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Incentive-Based Compensation

By: Ellen R. Marshall and John J. Heber

With considerable fanfare, the FDIC passed and then quickly announced its proposed rules implementing Section 936 of the Dodd-Frank legislation – even before the other regulatory agencies could put their own imprimatur on the jointly developed proposal.

The proposal takes some interesting approaches to its subject. The aspect that has received the most media attention is the part that applies to the largest banks. For financial institutions with $50 billion or more in consolidated assets, the proposal would require that, for any executive employee who receives incentive-based compensation, at least half of that must be in a form that is paid at least three years after it is earned.

Receiving less publicity in the immediate aftermath of the announcement is a set of rules, also part of the proposal, that applies to community banks and other financial institutions as small as $1 billion in consolidated assets. The proposal has sweeping application in that it covers not only commercial banks and thrifts, but also SEC-registered broker-dealers and investment advisers, government-sponsored enterprises and credit unions.

Although less headline-grabbing, the more broadly applied rules likely present a far greater challenge because they call for a deep understanding of the risk profile of the bank and of each part of the bank. The bank must provide reports to its designated federal regulator about the way its incentive-based compensation programs work, for all of the covered employees. The report must demonstrate how it is that the incentives of each program do not encourage inappropriate risk-taking. The banks are being asked, in effect, to prove a negative.

In explaining how an incentive-based compensation system might be tweaked to reduce its tendency to encourage inappropriate risk-taking, the regulators have identified four types of adjustments:

The goal, says the proposal, is to achieve a better balance than existed in the past between the incentive to take risks, so as to achieve rewards for the bank, and the incentive to avoid too much risk. What is striking about this mandate is how relativistic it is.

When regulators try to enforce the new regime, how will they be able to recognize the right (or wrong) amount of adjustment in the sensitivity of compensation to risk? The most we can expect is that the duty to explain these relationships in a periodic report to the regulator will sensitize bank managers to think deeply about the risks in their business models, and the incentives built into their compensation systems.

Besides motivating banks to think about these relationships, though, the outcomes may impact determinations of safety and soundness, if regulators disagree with the bank’s own assessment of its risk-reward balance. In this respect, the proposed regulations would give the regulators yet another tool for finding fault. Whether the tool will be used as intended, to curb unbalanced risk-taking, or will be applied with hindsight to trap the unlucky, remains to be seen.

Reporting and Plan Adjustments Required

For community banks under $1 billion in consolidated assets, the new proposal would require no changes. For financial institutions with $1 billion or more in consolidated assets (which the proposal calls covered financial institutions) the proposal:

Timing and Opportunity for Comment

The proposal will have a 45-day comment period after its publication in the Federal Register. That publication will not occur until after all of the relevant federal agencies have approved it.

Therefore, it may be a while before the comment period begins. Moreover, it is not inconceivable that changes may be made before the other federal agencies act.

After the comment period, the federal agencies will consider the comments and will come up with a final rule. The proposal anticipates that the final rule (whatever it may contain) will become effective six months after publication of the final rule in the Federal Register. The informational reports will be due within 90 days of the end of each covered financial institution’s fiscal year, after that effective date.

During the comment period, the various federal agencies request comment on many subjects, including the timing for becoming effective. Although the comment period will not even open until publication of the proposed rule in the Federal Register, it is not too early to begin thinking about comments that should, in the view of affected companies and individuals, be made.

Ellen R. Marshall is partner, corporate finance, capital markets at Manatt, Phelps & Phillips LLP in Orange County, Calif. Contact her at emarshall(at)manatt.com. John J. Heber is partner, tax, employee benefits and global compensation, capital markets in the San Francisco office. Contact him at jheber(at)manatt.com.

Copyright © April 2011 BankNews Media


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