New Compensation Rules and Their Impact on Small Banks

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.

2011 Shareholder Voting Trends – Preparing for 2012 Say on Pay

vote.jpgStarting with the 2011 proxy season, public companies were required to conduct a non-binding shareholder advisory vote on executive compensation practices at least every three years. Of the more than 3,000 companies disclosing their say-on-pay votes in 2011, only 40 (including one bank) failed to receive majority shareholder support.  While the percentage of failures was not high, we expect that number to increase in 2012 as investors (and advisory firms) have more time and resources to assess pay programs, and in 2013 when smaller reporting companies are required to hold their shareholder vote.

While non-binding, a failed vote can result in negative media attention, pressure on board members and shareholder lawsuits.   Of the 40 companies failing in 2011, seven already face shareholder lawsuits against executives, directors and, in some cases, their consultants.   

2011 Vote Results

While many companies initially recommended votes every three years (triennial), shareholders and advisory firms made clear their preference was for annual votes.  By the end of the 2011 proxy season, shareholders at 76 percent, 1 percent and 22 percent of companies, respectively, voted in favor of annual, biennial and triennial votes.

Many companies’ compensation packages passed when put to a shareholder vote by an overwhelming majority (68 percent passed with more than 90 percent of the vote), while 8 percent of companies received less than 70 percent shareholder support. 

Role of Shareholder Advisory Firms

Shareholder advisory firms such as Institutional Shareholder Services and Glass Lewis & Co. are having a significant impact on proxy vote results.  While these firms have no sanctioned powers, their influence cannot be ignored by boards and companies.  ISS in particular had an impact on 2011 vote results, especially at companies with high institutional ownership.  Overall, companies with an ISS “against” recommendation received an average of 68 percent shareholder support, compared to 92 percent at companies that received ISS support.   Going forward, ISS has indicated they will give extra scrutiny to companies that received less than 70 percent shareholder support in their prior year say-on-pay vote. 

What Factors Influenced the Vote?

Based on our review of ISS and Glass Lewis vote recommendations, a common reason cited for receiving an “against” vote was a pay-for-performance disconnect.  For ISS, this outcome was triggered when a company’s 1- and 3-year Total Shareholder Return (TSR) fell below industry GICS (global industrial classification standard) codes, without a corresponding adjustment in CEO pay.  Poor pay practices such as the use of tax gross-ups and single-triggers on Change in Control benefits also influenced a number of “against” votes.  In some cases, poor disclosure and excessive compensation were cited as contributing factors.

Increasing the Likelihood of  Shareholder Support

Companies can do several things to increase their level of shareholder support for SOP votes in the 2012 proxy season. 

Enhance Proxy Disclosure

The Compensation Discussion and Analysis (CD&A) is the basis of shareholder votes and should be written clearly and presented in an easy-to-read format.  Using tables, graphs and bullets can focus the reader on key points.  While not required, an executive summary allows companies to tell their “story,” reinforce pay-performance alignment and highlight pay practices shareholders will view positively.  The CD&A should plainly discuss incentive plan metrics and payouts, as well as any data, analysis and information considered in the compensation committee’s decisions.  Peer groups will receive increased scrutiny next year, when ISS adds peer data to its vote methodology. 

Understand Shareholder Criticisms

How companies respond to concerns about executive pay programs will be an important factor in future votes.  It is critical to understand the voting policies of major shareholders and any issues raised as concerns, even if they didn’t result in an “against” recommendation.  Compensation committees should discuss these concerns and consider whether to make changes to pay programs.  Companies should provide enhanced disclosure to rationalize  pay programs and decisions in light of investor concerns.

Some changes made by companies include amending employment agreements to eliminate golden parachute tax gross-ups (Disney); adding performance conditions for equity grants (Umpqua, Lockheed Martin, GE); reducing compensation (Key Corp), and changing peer groups (Occidental).

Improve Shareholder Communications

One positive impact of say-on-pay is that it has increased communication between companies and their shareholders. A two-way dialogue with major shareholders throughout the year can increase the likelihood of support for say-on-pay. 

In Summary

Shareholder advisory votes on pay packages were mandated with little notice for the 2011 proxy season, leaving investors and advisory firms with limited resources and time to prepare. As say-on-pay moves into its second year, scrutiny of executive pay practices will continue.  ISS has already changed its methodology for their vote recommendations. Companies that received shareholder support last year are not guaranteed the same result in 2012. 

Overall, monitoring and aligning the pay-for-performance relationship should be an ongoing responsibility and focus of compensation committees.  It is not too late to make well informed decisions, engage shareholders and improve disclosure to increase the likelihood of receiving a positive say-on-pay result in 2012.