered persons whose activities
covered person. In making this determination, the agencies will may expose the CFI to a material financial loss. These persons
consider: include:
• the combined value of all cash and noncash benefits provided • executive officers or other covered persons who are
to the covered person; responsible for oversight of firmwide activities or material
• the compensation history of the covered person and other business lines;
individuals with comparable expertise at the CFI; • other individual covered persons, including non-executive
• the financial condition of the CFI; employees, whose activities may expose the CFI to a material
• comparable compensation practices in comparable financial loss (for example, traders with large position limits
institutions based on such factors as asset size, geographic relative to the CFI’s overall risk tolerance); and
location, and complexity of the institution’s operations and • groups of covered persons who are subject to the same or
assets; similar incentive-based compensation arrangements and who,
• the projected total costs and benefits to the CFI of the in the aggregate, could expose the CFI to a material financial
covered person’s postemployment benefits; loss (for example, loan officers who, as a group, originate loans
• any connection between the individual and any fraudulent that account for a material amount of the CFI’s credit risk).
act or omission, breach of trust or fiduciary duty, or insider
abuse with regard to the CFI; and
• any other factors the agencies determine to be relevant.
Beyond banks: New incentive compensation rules reach entire industry 7
10. Complying with the proposed rules performance period, and amounts paid are adjusted for actual
The proposed rules state that an incentive-based compensation losses or other aspects of performance that become clear
arrangement established or maintained by a CFI for one or more during the deferral period.
covered persons does not comply unless it: 3. Longer performance periods — With this method, the time
• balances risk with financial rewards (for example, by using period of the performance measures is extended (e.g., from
deferral of payments, risk-based adjustment of awards, one year to two years). Longer performance periods and
longer performance periods, or reduced sensitivity to short- payment deferrals allow awards and payments to be made
term performance); after some or all of the risk outcomes are realized or better-
• is compatible with effective controls and risk management; known.
and 4. Reduced sensitivity to short-term performance — Under this
• is supported by strong corporate governance. method, the rate for which awards are increased for a covered
person who achieves a higher performance level is reduced.
The following provides additional details about these Rather than offsetting the risk-taking incentives for short-
standards: term performance, this method reduces their magnitude.
Balance of risk with financial rewards — The proposed The proposed rules note that these methods don’t encompass
rules identify four methods that are currently used to make the universe of risk-adjusting methodologies and that in the
compensation arrangements more sensitive to risk: future, new methods will emerge as incentive compensation
1. Risk-based adjustment of awards — This method adjusts practices evolve. Additionally, each method has advantages
the size or amount of incentive-based compensation awards and disadvantages that vary depending on the situation, and in
based on measures that take into account the risk the covered some cases, applying two or more methods may be necessary to
person’s activity poses to the CFI. Such measures may be achieve an appropriate balance.
quantitative or based on managerial judgment subject to
appropriate oversight.
2. Deferral of payment — Under this method, the actual payout
of an award is delayed significantly beyond the end of the
The proposed rules note that these methods don’t encompass the universe of risk-
adjusting methodologies and that in the future, new methods will emerge as incentive
compensation practices evolve.
8 Beyond banks: New incentive compensation rules reach entire industry
11. Compatibility with effective controls and risk management The proposed rules allow institutions to use a cliff deferral
— The role of the board of directors and the board’s when applying the deferral period. In a cliff deferral, the
compensation committee will be to provide broad oversight in incentive compensation is deferred for a full three-year period.
the development of strong controls to govern the design and The proposed rules permit a ratable deferral (in which the
implementation of incentive compensation while ensuring an compensation is paid in equal installments over the three-
appropriate balance between rewards and associated risks. Under year deferral period) or a variable deferral (in which amounts
the proposed rules, the board (or a committee of the board) deferred are paid in unequal amounts, but not less than amounts
should actively oversee the development and operations of the under the ratable deferral, over the three years). For example, if
incentive compensation system and related processes. compensation totaling $300,000 is deferred, a variable deferral
For example, the board should review and approve the permits payment of $50,000 after the first year, $100,000 at the
overall purpose and goals of the system to ensure that they end of the second year, and the remaining $150,000 at the end of
are consistent with the financial institution’s risk tolerance. the third year.
Additionally, the board has an affirmative requirement to
receive relevant compensation and related performance data and Special review and approval requirements for other
to assess whether the incentive compensation plan design and designated individuals — In the proposed rules, regulators
performance are consistent with the requirements in Section 956 acknowledge that certain non-executive officers potentially have
of the Dodd-Frank Act. the ability to expose the financial institution to losses that are
substantial relative to the institution’s size, capital, and overall
Larger financial institutions — The proposed rules provide risk tolerance. To strike an appropriate balance and discourage
special deferral arrangements for executive officers and a special exposure to the risk of material financial losses, the board of
review and approval requirement for other individuals at larger directors or a committee of the board must identify any non-
financial institutions (generally defined as those institutions with executives whose job responsibilities and impact on risk rise to
assets of $50 billion or greater) as described below. a level that could expose the financial institution to potentially
material financial losses.
Mandatory incentive compensation deferral — The deferral- Additionally, the board (or committee) may not approve any
of-compensation requirement states that at least 50 percent of the incentive compensation arrangement unless it determines that the
incentive-based compensation of an executive officer should be arrangement, including the payment method, effectively balances
deferred over a period of at least three years. Regulators believe the employee’s reward with the range and time horizons of
that incentive deferrals for executive officers at larger financial risks associated with the employee’s activities. The board must
institutions are likely to improve the balance between risk and evaluate the effectiveness of the risk-balancing methods that the
reward when a substantial portion of the executive’s incentive financial institution uses to mitigate financial risk.
compensation is deferred over a multiyear period. This belief is
consistent with international standards and allows for additional
time in which risk and performance can be evaluated, while
acknowledging that ex-ante risk adjustments are difficult to
measure and model.
Beyond banks: New incentive compensation rules reach entire industry 9
12. Policies and procedures — Under the proposed rules, CFIs • a record of the incentive-based compensation awards made
will have to adopt policies and procedures governing incentive under the arrangements or plans, and
compensation arrangements in order to foster transparency and • records reflecting the persons or units involved in approving
promote compliance and accountability. The scope of these and monitoring the arrangements or plans.
policies and procedures should reflect the size and complexity
of the financial institutions’ business activity as well as the Where deferral in connection with an incentive-based
scope and nature of their compensation arrangements. The compensation arrangement is used, the policies and procedures
regulators noted that some lower-level employees, such as tellers, should reflect the amounts of any payments, the time period
bookkeepers, couriers or data processing personnel, may be appropriate to the duties and responsibilities of the covered
outside the scope of these regulations. person, the risks associated with the person’s duties and
To ensure that risks are adequately understood, regulators responsibilities, and the size and complexity of the CFI.
believe that personnel involved in risk management, risk Additionally, the policies and procedures should require that
oversight and internal control monitoring should be involved any deferred amounts paid be adjusted for actual losses or other
in all phases of the design of incentive-based compensation measures of performance that are realized or become known
arrangements. Additionally, to maintain adequate independence, during the deferral period.
the institution’s risk management, risk oversight and internal In keeping with the need of every financial institution
control personnel must have a reporting relationship to senior for safety and soundness, the proposed rules require policies
management that is separate from their relationships to covered and procedures under which any incentive compensation
persons. The full-scope policies and procedures should be arrangement is subject to a strong corporate framework that
designed so that the board or committee receives sufficient includes active and ongoing board oversight.
data and analysis from management and other sources to assess
whether the overall design and performance of the institution’s Other topics — The proposed rules call for financial institutions
incentive compensation arrangements are consistent with both to describe the extent to which they prohibit personal hedging
Section 956 and the institution’s overall risk management policies. strategies to lock in the value of their equity compensation that
Preparation and documentation of incentive compensation is vested over time. Finally, the anti-evasion provision prohibits
policies and procedures should address the institution’s processes a CFI from evading the restrictions of the proposed rules by any
for establishing, implementing, modifying and monitoring indirect act such as replacing substantial numbers of covered
incentive compensation arrangements in enough detail for employees with independent contractors.
regulators to determine the extent of compliance with the Dodd-
Frank Act and the proposed rules. Documentation maintained
by a CFI should include but not be limited to:
• a copy of all incentive compensation arrangements and plans,
• the names and titles of individuals covered by such
arrangements or plans,
10 Beyond banks: New incentive compensation rules reach entire industry
13. Understanding the proposed
regulations in context
Largest institutions face biggest impact of one-half or more of all incentive compensation for executive
Although the Dodd-Frank Act and U.S. federal agencies have officers sends a clear message that larger banks must implement
addressed these proposed rules to a broad group of financial more restrictive incentive compensation policies. These policies
institutions, the focus of these rules is to restructure incentive must provide a substantial means to adjust the awards after the
compensation practices at larger financial institutions. Further, completion of the performance period based on future losses or
Policy Statement 09/15 as promulgated by the Financial Services other changes that take place in performance metrics after the
Authority — along with the Walker report — targets larger UK awards have been earned.
and international financial institutions. One can conclude that these Another message to the larger financial institutions is that the
institutions contributed more to the financial crisis and thus helped risk of material losses extends to employees outside the executive
spark the too-big-to-fail situation. The requirement of a deferral suite. The recent controversy over large bonus payments to
employees of banks in major money centers is a prime example
of what regulators are aiming to rectify. In the future, after these
rules are final, the practice of paying large bonus payments
will likely be prohibited. Violating these proposed rules —
especially those concerning bonus payments — will pose a huge
reputational risk.
Beyond banks: New incentive compensation rules reach entire industry 11
14. Proposed methodology
for compliance
A reasoned approach to complying with the proposed The first method requires that incentive plans and
regulations and ensuring consistency with the Guidance on arrangements be carefully and judiciously designed to ensure
Sound Incentive Compensation Policies (the Guidance) requires a that the potential reward or financial gain is balanced against the
three-pronged methodology that is intended to address: broad range of risks that may be associated with the reward or
• incentive plan design that appropriately balances risks with gain. Incentive plan design has traditionally been management’s
rewards, role and not an area where banking and securities regulators have
• integrated internal controls and risk management, and set policy — until recently. The SEC has broadened the scope
• strong corporate governance. of required proxy disclosures to include the Compensation
Discussion and Analysis, or CD&A, which expands on
The history of this tripartite methodology goes back to the the link between compensation and company/shareholder
Walker report, which concluded that boards of directors had performance. The American Recovery and Reinvestment Act
been neglecting their oversight responsibility of addressing of 2009 (ARRA) and Troubled Asset Relief Program (TARP)
the risks implicit in incentive compensation, especially the provided for restrictions on incentive pay and prohibitions
compensation of individuals whose roles and behavior exposed on excessive risk-taking and other practices such as golden
certain large financial institutions to significant risks and material parachute payments. The Guidance further addresses this topic
financial losses. As a consequence, the FSA’s remuneration by noting that “an unbalanced arrangement can be moved
policy focused on methods of sound incentive plan design, toward balance by adding or modifying features that cause the
implementation of meaningful internal control policies, and amounts ultimately to be received by employees to appropriately
heightened scrutiny of remuneration policies by independent reflect risk and risk outcomes.”2 The proposed regulations
board members. These themes continued to surface within establish guidelines for all CFIs and mandatory requirements
the principles established by the Financial Stability Board. As for large CFIs (generally those with assets above $50 billion).
regulators and legislators in the United States sought direction When incentive compensation potentially exposes the CFI to a
on how to respond to the financial crisis, policymakers relied significant risk, the institution must adjust (lower) the reward to
upon these global precedents to formulate the U.S. approach that mitigate the risk of a material financial loss. For large CFIs, this
led to the federal banking regulators’ guidance. means establishing a mandatory 50 percent deferral of incentive
compensation for at least three years. However, the regulators
are unclear as to the best approach to risk mitigation. They
ultimately conclude that for the present, risk mitigation is best
accomplished by the deferral of incentive compensation for an
appropriate time period that allows adjustment for any material
financial loss incurred. Because many decisions about the time
and magnitude of extending credit will have a long-term impact
(sometimes as long as 30 years), this approach seeks to mitigate
losses and recapture inappropriate incentive payments. Other
design features include using performance measures that span
longer time periods, such as a three-year average ROI versus
annual net income. Finally, this approach requires the CFI to
lessen its emphasis on short-term performance.
12 Beyond banks: New incentive compensation rules reach entire industry
15. Establishing effective internal controls and risk management Adopting a strong corporate governance program to ensure
represents the second method suggested in the federal regulators’ sound incentive compensation policies is the final method
approach. Developing a robust set of internal controls over suggested in the approach to adopting the proposed regulations.
incentive plan design and implementation and over the A strong corporate governance program should include
monitoring of incentive pay is the desired outcome. For most meaningful and regular oversight by the board of directors (or
CFIs, this will require an expanded role for internal audit the compensation committee of the board). The board should
personnel, who will need to work closely with management and/ provide broad oversight and policymaking guidance regarding
or HR staff so that the organization can integrate the process the design, implementation, monitoring and approval process
of applying sound internal controls and risk management for all incentive arrangements for senior executives — including
practices to incentive compensation plans and arrangements. The payments and the sensitivity of those payments to risk outcomes.
proposed regulations and the Guidance express concern about Additionally, this oversight should be expanded to encompass all
potential conflicts of interest and have suggested that internal individuals whose responsibilities and actions potentially expose
audit staff not report directly to management personnel who the CFI to material financial losses. The board should receive
participate in incentive compensation plans that are reviewed by regular reports, which should include data and analysis regarding
internal audit staff. In fact, the Guidance — echoing FSA Policy incentive compensation plans and arrangements sufficient to
Statement 09/15 — specifies that compensation for internal audit allow a determination of whether the outcomes are consistent
and risk management staff should be based on performance with the organization’s safety and soundness requirements.
measures other than those used by management personnel Finally, the board should have sufficient resources, which should
participating in incentive compensation arrangements reviewed include possessing, or having access to, a level of expertise and
by internal audit or risk management personnel. This is clearly experience in risk management and compensation practices in the
a new role for most internal audit departments and represents a financial services industry that is appropriate given the nature,
departure in policymaking for many CFIs. scope and complexity of the organization’s activities.
Adopting a strong corporate governance program to ensure sound incentive
compensation policies is the final method suggested in the approach to adopting the
proposed regulations.
Beyond banks: New incentive compensation rules reach entire industry 13
16. As noted in the Guidance, many believe that excessive
executive compensation and flawed incentive compensation
practices can be at least partially blamed for the imprudent
risk-taking that helped spark the economic crisis. The
proposed regulations identify specific restrictions on incentive
compensation as described above and further state that incentive
compensation arrangements are not compliant unless they
balance financial risks with rewards,3 are compatible with
effective controls,4 and are supported by strong corporate
governance.5 We conclude that implementing the three
risk mitigation methods proposed in the Guidance and
establishing enhanced process improvements are not simple
tasks. Inventorying current plans for balancing risks with
rewards and addressing new and expanded roles for internal
audit and risk management personnel will require a substantial
time investment, especially for CFIs whose use of incentive
compensation is substantial and far-reaching. Finally, the
proposed regulations raise the bar for the board, requiring it to
become more closely involved than ever before with incentive
plan design and oversight. These new requirements were not
unexpected; however, their adoption will make dramatic changes
to incentive compensation at CFIs.
3
Compensation Discussion and Analysis.
4
Guidance on Sound Incentive Compensation Policies, p. 30.
5
Ibid.
14 Beyond banks: New incentive compensation rules reach entire industry
17. Action steps: Top 10 tips
Compliance with these new and proposed compensation rules can 5. Evaluate the corporate risk factors affecting the
be overwhelming. Here are 10 steps your institution can take now. current plans and arrangements, assessing their impact on
inappropriate risk-taking for the plan participants.
1. Determine if you are a CFI under the proposed rules and, if
so, determine if you qualify as a large CFI. 6. Determine the current role of internal audit in the design,
implementation and monitoring of compensation plans and
2. Complete a thorough inventory of all the current arrangements. Evaluate that role against the current and
compensation arrangements by accumulating all written and proposed regulatory guidance.
other documentation describing, among other things:
• who is eligible and participating in each plan, 7. Adjust your current incentive plans to incorporate the
• the key provisions for each plan and arrangement, FRB’s Guidance on Sound Incentive Compensation
• how the plans are designed and how the performance Policies and the proposed rule’s guidance. Add a deferral
targets are established, period for risk adjustment and a clawback feature, implement
• how awards levels are determined and how plans are longer performance periods and place less emphasis on short-
approved for implementation, term results.
• what compensation is excluded from consideration
(such as broad-based plans and 401(k)s), 8. Engage the board and compensation committee in a
• when and how frequently payments are made to continuing education process on the proposed rule and
participants, and related guidance. Confirm their expanded role in incentive
• the risk that the current incentive compensation plan plan design and approvals, and gain their support for the
may expose the CFI to excessive or inappropriate risks. expanded role of internal audit/risk management personnel.
3. Assess the scope of each incentive plan and arrangement 9. Implement an ongoing monitoring and review process
(i.e., the number of named executive officers or NEOs and for all incentive compensation arrangements to include
employees covered by all plans and arrangements, including management, internal audit and the compensation committee.
individuals whose position and compensation may expose
the institution to excessive risk). Assess the magnitude of the 10. Prepare for annual regulatory reporting requirements
current target and maximum annual total compensation for on incentive compensation plans and arrangements by
all plans and arrangements, and identify the time horizons accumulating relevant documentation and plan data, as well as
(annual, monthly, multi-year, etc.) of the payment scheme obtaining appropriate management and internal audit staff input.
and the risk exposure for each compensation arrangement.
4. Conduct a review of all compensation and internal
audit policies and procedures that govern the design,
implementation and payment for all incentive compensation.
Beyond banks: New incentive compensation rules reach entire industry 15
18. For more information
Henry Oehmann Nichole Jordan Jack Katz
National Executive Compensation National Banking and Securities National Managing Partner
Services Director Industry Leader Financial Services
Grant Thornton LLP Grant Thornton LLP Grant Thornton LLP
T 919.881.2773 T 212.624.5310 T 212.542.9660
E henry.oehmann@us.gt.com E nichole.jordan@us.gt.com E jack.katz@us.gt.com
Offices of Grant Thornton LLP
National Office Florida Missouri Pennsylvania
175 West Jackson Boulevard Fort Lauderdale 954.768.9900 Kansas City 816.412.2400 Philadelphia 215.561.4200
Chicago, IL 60604 Miami 305.341.8040 St. Louis 314.735.2200
312.856.0200 Orlando 407.481.5100 South Carolina
Tampa 813.229.7201 Nevada Columbia 803.231.3100
Washington National Tax Office Reno 775.786.1520
1250 Connecticut Ave. NW, Suite 400 Georgia Texas
Washington, DC 20036-3531 Atlanta 404.330.2000 New Jersey Austin 512.391.6821
202.296.7800 Edison 732.516.5500 Dallas 214.561.2300
Illinois Houston 832.476.3600
Arizona Chicago 312.856.0200 New York San Antonio 210.881.1800
Phoenix 602.474.3400 Oakbrook Terrace 630.873.2500 Long Island 631.249.6001
Downtown 212.422.1000 Utah
California Kansas Midtown 212.599.0100 Salt Lake City 801.415.1000
Irvine 949.553.1600 Wichita 316.265.3231
Los Angeles 213.627.1717 North Carolina Virginia
Sacramento 916.449.3991 Maryland Charlotte 704.632.3500 Alexandria 703.837.4400
San Diego 858.704.8000 Baltimore 410.685.4000 Raleigh 919.881.2700 McLean 703.847.7500
San Francisco 415.986.3900
San Jose 408.275.9000 Massachusetts Ohio Washington
Woodland Hills 818.936.5100 Boston 617.723.7900 Cincinnati 513.762.5000 Seattle 206.623.1121
Cleveland 216.771.1400
Colorado Michigan Washington, D.C.
Denver 303.813.4000 Detroit 248.262.1950 Oklahoma Washington, D.C. 202.296.7800
Oklahoma City 405.218.2800
Minnesota Tulsa 918.877.0800 Wisconsin
Minneapolis 612.332.0001 Appleton 920.968.6700
Oregon Milwaukee 414.289.8200
Portland 503.222.3562
16 Beyond banks: New incentive compensation rules reach entire industry
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