Sen. Elizabeth Warren, D-Mass., recently wrote, “Almost ten years ago, Congress directed federal regulators to impose new rules to address the flawed executive compensation incentives at big financial firms. But regulators still haven’t finalized (let alone implemented) a number of those key rules, including one that would claw back bonuses from bankers if their bets went bad in the long run. As President, I will appoint regulators who will actually do their job and finish these rules.”
Warren is referring to the Dodd-Frank Wall Street Reform and Consumer Protection Act, which was introduced in 2010 as a response to the 2008 financial crisis. The act contained over 2,300 pages of provisions, including a number that impact executive compensation, to be implemented over several years. A few provisions — like management say-on-pay, say-on-golden-parachutes, CEO pay ratio — have been implemented, while others like incentive-based compensation arrangements (§ 956), clawbacks (§ 954) and pay-versus-performance (§ 953(a)) remain in limbo.
In any Democratic presidency, incentive-based compensation (§ 956) may be the easiest provision to finalize. The 2016 proposal creates a general restriction for banks with more than $1 billion in assets on incentive compensation arrangements that encourage inappropriate risks caused by a covered person receiving excessive compensation that could lead to a material financial loss. As proposed, it is very prescriptive for banks with assets of $50 billion or more, requiring mandatory deferrals, a minimum clawback periods, ability for downward adjustments and forfeiture.
The final rules for § 956 were re-proposed in 2016, but regulators’ interest in the topic has been muted during President Donald Trump’s administration. There are other ways that executive compensation programs could be impacted by a Democratic president, of which Warren is one contender for the nomination. While not exhaustive, we see three potential changes — beyond § 956 — that could impact executive compensation programs.
1. Increased Regulatory Oversight
In almost all scenarios, a Democratic presidency will be accompanied by an increase in regulation. The 2016 sales practices scandal at Wells Fargo & Co. brought incentives into the spotlight. The Federal Reserve Board has stressed the importance of firms having appropriate governance of incentive plan design and administration, and have audited the process and structure in place at banks. One key thing that firms can and should be doing, even if the party in power does not change, is implement a documented and thorough incentive compensation risk review process as part of a robust internal control structure. Having a process in place will be key in the event of regulatory scrutiny of your compensation programs.
2. Mandatory Deferrals
Warren re-introduced and expanded the concept of mandatory deferrals through her Accountable Capitalism Act of 2018. This proposed legislation restricts the sales of company shares by the directors and officers of U.S. corporations within five years of receiving them or within three years of a company stock buyback. Deferred compensation gives the bank the ability to adjust or eliminate compensation over time in the event of material financial restatements or fraudulent activity, and is sure to be a topic that will come up with a Democratic presidency.
While the concept is different from deferred compensation, many firms have introduced holding periods in their long-term incentive programs for executives. This strengthens the retentive qualities of the executive incentive program and provides some accounting benefits for the organization, making it something to consider adding to stock-based incentive plans.
3. Focus On More Than The Shareholder
The environmental, social and governance (ESG) framework has been a very hot topic in investment communities, with heavy-hitting institutional investors introducing policies relating to ESG topics. For example, BlackRock is removing companies generating more than 25% of revenues from thermal coal production from its discretionary active investment portfolios, and State Street Corp. announced that it will vote against board members for “consistently underperforming” in the firm’s ESG performance scoring system. Warren believes that companies should focus on “the long-term interests of all of their stakeholders — including workers — rather than on the short-term financial interests of Wall Street investors.” It remains to be seen exactly what future compensation plans for banking executives will look like, though the myopic focus on total shareholder return may become a thing of the past.
Many potential incentive compensation changes that are likely to occur under a Democratic presidency already exist in the marketplace, including holding periods for long-term incentive plans; incentive compensation risk review, including the internal control structure; mandatory deferrals and clawbacks; and aligning incentive plans with the long-term strategy of the organization. Directors should evaluate their bank’s current plans and processes and identify ways to tweak the programs to ensure their practices are sound, no matter who takes office in 2021.