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Incentive Compensation for Banks in the Dodd-Frank Era

Guidelines for incentive compensation policies indicate that such policies are “principles based,” leaving institutions with both a great deal of flexibility in addressing their requirements , but also a lack of clarity

Steven A. Lenn  

A community bank client recently asked us to prepare an executive employment agreement and a Board policy addressing requirements contemplated by the Dodd-Frank legislation and guidance with respect to incentive compensation provided jointly by the federal banking regulatory agencies.

While intended only as a general overview, and not necessarily applicable to any particular circumstance, the following outline and attachments might be helpful and of interest to institutions subject to those requirements.

As reflected, the incentive compensation policies in the agencies’ guidance indicate that they are “principles based,” leaving institutions with both a great deal of flexibility in addressing their requirements on one hand, but also a lack of clarity on the other. Accordingly, documentation of the exercise of appropriate governance based on adequate information is especially important in minimizing the potential for regulatory issues.

  1. Although the Dodd-Frank legislation and the agencies’ policies and guidelines apply, by their terms, only to institutions that are $1 billion and larger, the underlying principles and objectives will be applied to all insured institutions through the normal examination process.

  1. Authority to regulate compensation is initially rooted in the “safety and soundness” provisions of the Federal Deposit Insurance Act. Policies specific to incentive compensation have evolved under a series of policy statements issued primarily during the past 20 years, with the greatest activity occurring in connection with requirements under the Troubled Asset Relief Program (TARP) and Dodd-Frank. Not surprisingly, TARP requirements are significantly more detailed and stringent than those that appear to be contemplated thus far under Dodd-Frank.

  1. On June 25, 2010, federal banking regulators and the SEC issued joint guidelines covering, among other things, “safety and soundness” considerations and criteria with regard to incentive compensation. Relevant portions of these guidelines are attached as Exhibit 1.

  2. Generally, the incentive compensation requirements under Dodd-Frank and the agencies’ guidance are focused on the processes that insured institutions should follow, with an emphasis on several key principles:

  1. Avoiding “excessive” compensation and providing an appropriate mix of base and incentive compensation.

  2. Balancing risks and financial performance to minimize the potential that individuals eligible for incentive compensation awards pursue short-term earnings objectives that would or could present “excessive risks” in the longer term.

  3. Assuring that compensation arrangements are compatible with controls and risk management.

  4. Having in place appropriate “governance” structures and processes sufficient to provide effective and informed oversight.

  1. Responsibility vested in “independent” members or committees of the board of directors.

  2. Appropriate documentation of the policies and process reflecting:

  • the availability to and use by the board of data from credible outside sources (industry reports and/or qualified third-party sources such as recognized compensation consultants) to assess if (i) the overall design and application of incentive arrangements are consistent with Dodd-Frank and regulatory guidance, and (ii) the total compensation package is reasonable based on peer group statistics; and

  • in the case of each incentive compensation award to persons whose activities and responsibilities can have a material impact on the institution’s financial results and/or the safety and soundness of its operations, an informed balancing of risk and reward in a manner reasonably designed to discourage (or at least not encourage) excessive risk.

  1. The assessment of executive compensation is now part of management evaluation in CAMELS ratings.

  2. Initial proposals and analysis focused on the use of “clawbacks” to recover incentive compensation awards based on future events or circumstances. “Pure” clawbacks, i.e., those involving the recapture of payments already made, present some significant issues, including:

  1. Difficulty in enforcement

  2. Collectability and costs of collection

  • Some or all of the incentive compensation award may already have spent.

  • The award recipient may no longer be with the institution, eliminating the leverage of continued employment to promote voluntary compliance

  1. The risk of adversely affecting relationships with key employees.

  2. Tax issues for the incentive award recipients and tax and accounting issues for the institution.

  1. To address the issues necessarily involved in pure clawbacks, a number of institutions are instead using holdbacks instead of clawbacks.[1] These generally involve:

  1. Deferred vesting

  2. Deferred payment of vested awards

  3. Annual percentage vesting or payment over periods of 3-5 years

  4. The necessity of addressing potential tax and accounting issues.

  1. Regulatory guidance suggests several approaches:

  1. Deferring payment beyond the performance period for which an incentive compensation award is made and allowing for an adjustment charged against the deferred amount payable based on post-performance period losses, reserves, and/or required financial restatements.

  2. Adjusting awards at the time they are made based on quantifiable measures of risk (this option can be very complicated).

  3. Extending performance periods used for measurement so that some or all of risk outcomes will be determined or may be more determinable before payment is made.

  4. Greater use of equity or “equity equivalents.”

  1. Triggering Events:

  1. Available information reflects that the most common triggering event is a required restatement of financials that would have changed the calculation of an incentive award. Considerations that are often taken into account in this particular regard include

  2. Fault (knowing participation or acquiescence)

  3. No fault

  4. Degree of fault

  5. Failures/weaknesses in the exercise of management responsibilities

  6. Ethical violations

  7. Actual future losses even if they don’t require restatement of the financials on which the award was calculated (although, at least to some extent, losses recognized in future performance periods will impact awards for those periods).

  8. Non-compete/non-solicitation violations

  9. Termination for cause

  1. Methods of Accomplishing

  1. Specific contract provisions

  2. Incorporation into contracts or formal incentive plans of policies adopted by the Board, compensation or other committee of independent directors with responsibility for awards

  3. Examples attached

  1. Exhibit 4. Clawback provision from January 1, 2011, Heritage Bankshares Employment Agreement filed with the SEC

  2. Exhibit 5. Green Bankshares Letter Agreement (under TARP)

  3. Exhibit 6. Green County Bancorp Board Policy Statement and Letter Agreement of Employee to Be Bound Thereby

  4. Exhibit 7. August 17, 2010, report of Frederick W. Cook & Co., Inc. (Compensation Consultants) “Current Recapture Policies and the Dodd-Frank Act” which includes both sample group (90) analysis and specific policies from financial institutions (Bank of America and JPMorgan Chase) and non-financial companies (Cisco, Medtronic, DuPont, CVS, Chevron)

  5. Exhibit 8. Sample Clawback Policies of Boeing and CSC

  6. Exhibit 9. Deutsche Bank Group 2009 Remuneration Report

  7. Exhibit 10. Sample Contract Provision

  1. Miscellaneous Issues

  1. Due process notice and opportunity to be heard (see Exhibit 5)

  2. Indemnification policies reflected in organizational documents and director and officer insurance policy provisions relevant to contested recapture, in particular the extent to which:

  3. the institution may be obligated to advance or reimburse an individual whose award is to be clawed back or forfeited for legal fees incurred by the recipient in contesting the institution’s action

  4. the affected individual might have claims under the institution’s D&O Policy for reimbursement of expenses or recovery of amounts recaptured or forfeited

  5. State employment law considerations


In reviewing this summary and considering its applicability to your institution, please note that it is general in nature and not intended as legal or regulatory advice for any particular circumstance. While any element of the outline may be applicable to an institution’s situation, it should not be regarded or utilized as a substitute for specific, informed legal advice.

1See Exhibit 2, “Clawbacks or Hold-Backs,” by Gayle Applebaum of McLagan (a performance reward consulting firm for the financial services industry), and Exhibit 3, “Dodd-Frank Clawbacks: Hot Issues for 2012,” by James Earle and Allison Wilkerson of K&L Gates (compensation consultants) for a good summary of these issues and considerations.