Regulators Revive Efforts to Pass Dormant Compensation Rules

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When it comes to incentive compensation, everything old is new again.

Financial regulators are expected to revive rulemaking on a number of compensation provisions that never went into effect but were mandated by the Dodd-Frank Act of 2010.

Some of the issues that bank and securities regulators could consider in the coming quarters include measures that will gauge executive pay against their performance, as well as mandate clawback provisions and enhanced reporting around incentive compensation structures, said Todd Leone, a partner and global head of compensation at consulting firm McLagan. He was speaking during Bank Director’s 2021 Bank Compensation & Talent Conference, held Nov. 8 to Nov. 10 in Dallas.

All banks with more than $1 billion in assets would need to comply with the final version of the enhanced incentive compensation requirements. Public companies, including banks, would need to comply with any final rules around clawbacks and pay versus performance. If the topics sound familiar, Leone reminded the crowd, it was because they were debated when the banking reform bill initially passed in 2010. Regulators considered rulemaking several years later. But the move to finally pass those rules could catch banks off-guard, especially when considering that rulemaking was essentially paused under the administration of President Donald Trump. Below is Leone’s overview of the proposed rules.

Clawbacks
Clawback provisions, or a company’s ability to take back previously awarded pay or bonuses after a triggering event such as a restatement of earnings, were a hotly debated topic of the post-crisis financial reform bill more than a decade ago. They also came into focus in the bank space after news broke about the Wells Fargo & Co. fake account scandal in late 2016. In 2017, the bank’s board announced it would seek $75 million in previously awarded compensation from two of the senior executives that it held accountable for the scandal. In response, a number of banks created clawback policies of their own.

In October 2021, the U.S. Securities and Exchange Commission, under Chair Gary Gensler, reopened the comment period for the clawback provision, or Section 954 of the act. Leone pointed out that the proposed rule defines a triggering event as an accounting restatement for a material error. A company has up to three years to claw back incentive pay linked to the financial information that is restated; potentially impacted employees include current or former executive officers. Leone expected a final rule by the second half of 2022 but recommended that audience members stand pat until something is published.

“Don’t touch existing policies, since it’s in flux,” he recommended for banks that created their own policies.

Pay For Performance
Pay for performance, or Section 953(a), is a proposed disclosure requirement for public companies, including banks, that would most likely appear as a table in the proxy statement. The disclosure compares total shareholder return for a company against a company-selected peer group, along with compensation figures of a company’s top executives. The company would need to state the principal executive’s reported total compensation for the current year and past four years, along with the average reported total compensation for other named executive officers over the current year and past four years.

Like the clawback proposal, this provision was first debated by the SEC in 2015; it is in “final rule stage,” according to the agency, and Leone believed it could go into effect in the second half of 2022. The rule could create a “fair bit more work” for companies to comply with, he said. But he believed it will have a similar impact on the industry as the CEO pay ratio disclosure, which compares the pay of the CEO to that of the company’s median employee and has yet to lead to significant changes in pay for either group.

Incentive Compensation Rules
Similar to the other two proposals, the enhanced incentive compensation rule, or Section 956, has come up again. The SEC included it as a proposed rule in its agency rules list for spring 2021. Leone joked that he had used the same presentation slide on the enhanced incentive compensation rule a decade ago. The rule has been proposed by regulators twice since the passage of Dodd-Frank: It was 70 pages when it was first proposed in 2011 but had grown to 700 pages when it was re-proposed in 2016, he said.

Leone believed this rule will come up again in the spring of 2022, and that rulemaking will take some time because a number of regulators will need to collaborate on it. It would apply to all banks with more than $1 billion in assets, along with other financial institutions such as credit unions and broker dealers. The requirements would vary based on asset size, with the biggest firms facing the most stringent rules around their incentive compensation agreements. Under previous iterations of the rule, financial institutions would need to include provisions to adjust incentive compensation downward under certain circumstances, outline when deferred incentive compensation could be forfeited and build in a clawback period of seven years.

In the end, Leone recommends banks be proactive when it comes to changing compensation rules.

“Expect more, not less regulation,” he said.

What Does the Wells Fargo Debacle Mean for Incentive-Based Compensation?

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incentive-pay-10-31-16.pngWith all of the recent press coverage from the Wells Fargo & Co. phony account scandal, you’d have to be living in a cave not to have heard about it. As the details come to light, I’m certain it will be a test case for how not to design an incentive-based compensation program. But, does it mean that incentive-based compensation is a bad thing? In my opinion, a properly designed program can be well within the measure of safety and soundness, can create proper inducements for the appropriate segment of your workforce, and, can avoid creating the negative results that were realized by Wells Fargo.

In our firm, Bank Compensation Consulting, one of the most common short-term, incentive-based compensation designs has at its heart a deferral component. When a participant obtains a bonus based on achieving the goals set forth in the design, all or a portion of that bonus is deferred until some point in the future, say, five years from earning it. The deferral component accomplishes a number of goals. For one, it creates a reason for the participating employee to continue to remain employed with the bank If the employee leaves the bank prior to receiving the deferral amount, it is forfeited. Also, it allows the bank to comply with clawback rules requested by the regulators. Since the unvested portion has not yet been remitted, it can more easily be “clawed back” should there be a violation of terms outlined in the plan document.

Would this deferral design have helped in the Wells Fargo situation? As of this writing, the answer to that question is unclear. I will say that, when I consider how many years I’ve been working with banks and non-financial institutions to implement incentive-based compensation programs, and I consider how many of those haven’t had the result that Wells Fargo has, I think the answer is clear. As a CPA who did his requisite time at one of the large accounting firms, I have to ask myself questions like: What types of internal controls exist at Wells Fargo? What management oversight is in place to ensure an employee can’t easily create a fake account? Weren’t there ‘red flags’? Certainly, when your inventory is cash, there is always an element of temptation that some people simply cannot overcome. But, the sheer volume of the fraudulent accounts created indicates, at least to me, that at some level Wells Fargo management was sending the wrong message to the staffers involved. The corporate culture in the division of Wells Fargo where this took place must have played an enormous role.

The fact that an incentive-based compensation program existed shouldn’t mean that its utilization was the culprit that induced employees to create fraudulent accounts. For me and my colleagues, we feel that the malleability of such programs is extremely advantageous when trying to encourage certain actions by one or a group of employees. However, care and experience should be used when creating a safe and sound incentive-based compensation design.

You might just want to get inside a cave if you were an executive at Wells Fargo right now. Designing an effective and safe incentive-based compensation program and making sure it’s implemented correctly is one way to avoid the glare of bad publicity.

Bank Compensation: How Banks are Changing Bonus Plans

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compensation-10-26-16.pngThe problem with creating an incentive plan is that your employees just might do whatever you incentivize them to do. If you pay bonuses based solely on earnings growth, then you might not only get growth in earnings but also really bad loans that eventually sink the bank. If you don’t include the quality of the bank’s ratings with regulators in the performance metric for your CEO, then you might end up with a bad regulatory rating.

During Bank Director’s Bank Executive and Board Compensation Conference on Amelia Island, Florida, yesterday, it became clear that many banks in the wake of the financial crisis are beginning to incorporate a variety of mechanisms to incentivize the behavior they want from their employees and management.

  • Fifty-nine (59) percent of banks in a Blanchard Consulting Group 2016 survey of more than 200 public and private banks have some kind of formal performance-based incentive plan for management. Only 22 percent have a bonus plan that is solely discretionary, according to the survey. This is of increasing importance for publicly traded banks as well. The shareholder advisory group Institutional Shareholder Services recommends that at least 50 percent of a CEO’s shares be tied to performance, said Gayle Appelbaum and Todd Leone of consulting firm McLagan.
  • Sixty-eight (68) percent use net income as one of the metrics in their performance-based incentive plan for the CEO. Seventy percent use it as a metric when evaluating the senior management team. It is more difficult for management to manipulate net income in their favor compared to return on assets or return on equity, said Mike Blanchard, CEO of Blanchard Consulting Group.
  • In a survey of the audience at the conference, which consisted of roughly 225 attendees, 35 percent used asset quality as the primary non-profitability metric in their incentive compensation plan. Regulators want to see other metrics besides profitability in bank incentive compensation schemes. “Be careful if you have profits only,” Blanchard said. Building in a little bit of discretion for the board in setting senior management pay is a wise idea, rather than basing incentives solely on metrics, Blanchard said. That could give the board more flexibility when something has gone wrong.

Banks are increasingly using clawback measures or deferral of pay to reduce the risk of their compensation plans. A clawback measure could be similar to one used by Wells Fargo & Co.’s board recently when departing CEO John Stumpf forfeited $41 million in unvested stock and Carrie Tolstedt, the former head of consumer banking, forfeited $19 million, following a fraudulent account opening scandal. Clawing back unvested stock is helpful because it’s difficult to clawback pay when the executive has already received it, and presumably, spent it. Some banks are adding clawback provisions to their incentive compensation plans that allow the board to clawback for unethical behavior or reputational damage to the firm.

With Wells Fargo in the headlines, questions about incentive pay and motivating the right behavior were a big focus of the conference, although not the only one. Most speakers thought Wells Fargo’s crisis was more related to its culture and how management responded to problems, rather than its incentive plan.

Chris Murphy, the chairman and CEO of 1st Source Bank in South Bend, Indiana, a $5.4 billon asset institution, talked during a panel discussion at the conference about building integrity and character among staff. If someone violates the basic values of the company, he wants other employees to know why that person was let go. A reputational crisis could hurt the bank financially but it’s an even bigger deal than that. “We now understand a little better the impact of little things building up over time,’’ he says. Lying is a nonstarter. “You can’t have anyone lying in any way, shape or form in your organization.”

Clawbacks Are Coming. Are You Ready?

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clawbacks-8-1-16.pngFive years after the passage of Section 954 of Dodd-Frank adding new provisions on clawbacks, we expect the Securities and Exchange Commission (SEC) to make some minor adjustments to its proposal and adopt a final rule before summer’s end.

The proposal, which would amend Section 10D of the Securities Exchange Act of 1934, shifts responsibility for recouping excess compensation from the SEC to the registrant, creates a non-fault standard as opposed to the Sarbanes-Oxley “misconduct” standard, extends the clawback period to three years and significantly expands the number of executives subject to its reach. Almost all issuers publicly registered with the SEC, including smaller reporting companies and current or former executive officers, are covered. Small and emerging companies, which previously were exempt under Reg SK from making detailed compensation disclosures, will shoulder a disproportionate burden.

Which Officers Are Subject to Section 10D Clawback?
Unlike Sarbanes-Oxley, which only applies to the CEO and CFO, the proposal uses the definition of executive officer from Rule 240.16a-1. It includes principal officers as well as any vice president in charge of a principal business unit, division or function and any other persons who perform similar policy-making functions for the registrant.

What Triggers a Clawback?
The law requires that the company recoup excess compensation received during the three-year period prior to the date the issuer is required to prepare an accounting restatement. Again, unlike Sarbanes-Oxley, no misconduct or error on the part of the executive need be shown. The accounting restatement is the triggering event.

What Type of Compensation Is Subject to the Rule?
The proposed rule applies to all “incentive-based compensation,” which is defined as any compensation that is granted earned or vested based wholly or in part upon the attainment of any “financial reporting measure.” A financial reporting measure is defined to mean any measure derived wholly or in part from financial information presented in the company’s financial statements, stock price or total shareholder return. This is an expansion of the language of Dodd-Frank which states that the law applies to incentive-based compensation that is based on financial information required to be reported under the securities laws. The proposed rule excludes by its terms salaries, discretionary bonus plans, time-based equity awards or other payments not based on financial reporting measures, including strategic or operational metrics.

What Is Excess Compensation?
Excess compensation is defined to be erroneously awarded compensation that the officer receives based on erroneous information in excess of what would have been received under the accounting restatement. Examples include unexercised options, exercised options with unsold underlying shares still held and exercised options with underlying shares already sold. Similarly, all excess stock appreciation rights and restricted stock units awarded must be forfeited and if already sold, any proceeds returned to the company. The clawback would also apply to bonus pools and retirement plans based on the attainment of financial metrics. What should be emphasized is the law and proposed rule leave almost no discretion to the company. Clawback is mandatory except in cases where the pursuit of recovery would be futile or counterproductive.

What Is the Tax Consequence of a Clawback?
What is particularly troublesome is the tax complications. The most common problem is likely to be that the employee will be taxed fully on the original income. When income is paid back in a different tax year, it will be treated most likely as a miscellaneous itemized deduction and its full deductibility will be subject to whether the taxpayer has sufficient deductions to equal or exceed the 2 percent threshold of adjusted gross income. A clawback could have the effect of penalizing the employee through no fault of his own beyond the amount received.

How Should a SEC Registered Bank Adjust Its Compensation Approach?
Banks which may qualify to deregister should consider it. For companies that desire to remain registered or who have no alternative, then executives should consider purchasing insurance products with their personal funds to hedge against an unexpected loss of income already earned and spent. The SEC rule does not permit the issuer to indemnify or purchase insurance for the executive to cover clawbacks. What is unfortunate is that onerous rules governing circumstances out of the control of most executives only makes performance-based incentive compensation less desirable.

Playing Your Cards Right With Executive Compensation Disclosures

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proxy-season-11-13-15.pngAs the 2015 calendar gets shorter, are you hedging bets that your next Compensation Discussion & Analysis (CD&A) will wow shareholders and ensure a strong say-on-pay vote next year? Or are you hoping to bluff your way through the next proxy season? Between regulatory changes and a high level of public scrutiny, it’s never too early to begin focusing on your executive compensation disclosures. 

Why Communication Strategy Matters More Than Ever
Effectively communicating your compensation plan and its link to the bank’s business and leadership strategies is a growing priority among boards and management teams. As we all know, executive compensation—and the regulation surrounding it—is increasingly complex. A well-planned and artfully delivered disclosure document can improve chances of a favorable say-on-pay outcome and potentially bolster your defenses against shareholder activism. At a minimum, it can help improve overall shareholder engagement and build communication between the board, management and other stakeholders.

The Ante: Emerging Compliance Requirements
Unfortunately, the Dodd-Frank Act’s many provisions are still looming and it’s only a question of time before the final proposals on matters such as the CEO pay ratio, pay-for-performance, and clawbacks are implemented. These fast-changing rules can make it difficult to keep up from a communication perspective. How might these new mandates complicate or conflict with your compensation strategy and how can a public bank ensure they’re fully compliant, while delivering the most effective story to shareholders and employees about the executive pay programs?

Remember—balance is the key. With so many requirements coming, it will be necessary to offset the potential complication of your message with clear details on your compensation design and its alignment with the bank’s business strategy. Within the regulatory context, there’s an opportunity to discuss:

  • How executive compensation supports your business strategy and leadership talent goals;
  • How compensation is defined;
  • How performance is viewed;
  • How sound governance and risk management is practiced; and
  • What you pay your executives and why.

It’s not just public banks that face these issues. While private entities aren’t required to disclose, many feel the resulting public pressure to communicate more and can benefit from the following guidelines.

The Winning Hand: Moving Beyond Compliance to Tell Your Story
Obviously, compliance is important, but companies need to continue shifting program design focus from compliance to a compensation philosophy that supports the long-term business strategy.

Results from Pearl Meyer’s 2015 OnPoint Survey: The New Normal of Annual Compensation Disclosure, offer several points to consider as you begin the CD&A development process. Perhaps most surprising is that ”reader-friendliness” of the CD&A is just as important to compensation committees as technical accuracy. In fact, making the content easier to read/understand ranked as the number one request compensation committees make to staff regarding the CD&A. Survey results also indicate those companies who rate their CD&A as “excellent” or “very good” experience a higher percentage of yes votes for say-on-pay from shareholders than companies who don’t rate their CD&A as high.

There are three ways to ensure you “win the hand” in regards to your pay communications to shareholders:

  1. Take advantage of emerging trends for content and design.  There have been big changes over the past five years in how information about pay is presented within the CD&A. Content needs to be accurate, complete and concise while keeping in mind that shareholders are the target audience. Incorporating elements such as executive summaries and visuals that illustrate year-over-year pay levels, mix of variable versus fixed pay, and realizable/realized pay help organize the story and pull the reader through the document. The survey results show a clear pattern: companies with favorable views of their communication use these methods far more than companies who believe their CD&A is only fair or needs improvement.
  2. Leverage the experts to develop and deploy your message. Using internal corporate communications practitioners, graphic designers, and external writers can be worth the expense. Survey results show that companies who have relied on communication experts to help develop content typically have excellent or very good communication effectiveness and almost 80 percent of these companies are using at least one professional resource.
  3. Adjust your timeframe. The quality of executive compensation disclosure is more important today than ever and the quantity of information required is growing. Therefore, it it’s never too early to get started! Our survey confirmed that those who began working on their disclosures before the close of the fiscal year reported excellent or very good communication effectiveness. It’s a safe bet to follow their lead.

Taking this disciplined approach to communicating the value of your programs should pay off in the long-term and can help your board successfully move ahead with strategy-based design.

Bank Compensation Committees Lose a Whole Lot of Discretion

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compensation-committee-11-6-15.pngA lot has changed since Bank Director hosted its first compensation conference 10 years ago. I was at the inaugural conference in Dallas in 2005, and back then, the big issues in bank compensation were the competitiveness of CEO pay plans, proxy trends, the attitudes of institutional shareholders, and the structuring of incentive compensation plan for executives.

As we all know, 2005 was still something of an age of innocence for the banking industry. The financial crisis, which was in full bloom two years later, changed everything. Congress and the bank regulatory agencies responded to the crisis with an avalanche of new requirements and restrictions, including many that targeted the industry’s compensation practices. It was taken as an article of faith in Washington that out-of-control pay practices in the financial services industry during the home mortgage boom helped precipitate the crisis, and bank incentive compensation practices are now under tight regulatory scrutiny. The compensation committee was a fairly uneventful assignment for bank directors prior to the crisis, but now rivals the audit committee for regulatory complexity. Serving on the compensation committee was once analogous to a military posting well behind the front lines, but now it is the front line from a governance perspective.

At the front lines this year, Bank Director hosts its annual Bank Executive and Board Compensation Conference Nov. 10-11 in Chicago at the Swissotel. Granted, this is a time of year when the weather is so unpredictable, it might be warm or it might be snowing.

While the weather might be uncertain, the change in compensation committee responsibilities will be pretty clear.

The initial barrage of regulations occurred in 2010, when the four bank regulatory agencies—led by the Federal Reserve—issued joint guidance on what has come to be called Sound Incentive Compensation Practices, or SICP. This guidance focused on the relationship between risk and compensation and has had several practical results, including a new emphasis on compensation risk management (banks are required to perform an annual risk analysis of their incentive compensation programs); a much longer payout of incentive awards; and a significant reduction in the use of stock options, which the regulators generally frown upon because they might promote risky behavior, as stock prices generally have to rise for the options to be worth anything.

Another big shoe that is about to fall is a series of new requirements that are part of the Dodd-Frank Act of 2010, which was the U.S. Congress’ signature response to the financial crisis. Although far reaching in its scope, Dodd-Frank did address bank compensation practices as well. Some of its compensation-related provisions—including public company mandated, nonbinding shareholder votes on executive compensation and independence requirements for compensation committees—have already been put into place. Other requirements that will apply to all public companies, including disclosure of the ratio of the CEO’s total compensation to the median compensation for all of a company’s employees, and a clawback provision that allows companies to recover incentive compensation paid to executives if it was based on inaccurate financial statements, are expected to take effect in 2016 or 2017.

Perhaps the greatest difference between service on a compensation committee today compared to 2005 is the loss of discretion, and this cuts across the entire industry even though the most serious compensation abuses leading up to the crisis were found at the big banks, or at unregulated financial companies operating outside of the banking industry. Bank boards must be able to justify their compensation decisions to the institution’s primary regulator, who are standing at their shoulder like a shop floor supervisor. There might still be some element of discretion left when it comes to the specifics of an incentive compensation award to a senior bank executive, but it’s certainly much less than it used to be. In the banking industry today, the regulators are the primary drivers of incentive compensation for senior executives, and the greatest challenge for compensation committees is compliance.

As for the weather in Chicago, what are a few snow flurries to compensation committees buried under a blizzard of regulations?

Taking the Fear out of Phantom Stock

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The use of equity compensation has increased in the banking industry in recent years, coinciding with enhanced compensation guidelines from the Securities and Exchange Commission (SEC), bank regulators, and the Dodd-Frank Act. These parties recommend that some executive compensation be deferred and tied to long-term performance. Equity programs typically accomplish both of these goals. A recent study of 177 public banks from Blanchard Consulting Group’s internal database found that the use of equity grants as a percentage of total compensation increased two to three times from 2009 to 2013, depending on the asset size of the bank.

Asset Size 2009 Proportion of Equity to Total Compensation 2013 Proportion of Equity to Total Compensation
Over $1B 15% 26%
$500M to $1B 4% 12%
Under $500M 4% 7%

Most publicly traded banks will use compensation plans tied to the organization’s stock to distribute long-term incentives in the form of stock options or restricted stock. Some private or thinly traded banks will use these types of “real” stock programs; however, many of these banks have limited availability of actual stock. As an alternative, private banks may use synthetic equity, such as phantom stock or stock appreciation rights, which are settled in cash.

Phantom stock programs are modeled to look and feel like restricted stock, where the participant receives the full value of the share plus any appreciation over time. The value of phantom stock is typically linked to the company’s stock price or book value per share. In addition, dividends could be factored into the phantom stock value during the vesting period, typically 3-5 years. Ultimately, the phantom stock awards will be settled in cash.

Advantages to Synthetic Equity
Banks concerned with equity dilution often prefer phantom stock, which provides a value comparable to that of restricted stock, but does not result in actual equity dilution. The value of the phantom stock is paid out in cash upon vesting, so the officer still receives value commensurate with having a real share of stock. Because phantom stock is settled in cash, it does not receive equity-based accounting treatment (value fixed at grant date). Instead, the expense is adjusted over time to reflect changes in the bank’s stock price or book value. The advantage of using phantom stock is the absence of any share dilution.

Stock Appreciation Rights (SARs) are another form of synthetic equity that are settled in cash. Cash SARs work similarly to stock options, as SARs give the participant the right to any appreciation in stock price or book value between the grant date and settlement. The appreciation value is paid in cash and taxed as ordinary income. Similar to phantom stock, cash SARs do not receive equity-based accounting treatment. The SARs are re-valued periodically, and the expense is adjusted to reflect the changes in value throughout the vesting period. This could lead to expensive accruals if the underlying stock price increases dramatically. Similar to phantom stock, there is no share dilution.

Other Considerations
Before implementing any type of equity or long-term incentive plan, a bank should consider a number of factors, such as the following:

  1. Performance-based awards: In today’s environment, equity awards are typically based on the achievement of bank-wide, department and/or individual goals.
  2. Service vesting: We typically see three to five-year vesting schedules within the banking industry. The vesting schedule may vary by grant or employee based on the bank’s retention goals.
  3. Dividends: The board should determine when and if the plan participant will receive value for dividends. This provision can be customized by the bank for each eligible employee.
  4. Termination of employment: If a participant voluntarily terminates employment during the plan term, the employee typically forfeits any unvested awards.
  5. Death or disability: Most banks will accelerate vesting and allow the participant or beneficiary to exercise shares in the event of a disability or executive’s death. All early disbursements will need to comply with Internal Revenue Service (IRS) restrictions (section 409A).
  6. Change-in-control: Shares will typically vest immediately and be paid upon the acquisition or merger of the bank if an employee is terminated as a result, also known as a “double trigger”.
  7. Clawback provision: This allows the bank to recoup incentive compensation payments made to plan participants in error from any unvested phantom stock or SAR grant.

In order to retain and attract talent, private banks need to ensure that they have the compensation tools available to compete with public banks that use real stock compensation. By using phantom stock or SARs settled in cash, private banks can help ensure that they are competitive with the market.

Compensation Regulation and Dodd-Frank: Where Are We Four Years Later?

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9-12-14-McLagan.jpgWhere were you on July 21, 2010? If you were working for a bank, or in compliance for a publicly traded company, you know the world got much more complex on that date. The Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) was signed into law, all 2,315 pages of it. Four years later, it makes sense to ask the status of the various regulations coming out of the Act, especially in one of the most complex areas, compensation.

Overview
There were six items in the Dodd-Frank Act that specifically focused on compensation. Of these six, five applied to all public companies; only one was focused specifically on financial institutions—incentive compensation. Four years later, only two of these six have been implemented. While this speaks to the general level of gridlock in Washington, D.C., at our regulatory bodies, it is important to understand what has been implemented, what is coming and how it impacts your bank.

If you are a publicly traded bank, say-on-pay has been with you for four years and has had a very direct impact on executive compensation. This fall, we may get final regulations on the pay ratio disclosure, which requires public companies to report the ratio of CEO pay to the median pay of all other employees. This could go into effect in 2015, which could impact proxy statements in 2016. Also, we may see proposed regulations on clawbacks this fall.

Most bankers are awaiting final regulations on incentive compensation arrangements; a regulatory item that has been in a proposed state for more than three years. However, there is related final guidance on a similar subject—Sound Incentive Compensation Policies. Although this joint regulatory guidance did not come out of the Dodd-Frank Act, it is in effect today and applies to all banks and thrifts, regardless of whether they are public or private and regardless of size.

Section Provision Shorthand Applicability Status
951(a) Shareholder Vote on Executive Compensation Say-on-Pay All public companies Effective, January 2011
951(b) Shareholder Vote on Golden Parachute Compensation Say-on-Golden-Parachutes All public companies Effective, January 2011
953(a) Pay Versus Performance Disclosure — All public companies Not proposed
953(b) Pay Ratio Disclosure CEO Pay Ratio All public companies Proposed, September 2013
954 Recovery of Erroneous Awarded Compensation Clawbacks All public companies Not proposed
956 Enhanced Compensation Reporting Structure Incentive Compensation Arrangements All banks and thrifts >$1 billion in assets  Proposed,
May 2011

Say on Pay
In the 2014 proxy season, there were five banks who failed to receive majority shareholder support for their executive pay plans, or say-on-pay. Collectively in the 2012 and 2013 proxy seasons, there were a combined five banks that failed. The frequency of failed say-on-pay votes has increased.

What four years of say-on-pay has taught us is that you don’t want to fail your say-on-pay vote, and compensation that is extraordinarily high will get highly scrutinized. Plus, institutional investors have created their own governance groups and fighting a failed say-on-pay vote is expensive.

If your firm has a less than 70 percent positive vote for say-on-pay you have some homework to do for the next year. Also, having a healthy dialogue with your institutional investors has never been as important as now.

Clawbacks
There have been no proposed regulations on clawbacks to date. This section would require that a company recover compensation that should not have been paid because of a restatement of earnings. This applies to current and former executive officers for the preceding three years after the restatement of earnings.

This absence of a proposal is striking given this is already a rule for the chief executive officer and chief financial officer as a result of the Sarbanes-Oxley Act.

Incentive Compensation Arrangements
Section 956 is the one area which specifically focuses on financial institutions. This provision applies to all banks greater than $1 billion in assets—public or private as well as credit unions over a certain size, all farm credit agencies and broker dealers.

The essence of the provision requires reporting to a firm’s primary federal regulator within 90 days of the end of the fiscal year. What has to be reported relates to a firm’s incentive compensation arrangements, primarily a description of all incentive compensation plans (including equity and post-retirement benefits), governance structures in place to ensure excessive compensation is not paid, and changes in incentive compensation from the previous year.

In addition for firms with assets greater than $50 billion, 50 percent of all incentive compensation has to be paid over a three year period.

Interestingly, Section 956 was proposed in April, 2011 it still has not been finalized more than three years later.

Still, banks should get prepared. All banks covered under the rule should have a formal review process of incentive compensation: Identify covered employees, review the plan designs and how compensation is paid over time; and make sure you have proper internal risk controls in place. The compensation committee of the board should oversee this review.

In the end, much of Dodd-Frank has not been finalized, but you can help prepare now by educating yourself about what is coming down the pike.

New Compensation Rules and Their Impact on Small Banks

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The Dodd Frank Wall Street Reform and Consumer Protection Act has an expansive collection of provisions that impact financial institutions.  Perhaps the most hotly debated part of the legislation is Section 956, which addresses incentive-based compensation.  The requirements of Section 956 are applicable to banks and other financial institutions of $1 billion in assets or more.  So, does that mean that financial institutions of less than $1 billion are not impacted?

A key element of Section 956 is its reliance on current standards for all banks established under Section 39 the Federal Deposit Insurance Act (FDIA) relative to employee, executive and director compensation It requires federal agencies to establish standards prohibiting any unsafe and unsound practice relative to any compensatory arrangement that could lead to material financial loss to an institution, including standards that specify when compensation is excessive.

Some of the considerations of federal agencies in determining if compensation is excessive include:

  1. the combined value of all cash and noncash benefits provided to the individual;
  2. the compensation history of the individual and other individuals with comparable expertise at the institution;
  3. the financial condition of the institution;
  4. compensation practices at comparable institutions, based upon such factors as asset size, geographic location and the complexity of the loan portfolio or other assets;
  5. for postemployment benefits, the projected total cost and benefit to the institution;
  6. any connection between the individual and any fraudulent act or omission, breach of trust or fiduciary duty, or insider abuse with regard to the institution; and
  7. any other factors the agencies determine to be relevant.  

So, while institutions less than $1 billion in size currently do not have to comply with the specific rules of Section 956 of Dodd-Frank, the current guidelines for all banks would indicate that some Section 956-like actions are warranted in identifying excessive compensation.  Some of the technical aspects of Section 956 may seem burdensome; however, other requirements are practical and, in some cases, just good common sense.

Below are some of the key provisions of Section 956 that may not be enforceable for institutions under $1 billion but may serve as guidance for best practices:

The institution is required to adopt written policies and procedures to ensure and monitor compliance with the rules. 

Having written policies and procedures to provide guidance and maintain control of your compensation programs is a no-brainer.  Formally documenting your plans to address elements of risk and the guidance in the FDIA demonstrates to regulators you have a framework for meaningful and effective control.

Covered institutions are to submit an annual report to their primary regulator. 

A methodical and periodic review of your plans and documentation of their adherence to your policies and risk management procedures will demonstrate appropriate management oversight. 

Strong corporate governance and an active role by the compensation committee or board are required. 

Establish processes whereby your compensation committee or board takes an active role in all matters relating to compensation.  This will institute a best practices approach, providing for better risk management, effective internal controls and regulatory compliance.          

The proposed regulations provide suggested ways to balance risk and reward performance.

These approaches to balancing risk and rewarding performance make sense for banks of all sizes and will help limit risk as well as lessen the need for clawbacks.  Some of the suggested approaches include:

  • Payment Deferrals: allows for adjustment of the compensation through the deferral period;
  • Risk Adjustment: awards are adjusted to account for the risk posed to the bank;
  • Longer Performance Periods : longer measurement periods better reflect ultimate financial outcomes; and
  • Reduced Sensitivity to Short-Term Performance: reduced rates of reward for higher performance levels over the short-term.

Does Section 956 of Dodd-Frank apply to banks under $1 billion?  Technically, no.  However, banks under $1 billion should certainly be aware of its impact, since all financial institutions should adhere to established best practices.  The primary focus for bank compensation will continue to be safety and soundness, monitoring and controlling compensation programs, and managing risk while matching compensation to performance.

Wilmington Trust blunders on CEO Pay

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pencil.jpgIt’s been a bad few weeks for Wilmington Trust Corp. Make that a bad year.

The $10.4-billion-asset Wilmington, Delaware-based bank, which specializes in advisory services for wealthy clients and personal trust accounts, reported a $370 million loss in the third quarter of 2010 after it beefed up its loan loss provision. The bank, which has been around since 1903 but recently stumbled on bad commercial real estate loans, will be acquired this year by Buffalo, New York-based M&T Bank Corp. The deal was announced Nov. 1 at a value of $351 million or $3.84 per Wilmington Trust share, a 46 percent discount to the prior trading day’s closing price. No doubt Wilmington Trust shareholders are still unhappy because the bank was trading at about $4.41 per share Tuesday morning on the New York Stock Exchange.

It gets worse.

The bank subsequently announced in December that it was yanking back most of the CEO’s 2010 compensation, more than $1.75 million, because his pay package violated the rules for banks that participated in the federal government’s Troubled Asset Relief Program. (Wilmington Trust received $330 million in TARP funds in December 2008.) Oops! Bloomberg News picked up the story last week from one of the bank’s regulatory filings.

The TARP rules can be fairly complicated. But they aren’t complicated on this point:No retention or signing bonuses are allowed for banks that took TARP money according to multiple compensation experts, including Paul Hodgson, senior research associate at GovernanceMetrics International, formerly known as The Corporate Library, and Susan O’Donnell, managing director at compensation consulting firm Pearl Meyer & Partners.

Back in June, when Wilmington Trust board member Donald Foley was hired by the board to replace Ted T. Cecala as CEO, Foley was given a $1.75 million signing bonus that was clearly disclosed to shareholders. A full $1.3 million of that was to be paid in restricted stock vesting immediately and the rest of the $450,000 was in cash.

Then in December, the bank said it was taking back the full $1.75 million signing bonus and an additional 16,000 shares in restricted stock. And it also rescinded a part of the pay agreement that awarded Foley 14 years credit on the company’s executive retirement plan. Ouch!

The board did agree to increase Foley’s base pay from $1.2 million to $1.5 million, which is allowed under TARP, but the move doesn’t nearly make up for what was taken away.

Contrary to news reports, this doesn’t look like a claw-back, where a company is forced to take back executive pay based on a restatement of earnings or fraud.

“It’s a unique situation,” says Tim Bartl, senior vice president and general counsel for the Washington, DC-based Center on Executive Compensation, which was started by the human resources industry group, the HR Policy Association. “(This was) a do-over, more than it was a claw-back.

So who screwed up? Did the compensation committee fail to look at the TARP rules when granting the incentive package? Or did a consultant paid to do this job fail to understand the TARP restrictions? Foley did not return a phone call this week on the matter and a company spokesman, Bill Benintende, issued a statement saying the board took the action to comply with TARP rules and:  ” . . . the Board wishes to express its recognition and appreciation of the fact that since he became CEO in June, Mr. Foley has worked tirelessly and effectively to address both the challenges and opportunities facing Wilmington Trust.”

O’Donnell and Hodgson had never heard of a TARP bank having to take back a signing bonus, and TARP rules have been in place for more than a year.
 
But what about Wilmington Trust? How long will Foley’s tenure last at this point, especially since M&T is buying the company? (He has been invited to join the board of the newly merged bank). What kind of fruitful relationship can the board possibly have with Foley after reaching into his pocket and taking back nearly $2 million?

“That has to be a difficult conversation,” Hodgson says, in what may be the understatement of the year.

Stanley Baum, an attorney who consults with companies on compensation issues for Lerner Law Firm & Associates in Westbury, New York, was less circumspect.

“My impression is, ‘what the heck is going on over there?”’ he says. “It’s so blatant, you wonder what sort of procedures are in place here and at other companies.”

The upside is there probably won’t be too many more of these banks that have this problem, say Bartl and O’Donnell – not after Wilmington Trust embarrassed itself publicly.

For a full primer on the pay rules regarding TARP banks, check this out:http://www.kattenlaw.com/treasury-releases-tarp-executive-compensation-and-corporate-governance-guidance-06-19-2009/