CFPB Takes Aim at Class Action Waivers in Arbitration


arbitration-11-30-15.pngOn October 7, 2015, the Consumer Financial Protection Bureau (CFPB) announced that it is considering proposing rules that would prohibit companies from including arbitration clauses in contracts with consumers. This would effectively open up the gates to more class action lawsuits in consumer financial products such as credit cards and checking accounts.

In March 2015, the CFPB released its Arbitration Study: Report to Congress 2015, which evaluated the impact of arbitration provisions on consumers. The CFPB conducted the study as mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act. Among other things, the study concluded that:

  • arbitration clauses “restrict consumers’ relief for disputes with financial service providers by allowing companies to block group lawsuits;”
  • most arbitration provisions include a prohibition against consumers bringing class actions;
  • very few consumers individually pursue relief against businesses through arbitration or federal courts; and
  • more than 75 percent of consumers in the credit card market did not know if they had agreed to arbitration in their credit card contracts.

The advantages and disadvantages of pre-dispute arbitration provisions in connection with consumer financial products or services—whether to consumers or to companies—are fiercely contested. Consumer advocates generally see pre-dispute arbitration as unfairly restricting consumer rights and remedies. Industry representatives, by contrast, generally argue that pre-dispute arbitration represents a better, more cost-effective means of resolving disputes that serves consumers well. With limited exceptions, however, this debate has not been informed by empirical analysis. Much of the empirical work on arbitration that has been carried out has not had a consumer financial focus.

As a result of the study, which allegedly contains the first empirical data ever undertaken on the subject of arbitration clauses, the CFPB is currently considering rule proposals that would:

  • ban companies from including arbitration clauses that block class action lawsuits in their consumer contracts, unless and until the class certification is denied by the court or class claims are dismissed by the court;
  • require companies that use arbitration clauses for individual disputes to submit to the CFPB all arbitration claims and awards (which the CFPB may publish on its website for the public to view) so that the CFPB can ensure that the process is fair to consumers and determine whether further restrictions on arbitrations should be undertaken; and
  • apply to nearly all consumer financial products and services that the CFPB regulates, including credit cards, checking and deposit accounts, prepaid cards, money transfer services, certain auto loans, auto title loans, small dollar or payday loans, private student loans, and installment loans.

Critics have found the CFPB’s data and conclusions leave something to be desired. An abstract of a report authored by researchers at the University of Virginia School of Law and Mercatus Center at George Mason University finds that the CFPB report “contains no data on the typical arbitration outcome—a settlement—and it is these arbitral settlements, and not arbitral awards, that should be compared to class action settlements. It does not address the public policy question of whether, by resolving disputes more accurately on the merits, arbitration may prevent class action settlements induced solely by defendants’ incentive to avoid massive discovery costs. It shows that in arbitration, consumers often get settlements or awards, are typically represented by counsel, and achieve good results even when they are unrepresented. In class action settlements, CFPB reports surprisingly high payout rates to class members and low attorneys’ fees relative to total class payout. These aggregated average numbers reflect the results in a very small number of massive class action settlements. Many class action settlements have much lower payout rates and higher attorneys’ fees.”

Needless to say, businesses with arbitration clauses prohibiting class actions wait anxiously for CFPB’s final rules on this subject matter. Is there any doubt what the final rules will contain? We think there will be restrictions on the use of arbitration clauses that prevent consumers from initiating class action lawsuits in contracts for consumer financial products or services.

Compensation and Governance Committees: Sharing the Hot Seat in 2016


hot-seat-11-19-15.pngThe compensation committee has been on the hot seat for several years. Outrage regarding executive pay and its perceived role in the financial crisis has put the spotlight on the board members who serve on this committee. Say-on-pay, the non-binding shareholder vote on executive compensation practices, was one of the first new Securities and Exchange Commission (SEC) requirements implemented as part of the Dodd–Frank Wall Street Reform and Consumer Protection Act in 2010. Since that time, public companies have responded to shareholder feedback and changed compensation programs and policies to garner support from shareholders and advisory firms such as Institutional Shareholder Services (ISS) and Glass Lewis & Co. In recent years, only 2 percent of public companies have “failed” their say-on-pay vote. The significant majority of public companies (approximately 75 percent of Russell 3000 companies) received shareholder support of 90 percent or greater during the 2015 proxy season. Today, companies with less than 90 percent should increase their shareholder outreach, as a dip below that level is often an indicator of emerging concerns.

Compensation committees can’t sit back and relax on these results. The SEC’s proposed rule for pay versus performance disclosure (published in April) and the final rule for the CEO pay ratio (published in August) will further intensify the focus on executive pay and require compensation committees to dedicate much more time and energy to evaluate and explain their pay decisions in light of these new disclosures. Fortunately, implementation of the CEO pay ratio is delayed until the 2018 proxy season while the SEC has not yet adopted final rules for the pay versus performance disclosure (as of September). It is hard to predict what influence these additional disclosures will have on shareholders’ say-on-pay votes. What is clear is that boards will need to monitor these and other pending Dodd-Frank Act rules (i.e. mandatory clawback, disclosure on hedging policies, incentive risk management) in the coming year.  

In the meantime, however, boards may face increased shareholder scrutiny in key governance areas.

Proxy access, the ability of significant shareholders to nominate board members on the company’s proxy ballot, achieved momentum in 2015 when New York City Comptroller Scott Singer submitted proxy access proposals at 75 public companies as part of his 2015 Boardroom Accountability Project. We expect proxy access proposals will remain a focus among activist shareholders during the 2016 proxy season. Dissatisfaction with executive compensation and board governance are often the reasons cited by shareholders seeking proxy access.

Institutional shareholders and governance groups have also started to focus on board independence, tenure and diversity. Institutional investors such as Vanguard and State Street Global Advisors consider director tenure as part of their voting process and ISS includes director tenure as part of their governance review process. This could lead to a push for term and/or age limits for directors in the near future. While many companies use retirement age policies as a means to force board refreshment, it is unclear if that will be enough. Boards would be wise to start reviewing their board composition and succession processes in light of their specific business strategies but also in consideration of these emerging governance and shareholder perspectives.

The intense scrutiny by investors and proxy advisors of public companies’ compensation and governance practices shows no signs of abating. Bank boards will need to develop their philosophies, programs and policies with an acknowledgement of emerging regulations and perspectives. Board composition and processes such as member education, evaluation, nomination and independence will gain focus. Executive pay levels and performance alignment will continue to be scrutinized based on new disclosures mandated by Dodd-Frank. The spotlight on pay and governance is not winding down, but rather widening and both the compensation and governance committees will need to spend more time addressing these issues in the years to come.

Playing Your Cards Right With Executive Compensation Disclosures


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.

Keeping Your Compensation Committee On Track During the Busy Winter Season


executive-compensation-11-11-15.pngThe Dodd-Frank Act, regulatory guidelines on compensation risk and shareholder advisory votes on executive compensation have all contributed to an increase in the compensation committee’s responsibilities and time requirements. That pressure is compounded this time of year as committees enter their “busy season.” The fourth quarter is the start of many critical and often scrutinized committee activities: reviewing performance, approving 2015 incentive awards and developing 2016 performance incentive plans.  This article provides a sample full year committee calendar and a checklist of activities and actions compensation committees should be focusing on during Q4 2015 and Q1 2016.

It is best practice for compensation committees to define and schedule their annual activities for the year in advance. A well-defined calendar helps members better plan and prepare for the critical, and often timely, decisions that are required. There are three key cycles to the annual calendar: Assessment, Program Design and Pay Decisions.

Assessment occurs during the more “quiet” months following the prior year’s performance cycle where pay decisions are made, but before the start of the next performance cycle when a new program starts. For companies whose fiscal year follows the calendar year, this typically occurs between June and October (following most public company annual meetings). While there may be less pressure to approve and take action during this time, the analysis conducted during this phase will be critical for decisions made later in the year. Compensation committees should use this time to reflect on the pay program and decisions of the prior year and assess peer, market and regulatory trends that might influence programs in the coming year. This is a perfect time to conduct robust tally sheets, assess the pay and performance of your company relative to peers, conduct peer/competitive benchmarking, and if you are a public company, review say-on-pay results and conduct shareholder outreach. Information reviewed during this phase provides the foundational knowledge needed for the upcoming design and decision cycles.

Program Design typically occurs in the late fall and early winter (e.g. November–January), when compensation committees review the assessment phase results and begin defining total pay opportunities and programs for the upcoming year (i.e. base salary, annual and long-term incentive opportunities and performance goals). Compensation committees should pay careful attention to performance metric selection and goal setting to ensure proper pay-performance alignment. It is also critical to ensure the incentive plans support sound risk management practices. Many banks will complete their annual incentive risk review at this time. This is also an opportune time to consider implementing or revising compensation policies or practices, perhaps in light of shareholder feedback.

Pay Decisions occur in the late winter (e.g. January–April). During this phase, performance evaluations are conducted and decisions are made related to incentive payouts. Pay opportunities for the new year are also set, including annual incentive opportunities and long-term incentive grants. All banks should have conducted their risk assessment review by this time as well. Once Section 956 of the Dodd-Frank Act is finalized, banks will be required to provide documentation of their risk review to regulators. For companies whose fiscal year ends at the end of the year, this will occur during the same timeframe, in the late winter or early spring. This is also a very busy time for public companies that are required to document the prior year’s pay decisions in the proxy in preparation for shareholder review. Many committees spend several meetings discussing these issues.

Periodic activities include, but are not limited to: executive and board succession planning, incentive risk assessment, board and committee evaluations, consultant evaluations, benefit plan review, employment agreement/severance arrangement review and shareholder engagement.

Ongoing updates throughout the year include incentive payout projections and regulatory updates.

Below is an illustration of a typical compensation committee annual cycle with a check list of key activities for Q4 and Q1:

Today’s environment of increased scrutiny on executive compensation and governance requires compensation committees to spend more time fulfilling their responsibilities. Having a well-planned calendar, with a heightened focus on the “off season” assessment activities, can help committees be better prepared for the many critical year-end decisions.

*Section 162(m) of the Internal Revenue Code allows public companies to deduct performance-based compensation above $1 million if it meets specific requirements.

Taking the Fear out of Phantom Stock


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.

The Current Status of Dodd-Frank Act Compensation Rules


dodd-frank-8-17-15.pngWe have waited for five years since the Dodd-Frank Act became law and we are now seeing consistent movement to finalize several compensation provisions of the law.  

Meetings started in October with President Barack Obama gathering the heads of U.S. financial regulators and urging them to finish the Dodd-Frank rules. To date, we have already adopted Securities and Exchange Commission (SEC) rules that include shareholder votes on executive compensation (Section 951 on say-on-pay and so-called golden parachutes), and on independence of compensation committees (Section 952). Remaining Dodd-Frank provisions, designed to regulate behavior encouraged by compensation structures, are Sections 953, 954, and 956. Already, many institutions have implemented more stringent variable pay plans since 2010, with more compensation tied to longer term performance. The current status of the rules is highlighted below.

Pay Versus Performance Disclosure, Section 953(a)
The proposal for section 953(a) is intended to provide compensation information to augment the say-on-pay vote for public companies. The proposal highlights a new form of realized pay versus reported pay as well as a comparison of the company and peer group total shareholder return (TSR) over several years. The proposed disclosure reflects the SEC’s attempt to help shareholders gain a better understanding of how executive pay compares to company performance by comparing named executive officers’ total compensation as described in the summary compensation table to what the SEC is now defining as compensation actually paid. As an example, the vested value of equity will be incorporated into the actually paid definition versus the value of equity at grant date. Also, the new rule uses total shareholder return (TSR) as the performance measure comparing performance to compensation “actually paid,” and using TSR of a company’s peer group to provide additional context for the company’s performance. In addition, companies will be required to provide a clear description of the relationship between the compensation actually paid and cumulative TSR for each of the last five completed fiscal years.

Current Status of Rulemaking: We expect either a final, or re-proposed rule, by fall, 2015.

Pay Ratio Disclosure, Section 953(b)
The SEC finalized this rule in August, 2015, with implementation deferred to fiscal years beginning on or after January 1, 2017. The rule requires that public companies disclose the ratio of the CEO’s total compensation to the total compensation of all other employees. For example, if the CEO’s compensation was 45 times the median of all other employees, it can be listed as a ratio (1 to 45) or as a narrative. Total compensation for all employees has to be calculated the same way the CEO’s is calculated for the proxy. All employees means all full-time, part-time, temporary and seasonal employees.

Current Status of Rulemaking: The SEC finalized the rule on August 5, 2015. The first disclosure is expected for 2017 fiscal year as shown in proxy statements filed in 2018.

Clawbacks, Section 954
Section 954 is often referred to as the “clawback” provision of Dodd-Frank and applies to all public companies. The proposal requires companies set policies to revoke incentive-based compensation from top executives with a restatement of earnings if the compensation was based on inaccurate financial statements. The company has to take back the amount of compensation above what the executive would have been paid based on the restated financial statements. This rule applies to public company Section 16 officers, generally any executive with policy making powers. Variable compensation that is based upon financial metrics as well as total shareholder return would need to be clawed back, and there is a three year look-back for current and former executives.

Current Status of Rulemaking: Expect final rules in fall, 2015; once final from SEC, stock exchanges will create the listing rule and an effective date (expected late 2016 or early 2017).

Enhanced Compensation Structure Reporting, Section 956
This rule was proposed in April, 2011—more than four years ago. This rule applies to financial institutions, specifically banks greater than $1 billion in assets. The rule is primarily a codification of the principles as found in joint regulatory Guidance on Sound Incentive Compensation Policies, which stated that compensation needs to be:

  • Balanced to both risk and reward over a long-term horizon
  • Compatible with effective controls and risk management, and
  • Supported by strong corporate governance.

In addition, there is an annual reporting requirement and for large banks (greater than $50 billion in assets), there is a mandatory deferral of incentive pay. Given that there have been four years since the original proposal, we are expecting a number of changes as the global regulatory structures have changed greatly since 2011.

Current Status of Rulemaking: Originally proposed in April 2011, changes are expected to be re-proposed in 2015.

Could a Republican President Mean More M&A Activity?


Banking-Industry-8-12-15.pngWith the first prime time Republican primary debate of the 2016 election cycle in the rear view mirror, we have all gotten an inkling of what the candidates think about the banking industry. I did take particular note of Senator Marco Rubio when he stressed the importance of repealing the Dodd-Frank Act. As Commerce Street Holdings’ CEO shared in an article on BankDirector.com, “many bankers feel that given the legislative and regulatory environment coupled with low rates, low margins, low loan demand and high competition, growth is very difficult.”  So repealing Dodd-Frank is a dream for many officers and directors, and Rubio is echoing their concerns.

Senator Rubio’s comments build on those of former Texas Governor Rick Perry, who recently laid out a sweeping financial reform agenda earlier. He believes the biggest banks need to hold even more capital—or Congress should possibly reinstitute elements of the Glass-Steagall Act. While his campaign appears to be winding down, I do agree with his call for government to work harder to “level the playing field” between Wall Street banks and community institutions.

With so much political scrutiny already placed on banks, it is interesting to think of the pressures being placed on institutions to grow today. On one side, you have politicians weighing in on how banking should operate. On the other, regulatory and investor expectations are higher now than in recent years. Buckle up, because I believe the coming election will only further encourage politicians with opinions, but little in the way of detailed plans, about “revitalizing” the economy.

Against this political backdrop, today’s business environment offers promising opportunity for bold, innovative and disciplined executives to transform their franchises. But I believe regulatory hurdles are making it tougher to do deals. Indeed, the recently approved merger of CIT Group and OneWest Bank creates a SIFI [Systemically Important Financial Institution] which will have to submit to increased regulation and scrutiny. However, when the deal was first announced, CIT’s CEO, John Thain, suggested that his purchase of OneWest could spur other big banks to become buyers. A year later and such activity has yet to be seen.

I see the absence of bigger deals reflecting a reality where any transaction comes with increased compliance and regulatory hurdles. For CIT, going over the $50 billion hurdle meant annual stress tests will now be dictated by the government, as opposed to run by the bank. The institution will have to maintain higher capital levels. Thain seems to think that those added costs and burdens are worth it. By the lack of action, other banks haven’t yet agreed.

Without a doubt, regulatory focus has impacted strategic options within our industry. For instance, we learn about CRA [Community Reinvestment Act] impacting deals and also find fair lending concerns and/or the Bank Secrecy Act delaying or ending potential mergers. Consequently, deals are more difficult to complete. As much as a bank like CIT can add cost savings with scalability to become more efficient, you can understand why banks in certain parts of the country need to debate whether it is better to sell today or to grow the bank’s earnings and sell in three to five years.

The evidence is clear that big banks are not doing deals. Maybe a GOP victory in the next election will thaw certain icebergs, creating a regulatory environment more friendly to banks. While regulators have to comply with existing laws, the leadership of regulatory institutions is appointed by the president and the tone at the top is critical in interpreting those laws. Until we see real action replace cheap talk, I’m looking at CIT as an outlier and simply hoping that political rhetoric doesn’t give false hope to those looking to grow through M&A.

The Elements of a Compensation Plan: What a Board Needs to Know


5-25-15-BCC.pngReviewing compensation within an organization is an integral part of the board’s duties, but it can be challenging to get right. There are a number of reasons for this.

Philosophy
Compensation committees need to determine the bank’s philosophy regarding compensation. Will it be a zero-sum equation where paying more compensation creates fewer dollars for management and/or the shareholders, or an abundance mentality where paying for performance generates shareholder value? Having tension between the two is healthy for setting compensation practices correctly while maintaining balance.

Regulatory
One facet that overlays any compensation structure is regulatory constraints. Over the last decade, there have been three major regulatory pronouncements affecting how banks can structure compensation.

The first is the adoption of the Internal Revenue Code Section 409A, which prohibits the acceleration of payment of deferred compensation.

The second major regulation originates from the Dodd-Frank Act. Essentially, mortgage compensation incentives can only be paid based upon: (i) the dollar volume of the mortgage loans made; or, (ii) the transaction volume generated by the mortgage lender. However, the incentives can vary as to how much is paid to each lender on either method.

The third regulation adopted is the Interagency Guidance on Sound Incentive Compensation Policies effective June 25, 2010. In the guidance, policy steps are set forth that require incentive compensation to be structured to balance the risk to the institution of such incentives, and the guidance dictates that boards are responsible for reviewing this.

Delivery
In what form will your bank deliver compensation? The following are some major ways that banks pay their executives.

Non-statutory stock options
Non-statutory options (NSOs) can be granted to just about anyone. It is not unusual for a participant to fail to realize that not only must they have sufficient funds to purchase the stock, but that there will be ordinary taxation on the gain in stock value from the exercise price for the shares compared to the fair market value of the shares at exercise. In addition, the participant will also owe Social Security and Medicare taxes on the gain.

Incentive stock options
Incentive Stock Options (ISOs) have the benefit of being taxed as capital gains upon the sale of the purchased shares for the gain over the exercise price. However, there can be one surprise in the way of alternative minimum tax (AMT).

Restricted stock
Restricted stock has become more popular as a delivered component of compensation since restrictions come with the grant of the shares. Unlike options, which do not have restrictions once the options become exercisable, restricted shares often carry a restriction as to when they can be sold. This avoids the potential of a quick sale that can occur with options, leading to volatility in the stock price and negative news when investors and others learn of executive sales of stock.

Deferred compensation
Many banks will use nonqualified deferred compensation to recruit, reward and retain key executives in various formats because plan design can be very flexible, structured as defined contribution or defined benefit plans. With closely-held organizations, the shareholders are not subjected to dilution of ownership with deferred compensation as it is accrues through the financial statements. Also, unlike the equity components previously mentioned, shareholder approval is not required. Programs of deferred compensation require board approval. There are various types of deferred compensation programs including, but not limited to, Supplemental Executive Retirement Plans (SERPs), deferred incentives, deferred grants, phantom stock, stock appreciation rights and elective deferrals.

BOLI
While it might appear that deferred compensation is expensive because the entire value of any program generates expense to the bank, often bank-owned life insurance (BOLI) is utilized as an asset to offset or recover the cost incurred by the deferred compensation. This happens in two ways. First, the interest earned while the BOLI contracts are owned informally counterbalance the expense of a deferred compensation program. Second, if the participant meets an untimely death, the death benefit the bank receives in addition to the return on its investment is available to offset the additional expense to complete the accrual of the deferred compensation benefit, so that such benefit can be paid in full to the employee’s beneficiaries.

While the components of compensation are numerous, banks can use the various components for certain tiers of executives within the organization. Further, no single component discussed is superior to the other. Each has its advantages and disadvantages, and can be tailored to the bank’s needs.

Regulatory Concerns about Bank Culture Should Serve as a Wake-Up Call


2-4-15-AlstonBird.pngThe culture inside a bank has received renewed discussion in various forums over the course of the last year. The regulators are now moving from crisis and reaction to root cause analysis of the financial crisis. Regulators have expressed concern that despite the array of new rules, guidance, and enforcement actions brought in the wake of the financial crisis and the Dodd Frank Act, banks just seem to keep turning up problems. Fair or not, and whether you think that this concern is really attributable to the largest financial institutions, the regulators’ signals merit attention for any bank.

Bank regulators, notably the Federal Reserve and the Office of the Comptroller of the Currency (OCC), have contrasted two broad categories of banks:  those that adopt an approach of mere compliance with regulation, where compliance concerns are background noise to be silenced; and those that embrace risk management and compliance programs as an important part of cultural norms. The signal from the regulators is that they look for, and can sense whether the bank is in one or the other of these camps. Supervisory judgment calls are informed by those perceptions.

What is culture? William Dudley, president of the New York Fed, recently stated: “Like a gentle breeze, culture may be hard to see, but you can feel it.” Culture is the norms of behavior that drive the business, including ethical standards above and beyond the rules. This is attributable to the tone at the top set by directors and top executives, but it is manifested (or not) in behaviors throughout the organization. What incentives (compensation and otherwise) drive what kinds of performance throughout the organization? To what degree do risk management concerns get air time alongside financial performance in the board room? Do the board and senior management discuss risk management and compliance in terms of “regulatory burden?”   Worse, do you talk openly about your talented risk and compliance staff as a “burden” weighing on the bottom line?

Increasingly, bank supervisors are beginning to mandate cultural norms. Internationally, the Basel Committee on Banking Supervision has set forth corporate governance principles to assess whether a bank’s board and senior management perform their risk governance responsibilities and establish an appropriate organizational risk culture. The OCC’s heightened expectations for enterprise risk management by the largest banks have emphasized the need for a board to provide what’s known as an “effective challenge” of management, and this has become the gold standard for all banks. The OCC has had open debate with the industry over whether directors must “ensure” rather than only “validate” the effectiveness of a risk management and compliance program. All of the regulators, including the Consumer Financial Protection Bureau, have sent strong signals in the form of enforcement actions, guidance and examination messages.

A key cultural norm is how the bank thinks of its customers. Thomas Watson, legendary leader of IBM, famously said: “The essence of trust building is to emphasize the similarities between you and the customer.” Does your bank consider borrowers as counterparties in a contract, or customers for whom the bank has a shared (fiduciary-like) interest in their success?

Moreover, once a strategic decision is made by the top leaders of the organization, does the company do a good job of challenging the decision when evidence arises that it was wrong-headed, or does the company suffer from confirmation bias, collectively seeking only the evidence that justifies the strategy? Institutional groupthink can result in hidden problems for a bank, whether they are credit concerns, compliance concerns, or lost market opportunities, for example. Does the organization value diverse views that can positively challenge norms?

Examiners assess culture by looking for patterns of behavior, rather than individual instances, just as they focus less on specific loans than on concentrations of credit risk. Distinctions between policies and actual behavior are measurable; exceptions to policy are measurable; meaningfully reviewable management reports should allow detection of patterns. In this sense, examiners and directors are aligned and can be complementary of each other.

Undoubtedly, the audit of risk management or compliance culture is subjective. Are we on the verge of bank supervisors becoming culture police? There is a real concern that supervisors could also suffer from confirmation bias and thereby feed a concentration of cultural norms and fail to appreciate the idiosyncratic nature of institutions and the value of their diversity. Nevertheless, it behooves all boards of directors to look inward and take heed of the bank regulators’ messaging about culture.

The CFPB: How It Impacts Your Bank


1-16-15-Naomi.pngCreated by the Dodd-Frank Act in 2010, the Consumer Financial Protection Bureau (CFPB) represented a seismic shift in federal regulation of the financial sector, an entirely new federal agency created just to protect consumers dealing with financial products. Coming along in the wake of the financial crisis, the CFPB’s mission was to provide a level of protection for individuals in the marketplace that critics felt was missing. The primary banking regulators, sometimes known as prudential regulators, such as the Federal Deposit Insurance Corp. (FDIC), the Office of the Comptroller of the Currency (OCC) and the Federal Reserve, focus on the overall health of the banking industry and the safety and soundness of the financial institutions they regulate. The Dodd-Frank Act moved enforcement of several laws that dealt with consumer protection out of the hands of those agencies and into the hands of the CFPB. Those laws include the Truth in Lending Act, the Truth in Savings Act, the Real Estate Settlement Procedures Act, the Home Mortgage Disclosure Act, the Equal Credit Opportunity Act and the Electronic Fund Transfer Act, among others.

“None of those [laws] are new,” says Jerry Blanchard, a bank attorney at Bryan Cave LLP in Atlanta. “Now, you have somebody applying them in a consistent fashion in banking.”

The CFPB also has the power to enact new regulations to ensure a more transparent and fair marketplace for consumers, and to ensure consumers have timely and understandable information to make responsible decisions about financial transactions. In short, the CFPB is now very much involved in regulating the world in which banks live.

It is also increasingly in the world in which nonbanks live. The CFPB began regulating a whole host of nonbanks that were thought to exist outside of a coherent regulatory system, including payday lenders, mortgage companies, consumer reporting agencies, student loan companies and debt collectors. This could be seen a positive development for banks and thrifts, which often had to compete against players that were not regulated in the same way banks were.

For fiscal year 2015, the CFPB has a budget of $583 million and 1,796 employees, paid for out of the revenues of the Federal Reserve System. The biggest line item both in terms of employees and dollars spent is supervision and enforcement of financial institutions. For banks above $10 billion in assets, that means regular visits and exams conducted by an agency solely focused on consumer protection, which is a new experience for them. For banks below $10 billion in assets, they are not getting examined by the CFPB except in rare circumstances—that responsibility falls to their prudential regulator—but they are impacted by the rules and regulations promulgated by the CFPB.

For instance, the agency finalized a new set of mortgage servicing rules that went into effect in January 2014 impacting any institution that services a mortgage. The CFPB is very focused on mortgage servicing. “It doesn’t matter what size of bank you are,’’ says Blanchard. “If you do a lot of mortgage servicing, you will be dealing with the CFPB.”

The agency implemented a new ability-to-repay mortgage rule and a qualified mortgage standard in January 2014 that some community banks said would negatively impact customers who don’t fit into the standard check-the-box underwriting model for a 15-year or 30-year mortgage. Banks can still offer mortgages outside of the qualified mortgage standard, but they have to keep those mortgages on their books. There also has been concern that offering mortgages outside of the qualified standard might expose the bank to more liability from lawsuits in the future. New rules have also impacted the way banks can pay bonuses to their loan officers. Violations of any of the rules promulgated by the CFPB can have dire consequences. Banks that already have been hit with fines in the millions of dollars or lawsuits include: U.S. Bank, Ally Bank, SunTrust Banks and American Express Centurion Bank.

One area where banks are finding themselves in the hot water in particular has to do with their use of outside vendors. “Banks are looking for more revenues,’’ Blanchard says. “The third party vendors show up saying, ‘We have ways to add a lot more money for you. We can sell these products for you.’” The CFPB, however, is holding banks responsible for the actions of their vendors, including the sale of credit card add-on products that consumers say they didn’t actually order. Some of those products might include identity theft protection or insurance. The bottom line for banks is they need to review and monitor vendors carefully to make sure they are complying with the bank’s and regulators’ expectations regarding consumers.

Some industry observers believe that the CFPB’s focus on consumers has impacted other banking regulators as well, making for tougher enforcement exams pertaining to consumer issues from the FDIC and the OCC. Prudential regulators such as the FDIC have been hitting banks with enforcement actions relating to consumer protection. One area to pay particular attention to in terms of consumer law is unfair or deceptive acts or practices (UDAP). The Federal Trade Commission previously enforced laws regarding UDAP, but Dodd-Frank gave enforcement authority to the CFPB in relation to financial institutions. The law has been expanded to include the term “abusive.” That sounds like a change for attorneys to argue about, but the significance for bank boards is that prudential regulators such as the FDIC are now hitting banks of all sizes with fines and enforcement actions regarding violations under this standard.

For banks that are not examined by the CFPB, the agency’s impact has hit them in a number of other ways. The agency houses a database of consumer complaints available online, so anyone can see, for example, how many complaints a particular bank received and for what general category of complaint, i.e. mortgages, debt collection, etc. The flow of consumer complaints to the agency has been increasing. During fiscal year 2014, it received 240,600 complaints. The agency lists each complaint once a company confirms a commercial relationship with that customer, and notes the company’s response and whether the consumer disputed that response. The CFPB itself can review those complaints and decide whether to investigate further and look for patterns for further investigations.

Attorneys have begun advising banks to keep a database of all complaints against the bank, including those delivered from customers directly to the bank. Banks should track complaints to their proper resolution, as well as look for patterns, to make sure the bank knows of any problems before the CFPB does. Each complaint needs to be taken seriously because you don’t know which one will get the attention of regulators, Blanchard says. Is a complaint alleging a violation of law or regulation? Or is it a matter that could be criminal? Some complaints could be very serious, and it’s important for the board to know the bank has a process in place to vet them and escalate them appropriately.

Understanding the CFPB and its impact on banking is important for any bank board these days. The CFPB has enhanced the level of scrutiny regarding treatment of consumers in the financial marketplace, and its actions and regulations are bound to impact your bank.