Severance Pay May Be Forbidden, Court Rules

Written by


severance-pay-8-31-16.pngNo one wants to imagine bad times for the bank. But it makes sense to plan in advance, just in case. Your bank needs to motivate and keep the executive management team in place during difficult times, and one way to ensure this is to put in place a competitive compensation package when times are good.

A troubled bank can have significant restrictions imposed on its executive compensation programs. In particular, 12 C.F.R. Part 359 (Part 359) broadly prohibits the payment of, or entering into an agreement for the payment of, any golden parachute payment without prior regulatory approval. For an overview of Part 359, see our BankDirector.com article dated September 23, 2011.

A decision in July of 2016 from the U.S. Court of Appeals for the 8th Circuit once again confirms the view of the “impossibility” of severance pay under Part 359 and serves as a reminder that prior planning can help a bank to work within those rules.

Overview of Von Rohr
Jerry Von Rohr was a long-serving senior executive at Reliance Bank, serving lastly as chief executive officer before Reliance terminated his employment. At the time, the bank was subject to Part 359. Von Rohr claimed he was entitled to compensation for a year following the effective date of his termination. Because it was subject to Part 359, Reliance asked the Federal Deposit Insurance Corp. (FDIC) whether the claimed payment could be made to Von Rohr. The FDIC advised that the payment would be a “golden parachute payment” under Part 359, which Reliance could not make without prior FDIC approval. Reliance declined to make the requested payment. Von Rohr filed a lawsuit against Reliance and the FDIC. He alleged breach of contract and requested a declaration that federal law does not prohibit the payment. The trial court upheld the FDIC’s determination and granted summary judgment to Reliance on the breach of contract claim. The appeals court affirmed the trial court’s decision.

In granting summary judgment to Reliance, the court affirmed the trial court’s finding that the FDIC’s determination made Reliance’s performance under Von Rohr’s contract “impossible.”

In upholding the FDIC’s determination that any post-employment payment to Von Rohr under his employment agreement would be a golden parachute because it would be a payment “for services he did not render,” the appeals court made clear that whether or not something is called severance or a “golden parachute” is irrelevant to the analysis as to whether it is prohibited under Part 359. Von Rohr had argued that the payment he was due was simply his compensation for the remainder of the term of his contract, not a payment solely and specifically contemplating his termination. The court indicated that, if it accepted Von Rohr’s view, it would “create a giant loophole” in the prohibitions of Part 359. The intent of the regulatory scheme is to prevent troubled banks from draining their already low resources with payments to terminated executives who may have been responsible for the bank’s condition. It would not serve that intent to allow artful drafting to avoid it.

Von Rohr also claimed that the FDIC’s position is in conflict with its consistently held view that Part 359 does not preclude payment of damages for statutory claims (e.g., discrimination, whistleblower retaliation, etc.). The court dismissed this claim by acknowledging the FDIC’s view on statutory claims and noting that Von Rohr was raising a contractual claim, not a statutory claim.

Planning Opportunities
Significantly, exempt from the scope of the prohibition of Part 359 are payments under tax-qualified retirement plans, benefit plans, bona fide deferred compensation plans and nondiscriminatory severance plans, as well as those required by statute or payable following death or disability.

In particular, Part 359 exempts bona fide deferred compensations and nondiscriminatory severance plans only where such arrangements have been in place at least (and not modified to increase benefits within) one year prior to the troubled condition designation.

Between bona fide deferred compensation, nondiscriminatory severance and death or disability benefits, a bank should be able to build the basics of an attractive compensation package for a member of executive management. However, many banks put off current consideration of these types of arrangements for one reason or another. The Von Rohr case should serve as a reminder that Part 359 is inflexible. Therefore, banks should consider today whether to implement such arrangements.

Finally, should a bank find itself involved in litigation related to an executive’s termination, it should remember that Part 359 does not prohibit payment of damages for statutory claims.

The Current Status of Dodd-Frank Act Compensation Rules

Written by


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.

Making Benefit Plans Work: It’s All in the Contract

Written by


5-2-14-equias.pngTo attract and retain key executives, banks have implemented nonqualified benefit plans as part of their overall compensation strategy. One of the challenges of bank board members is to understand what is or is not included in these agreements and how the agreement terms affect other agreements such as change-in-control, employment contracts, equity plans and others.

Prevalence of Nonqualified Plans
Such plans are common in the banking industry. According to the American Bankers Association 2013 Compensation and Benefits Survey, 64 percent of banks surveyed offer some kind of nonqualified deferred compensation plan for top management (CEO, C-Level, EVP), and 45 percent of respondents offer a Supplemental Executive Retirement Plan (SERP). Types include performance-driven benefit plans, director retirement plans, death benefit or survivor income plans, and phantom stock or stock appreciation rights (SARS) plans.

To avoid violating the U.S. Department of Labor rules concerning plan eligibility, participants in nonqualified plans should be limited to a “select group of management or highly compensated employees,” which taking a conservative approach, is typically no more than 10 percent of a company’s employees. In addition, the included employees should have the ability to affect or substantially influence the design and operation of their deferred compensation plan.

It is important for the board to understand the terms of their deferred compensation plans and the potential ramifications. Common questions that arise regarding some key agreement terms are:

  • What happens if the executive chooses to retire early or extend the time to retirement? Generally the benefits are payable at the time the executive separates from service. Depending on the plan design and the board’s intent, the benefit amount for delayed retirement may remain the same or may be increased.
  • What happens in the case of involuntary termination or termination-for-cause? Termination-for-cause provisions often include forfeiture of some or all of the benefit.
  • What happens if the executive becomes disabled? Some plans provide that payments commence upon separation from service due to disability while some commence at normal retirement age.
  • What type of vesting is common in plans? Since nonqualified plans are not governed by ERISA (Employee Retirement Income Security Act), they may use a number of different vesting options including: immediate, graded, cliff, rolling, or at-retirement. Vesting will vary depending on the objectives of the plan, tenure of the executive and annual expense accruals required.
  • What type of non-compete/non-solicitation terms are included? Some agreements include a definition of these terms, although many banks include them in separate agreements which should be consistent. The length of the non-compete/non-solicitation period as it relates to a nonqualified plan is typically 12 to 36 months, but may last as long as the benefit is being distributed.
  • Nonqualified benefit plan agreements should be reviewed together with other compensation related agreements, such as those mentioned above. So-called “golden parachute rules” are discussed in a previous article and are a perfect example of why a thorough review of all such agreements is critical.

Agreements generally include other terms such as pre- and post-retirement death, change-in-control, and form and timing of payment.

Key items to consider/evaluate when reviewing plans and agreements include:

  • Are key terms consistent with other implemented agreements such as employment agreements, change-in-control agreements, non-compete/non-solicitation, long term incentive plans and equity plans?
  • Has the total cost of a change-in-control based on the agreement provisions, including the accelerated vesting of benefits, been calculated and discussed with the board?
  • Are the plans properly documented in accordance with IRC Section §409A as appropriate, which governs deferred compensation plans?
  • Does the plan provide a meaningful benefit to the participant? Many plans were designed at a time when the benefit was meaningful, but the participant’s role and compensation may have significantly changed.

Summary
Nonqualified benefit plans will remain an important piece of the overall compensation strategy to attract and retain key officers, but it is critical to design meaningful and effective plans and ensure the plan documentation language is clear and avoids conflicts with all employment and benefit-related agreements. For deferred compensation plans subject to IRC 409A, there is limited ability to change the form and timing of payments after implementation; therefore, it is critical to work with experienced professionals who can help make sure you get it right the first time.

Equias Alliance offers securities through ProEquities, Inc. member FINRA & SIPC. Equias Alliance is independent of ProEquities, Inc.

Time to Dust Off Those Change-in-Control Agreements

Written by


1-3-14-Pearl-Meyer.pngThe best time to address compensation issues related to a potential change in control (CIC) is when you don’t need to: that is, when there’s not an imminent likelihood of being acquired. Too often, CIC provisions that appeared reasonable when written can yield unpleasant surprises for bank shareholders and/or executives in the heat of a potential transaction. From the shareholder perspective, surprises might be significant enough to unwind the deal or lead to unfavorable pricing, while executives may be unpleasantly surprised by net benefits far lower than anticipated, due to automatic cut-backs or excise taxes.

That’s especially true now that we’re in a perfect storm for CIC:

  • Many bank executives during the financial crisis had reductions in compensation in the form of smaller (or zero) incentive payouts and realized value from equity awards. This could result in lower base amounts from which golden parachute excise taxes are calculated (i.e., the individual’s five-year average W-2 earnings);
  • As banks have returned to consistent profitability in the last year or two, they are granting more equity-based awards and bank stock prices are starting to rebound, leading to potentially higher CIC payouts; and
  • merger and acquisition (M&A) activity is heating up in the community bank marketplace.

If your organization has any possibility of being pursued by a potential suitor in the foreseeable future, now would be a good time to review the CIC agreements and related provisions in your equity and supplemental retirement arrangements.

The general rationale behind a CIC agreement is pretty straightforward: to reduce potential management resistance to a transaction that is in shareholders’ best interests. If executives fear losing their jobs (and related future compensation opportunities) as a result of the transaction, they may be more likely to drag their proverbial feet and find reasons not to do the deal. Providing reasonable protection to executives in the form of CIC agreements and related benefit provisions can mitigate this risk. Common benefits promised upon termination following a CIC include cash severance; acceleration of vesting on outstanding equity awards and deferred compensation; and either the continuation of health and other benefits or payment of their cash value.

The unexpected consequences of CIC payments/benefits are mostly attributable to their potentially adverse income tax treatment. Under Internal Revenue Code §280G, punitive excise tax penalties are triggered for the employee and what’s referred to as “excess parachute payments” are not deductible for the company if the present value of all payments related to the CIC totals more than 2.99 times the individual’s base amount. For this reason, most CIC agreements are very clear about how CIC payments will be handled if this limit is exceeded. Historically, CIC payments by the company often included 280G excise tax gross-ups, where the company reimbursed the executive for the taxes owed, to keep the executive whole if the parachute limit was exceeded. As such, the most common bombshells at transactions were the eye-popping, nondeductible gross-up bonuses required to reimburse the executive.

Under extreme pressure from regulators and the investing community, excise tax gross-up provisions at most community and regional banks have been replaced more recently either by a cap on the present value of CIC benefits at the 2.99 limit, or by payout of severance benefits that will result in the most advantageous payout to the executive from an after-tax perspective (often called the best after-tax approach). However, such provisions can create another major challenge—forfeiture by the executive of a large portion of the intended benefits. This is particularly problematic in an environment in which the base amount is already likely to be low given the recent financial crisis.

If addressed far enough in advance of a CIC transaction, banks may be able to make adjustments to CIC provisions to ensure that a much greater portion of the intended benefits is delivered in a tax-efficient manner. At a minimum, reviewing your CIC agreements and performing a few scenario-based calculations can protect against being caught by surprise when a potential deal is in the works.

Don’t wait until a transaction is on your doorstep—dust off those CIC agreements and explore their potential real-life impact now, before it’s too late.

How Mergers Can Impact Deferred Compensation Plans: Part II

Written by


12-9-13-Equias.jpgSome compensation arrangements can cause headaches during a merger or acquisition or even derail a deal if they trigger the golden parachute rule under the Internal Revenue Code and possibly related excise taxes. So how do you know if your bank has such arrangements? It’s best to review compensation plans well ahead of striking a deal with another bank to plan for the possibility of the application of the golden parachute rules, otherwise known as exceeding the §280G limit. This is the second in a two-part series about what constitutes a golden parachute payment and what a bank can do about it. Check out the first article to see what constitutes a parachute payment.

Is there anything the bank can do to avoid the creation of parachute payments in a change of control?

Yes. There are several potential options:

  1. Accelerate vesting prior to the change in control (CIC). The bank can accelerate vesting of a Supplemental Executive Retirement Plan (SERP) or some other non-qualified deferred compensation arrangement at least 12 months in advance of the change in control to avoid triggering the “golden parachute” excise taxes. The downside is that the bank would have to accrue a liability for the increase in the vested benefit. In addition, if the executive terminated employment, the bank would be obligated to pay the executive the increased benefit. (This is a positive to the executive but may be a negative to the bank.)
  2. Classify payments as part of a non-compete. If the executive’s separation agreement provides that the executive cannot compete with the company for a period of time, then a portion of the payments may be attributable to the non-compete and therefore excludable from the parachute payment amount. There is no bright line test for how much can be excluded as it is based on facts and circumstances. The excludable amount will vary by bank and by individual within a bank. Any amount paid that does not represent reasonable value for the non-compete will be part of the parachute payment.
  3. Provide a retention agreement. The buying bank could enter into retention agreements with one or more executives. There is value to the buying bank in retaining key executives for some period of time after the merger to protect its investment. The amount paid to the executive for retention (including salary, bonuses, stock options or other) must represent reasonable compensation for the services rendered or it will be considered a parachute payment.
  4. Accelerate income. If it is anticipated that the bank may experience a CIC in the foreseeable future, it could take steps to increase the executive’s base amount by accelerating income (through bonuses or the exercise of stock options). In addition, the executive may want to discontinue deferrals under any voluntary deferred compensation plans. Lastly, it may be possible to increase the base amount by terminating the bank’s non-qualified deferred compensation arrangements and distributing the proceeds (being careful to follow the guidance under IRC section 409A).

What are the bank’s alternatives, when designing a plan, to address §280G?

There are three basic strategies:

  1. Cutback. The agreement provides that if the total parachute payments exceed the §280G limit, they will be reduced so as not to trigger an excise tax.
  2. Gross up. The executive is to receive the total payments and the bank will pay the executive additional compensation to cover his excise taxes.
  3. Neither cutback nor gross up. The executive receives his payments, even if they trigger an excise tax, but the bank does not cover his excise taxes. This one should include a filter that would cutback the parachute payments if the excise taxes cause the executive to receive less on a net after tax basis.

Do we have to apply the same strategy for all covered executives?

No. As with other nonqualified benefit plans, you can have different CIC provisions for each executive.

What happens after the CIC is completed?

Typically the timing and amount due the executive is paid pursuant to the CIC provisions in the plan agreement. However, Section 409A of the Internal Revenue Code allows the buying bank to terminate the plan and pay a lump sum to each executive in the plan. The buying bank may only do so if it follows the specific criteria detailed in §409A. Boards and executives should take this into consideration in designing or updating their plan.

Equias Alliance offers securities through ProEquities, Inc. member FINRA & SIPC. Equias Alliance is independent of ProEquities, Inc.). IRS Circular 230 Disclosure: As required by U.S. Treasury Regulations, we advise you that any tax advice contained in this communication is not intended to be used, and cannot be used, for the purpose of avoiding penalties under the Internal Revenue Code.

How Mergers Can Impact Deferred Compensation Plans: Part I

Written by


9-20-13-Equias.pngMany bank boards during merger discussions find themselves confronting the question of severance benefits and how that will impact the merger. What if the bank being sold has a Supplemental Executive Retirement Plan (SERP)? Could that trigger a so-called golden parachute clause with tax consequences for the acquiring bank? The answer is yes. In some cases, this could impact the negotiations. In a series of articles, Equias Alliance explains how Internal Revenue Service rules are triggered and what to do about it. This first article describes when a change-of-control triggers a parachute payment and subsequent excise taxes.

If our bank has a Supplemental Executive Retirement Plan (SERP) or other non-qualified deferred compensation (NQDC) arrangement, what is the potential impact on a merger with another bank?

If the plan agreement provides for accelerated vesting of the benefit upon a change in control (CIC), two things happen:

  1. The increase in the vested benefit must be immediately accrued as a liability.
  2. The acceleration, referred to as a parachute payment, must be included in the calculation of total parachute payments under Section 280G of the Internal Revenue Code (§280G). (Note: §280G does not apply to Subchapter S banks.)

But if the buyer pays for it, why should we be concerned?

These provisions can impact the price the buyer pays for your bank. A general rule of thumb is that if the cost of all severance benefits is less than 5 percent of the purchase price, it should not impact the price paid for the bank. When the cost exceeds 5 percent, it may impact the price, depending on many other factors. The board should be knowledgeable of the total impact compensation costs might have in the event of a CIC.

If the executive(s) plan on continuing to work for the buyer, does that reduce the impact?

No, both generally accepted accounting principles (GAAP) and §280G require that the present value of the vested benefits be measured and recognized at the date the CIC occurs, even if payments are to be made at a later date.

How do we determine the impact?

First, §280G is very detailed and complex. The bank should seek advice from its accountants and legal counsel.

That said, the income and excise taxes become payable if the total parachute payments equal or exceed three times the executives average W-2 compensation for the past five years. Be careful here as parachute payments are comprised of all forms of compensation, including severance payments, as well as the incremental value of stock options, restricted stock, medical benefits, and incremental accelerated vesting of SERPs and other NQDC arrangements.

Example #1:
The executive’s five-year average W-2 compensation is $100,000 and his parachute payments total $250,000.Three times his compensation is $300,000, so he is under the §280G limit. No excise taxes are due and the payments are fully deductible by the bank, but the present value of the additional benefit obligations created by the CIC still must be accrued for GAAP purposes.

Example #2:
Assume the same facts as #1, except the executive’s parachute payments total $500,000. Since the executive’s payments exceed the allowable amount, payments in excess of one times his salary will be subject to excise taxes. The excise taxes would total $80,000 ($500,000-$100,000) x 20 percent. In addition, he would also pay regular income taxes on the $500,000. The bank would only be able to deduct $100,000 of the compensation paid.

Can we reduce what’s considered to be a parachute payment by deferring payment?

No, the measurement for purposes of §280G is what he is entitled to after the CIC. The present value of the incremental increase in his vested SERP benefit has to be included even if he is to receive the money at a later date. For example, assume the executive is vested in an annual SERP benefit of $25,000 for 15 years, but upon a CIC he becomes entitled to an annual benefit of $60,000 per year. If the CIC occurs, he receives an incremental vested benefit of $35,000 per year, a total payment increase of $525,000, but using present value calculations, the increased value for parachute payment purposes would be around $395,000.

The intricacies associated with the implications of §280G are complex and not easily covered in limited space. Stay tuned for Part II of our series, which will explore what to do if your bank is impacted by §280G.

Equias Alliance offers securities through ProEquities, Inc. member FINRA & SIPC. Equias Alliance is independent of ProEquities, Inc. IRS Circular 230 Disclosure: As required by U.S. Treasury Regulations, we advise you that any tax advice contained in this communication is not intended to be used, and cannot be used, for the purpose of avoiding penalties under the Internal Revenue Code.

New Compensation Rules and Their Impact on Small Banks

Written by


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.

Troubled financial institutions face their own compensation restrictions

Written by


stormy-board.jpgWhile financial institutions will shy away from the hint of a “troubled condition” designation, such designations are unfortunately a common fact of life in today’s economy. Many more banks and thrifts are finding themselves subject to new compensation restrictions when they fall into the “troubled” category. After an institution is determined to be in troubled condition, it becomes subject to the restrictions on golden parachute payments set forth in 12 C.F.R. Part 359 (“Part 359”).  If its condition continues to deteriorate, the institution might also become subject to the prompt corrective action (“PCA”) rules, which limits the ability to pay bonuses and increase salaries.

Overview of Part 359.  Part 359 limits the ability of financial institutions and their holding companies to pay, or enter into contracts to pay, golden parachute payments to institution-affiliated parties (“IAPs”).  The Part 359 troubled condition “taint” will flow from a troubled institution to its healthy holding company and also from a troubled holding company to a healthy institution (but not from a troubled institution, through a healthy holding company, to a healthy subsidiary).

An IAP is broadly defined and can include any director, officer, employee, shareholder, or consultant.  In certain situations, it can also capture independent contractors including attorneys, appraisers, and accountants.

A “golden parachute payment” (“parachute payment”) is any payment of compensation (or agreement to make such a payment) to a current or former IAP of a troubled institution that meets three criteria.  First, the payment or agreement must be contingent upon the termination of the IAP’s employment or association with the financial institution.  Second, the payment or agreement is received on or after, or made in contemplation of, a determination that, among other things, the institution is in troubled condition.  Third, the payment or agreement must be payable to an IAP who is terminated at a time when the institution meets certain conditions, including being subject to a determination that it is in troubled condition.  Even where a contract pre-dates the troubled condition designation, any parachute payment payable thereunder will be prohibited by Part 359 while the institution is in troubled condition.

Certain types of payments and arrangements are excluded from the definition of a parachute payment.  Generally, payments made under tax-qualified retirement plans, welfare benefit plan, “bona fide deferred compensation plans or arrangements,” and certain “nondiscriminatory” severance plans, as well as those required by statute or payable by reason of the death or disability of an IAP are excluded.

In addition to the general categories of excepted payments, the rules under Part 359 permit a financial institution to make certain parachute payments, or enter into agreements providing for parachute payments, where the institution obtains the prior approval of one or more regulatory agencies.  Such approval is required to pay obligations that pre-date the troubled condition, for the institution to pay, or enter into an agreement to pay, severance to someone who is retained as a “white knight,” or to enter into agreements that provide for change in control termination payments (that are contingent on both the occurrence of a change in control and termination of employment).  In nearly every case, if approval is granted, the approved severance payments will be limited to no more than 12 months of base salary (tax gross-ups will not be permitted in any form) to be paid over time and subject to claw back.

In October 2010, the FDIC issued Financial Institution Letter 66-2010 (“FIL-66-2010”) which expanded the information required to be submitted with an application for approval under Part 359 by requiring an institution to demonstrate that the IAP is not a “bad actor” and is not materially responsible for the institution’s troubled condition.  The guidance also provides for a de minimis severance of up to $5,000 per individual that can be paid without regulatory approval, so long as the institution maintains records detailing the recipient’s name, date of payment and payment amount, and also maintains a certification covering each individual who receives a payment.

Overview of Prompt Corrective Action Rules.  The PCA rules designate four capital categories: “adequately capitalized” (which is an institution in “troubled condition”); “undercapitalized;” “significantly undercapitalized;” and “critically undercapitalized.”  If an institution is significantly undercapitalized or critically undercapitalized, the institution becomes subject to additional compensation restrictions.  Undercapitalized institutions may also become subject to these additional restrictions.  When subject to the PCA compensation restrictions, the institution generally cannot pay any bonus to or increase the salary level of senior executive officers.