Incentive Compensation for Banks in the Dodd-Frank Era
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
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.
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.
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.
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
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:
Avoiding “excessive” compensation and providing an appropriate mix of base and
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
Assuring that compensation arrangements are compatible with controls and risk
Having in place appropriate “governance” structures and processes sufficient
to provide effective and informed oversight.
Responsibility vested in “independent” members or committees of the board of
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
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.
The assessment of executive compensation is now part of management evaluation
in CAMELS ratings.
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:
Difficulty in enforcement
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
The risk of adversely affecting relationships with key employees.
Tax issues for the incentive award recipients and tax and accounting issues
for the institution.
To address the issues necessarily involved in pure clawbacks, a number of
institutions are instead using holdbacks instead of clawbacks. These generally
Deferred payment of vested awards
Annual percentage vesting or payment over periods of 3-5 years
The necessity of addressing potential tax and accounting issues.
Regulatory guidance suggests several approaches:
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.
Adjusting awards at the time they are made based on quantifiable measures of
risk (this option can be very complicated).
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.
Greater use of equity or “equity equivalents.”
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
Fault (knowing participation or acquiescence)
Degree of fault
Failures/weaknesses in the exercise of management responsibilities
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).
Termination for cause
Methods of Accomplishing
Specific contract provisions
Incorporation into contracts or formal incentive plans of policies adopted by
the Board, compensation or other committee of independent directors with
responsibility for awards
Exhibit 4. Clawback provision from January 1, 2011, Heritage Bankshares
Employment Agreement filed with the SEC
Exhibit 5. Green Bankshares Letter Agreement
Exhibit 6. Green County Bancorp Board Policy
Statement and Letter Agreement of Employee to Be Bound Thereby
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,
Exhibit 8. Sample Clawback Policies of Boeing
Exhibit 9. Deutsche Bank Group 2009
Exhibit 10. Sample Contract Provision
Due process notice and opportunity to be heard (see
Indemnification policies reflected in organizational documents and director
and officer insurance policy provisions relevant to contested recapture, in
particular the extent to which:
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
the affected individual might have claims
under the institution’s D&O Policy for reimbursement of expenses or recovery
of amounts recaptured or forfeited
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.
“Clawbacks or Hold-Backs,” by Gayle Applebaum of McLagan (a performance reward
consulting firm for the financial services industry), and
“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.