Has the regulator implemented rules in relation to remuneration paid by banks to its staff?
Yes, U.S. regulators have implemented mechanisms to supervise remuneration paid by banks to their staff.1 In fact, such initiatives were mandated by § 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.2 Banking regulators have specifically targeted bank practices regarding incentive-based compensation. In undertaking this initiative, the banking regulators have jointly implemented a variety of regulatory regimes.
Firstly, the banking regulators have implemented guidance (“Guidance”) based on safety and soundness principles propounded by the Federal Deposit Insurance Act (“FDIA”).3 In this respect, banking regulators have set forth three principles, which purport to align banks’ incentive compensation policies with the overall safety and soundness of the banking organization and are discussed below in the answer to Question 3.
Secondly, the banking, securities and federal housing regulators have proposed regulations (“Proposed Regulations”) that also limit and create reporting requirements for incentive compensation arrangements at different types of financial institutions, including banking organizations.4 Many of the aforementioned safety and soundness concerns that are described in the Guidance underlie these Proposed Regulations as well, and are discussed below in the answers to Questions 3 and 6.
What categories of staff are caught by the regulator’s rules?
The Guidance applies to both executive officers and non-executive personnel at banking organizations. With respect to the former, the Guidance applies to “senior executives and others who are responsible for oversight of the organization’s firm-wide activities or material business lines.” Given that commenters initially regarded the phrase “senior executives” as vague, the regulators further clarified the meaning of “senior executives.” For non-publicly traded banking organizations, regulators define “senior executives,” at a minimum, to mean:
"a person who participates or has authority to participate (other than in the capacity of a director) in major policymaking functions of the company or bank, whether or not: the officer has an official title; the title designates the officer an assistant; or the officer is serving without salary or other compensation. The chairman of the board, the president, every vice president, the cashier, the secretary, and the treasurer of a company or bank are considered executive officers, unless the officer is excluded, by resolution of the board of directors or by the bylaws of the bank or company, from participation (other than in the capacity of a director) in major policymaking functions of the bank or company, and the officer does not actually participate therein.”5
With respect to publicly traded banking organizations, “senior executives” means, at a minimum:
“(i) all individuals serving as the registrant’s principal executive officer or acting in a similar capacity during the last completed fiscal year (“PEO”), regardless of compensation level; (ii) all individuals serving as the registrant’s principal financial officer or acting in a similar capacity during the last completed fiscal year (“PFO”), regardless of compensation level; (iii) the registrant’s three most highly compensated executive officers other than the PEO and PFO who were serving as executive officers at the end of the last completed fiscal year; and (iv) up to two additional individuals for whom disclosure would have been provided pursuant to paragraph (a)(3)(iii) of this Item but for the fact that the individual was not serving as an executive officer of the registrant at the end of the last completed fiscal year.”6
With respect to the non-executive personnel, the Guidance encompasses employees who can expose their bank to material amounts of risk notwithstanding their individual status. Moreover, non-executive personnel even includes employees who cannot expose their bank to such material risk individually, but can do so when part of a larger group that, as a whole, materially exposes the bank. The regulators have specifically utilized loan originators to illustrate this latter category given that they materially expose banking organizations to credit risk when operating as a group.
Similarly, the proposed regulations identify the same groups of employees as “covered” for the purposes of the Proposed Regulations. Again, these covered employees encompass executive officers, individual personnel who have the ability to expose their firm to material risk, and groups of employees who can expose their bank to material loss when taken in the aggregate.
What are the key regulatory rules?
The Guidance sets forth three principles: “(1) incentive compensation arrangements at a banking organization should provide employees with incentives that appropriately balance risk and financial results in a matter that does not encourage employees to expose their organizations to imprudent risk; (2) these arrangements should be compatible with effective controls and risk-management; and (3) these arrangements should be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors.”7
The banking regulators have tapered expectations by explaining that the Guidance is flexible and should not be unnecessarily restrictive. In essence, large banking organizations (LBO’s)8, which utilize incentive compensation arrangements to a greater extent and are vulnerable to a greater array of risk, will likely need to develop a more complex set of procedures to fully comply with these principles than a smaller banking organization.
Regardless of the fact that the Guidance is “flexible,” the banking regulators reserve the right to impose sanctions on banking organizations that neglect to effectively incorporate these principles into their operations. Where an incentive compensation scheme exposes a banking organization to risk related to its safety and soundness, the entity’s federal regulator is entitled to institute an enforcement action against the firm. Pursuant to the Federal Deposit Insurance Act, such an enforcement action would likely consist of the banking organization “developing a corrective action plan that is acceptable to the appropriate federal supervisor to rectify safety-and-soundness deficiencies in its incentive compensation arrangements or related processes.” However, the regulator may require that the banking organization take further action in addition to the corrective action plan.
As previously mentioned, the Proposed Regulations set forth prohibitions with parallel underpinnings to the Guidance. The Proposed Regulations prohibit covered financial institutions “from having incentive—based compensation arrangements that may encourage inappropriate risks (a) by providing excessive compensation or (b) that could lead to material financial loss to the covered financial institution.” Although standards have not yet been established to give these ambiguous prohibitions greater substance, the regulators have noted, in their proposal, that such standards will be established. However, the regulators have indicated that any such standards will be aligned with those already established under § 39 of the FDIA (i.e., safety and soundness). In fact, § 956 of Dodd-Frank requires that any compensation standards established pursuant to the authority granted by the Act be consistent with § 39 of the FDIA.
The banking regulators have indicated that an incentive-based arrangement would be “considered excessive when amounts paid are unreasonable or disproportionate to, among other things, the amount, nature, quality, and scope of services performed by the covered person.” The regulators also have attempted to clarify the scope of the latter prohibition by providing a list of factors that they would consider when determining whether a particular arrangement encourages behavior that “could lead to material financial loss.” This list essentially cites the Guidance. For instance, the regulators state that they would test whether an arrangement “balances risk and financial rewards.” In addition, regulators would consider a covered financial institution’s controls, risk-management, and corporate governance within the context of the incentive-based compensation for covered employees.
However, several new features are included in the Proposed Regulations. Firstly, there is a compensation deferral requirement for executives at larger covered financial institutions.9 Under this mandate, 50% or more of an executive’s incentive-based compensation would need to be deferred over three years. Secondly, the boards at these larger institutions are required to identify individual (non-executive) employees who can expose the institution to material losses. Moreover, the board or a committee of directors would have to approve the incentive-based arrangements of such employees. In doing this, the board or committee of directors must determine that the arrangement for these identified employees is appropriately balanced.
Are bonuses subject to the regulator’s rules?
Yes, the Guidance and Proposed Regulations both exclusively deal with incentive compensation, which encompass bonus arrangements.
What is the position concerning role based allowances?
The Guidance and Proposed Regulations do not explicitly reference role based allowances. This is most likely a result of the fact that role based allowances are a European phenomenon and are not, so far, a significant occurrence in the United States. However, an argument could be made that the Guidance and Proposed Regulations apply to role based allowances if the regulators can effectively demonstrate that role based allowances are in fact incentive based.
Do the regulator’s rules on remuneration have extraterritorial effect?
The Guidance and Proposed Regulations have limited extraterritorial effect. They apply to the U.S. operations of foreign banks with a branch, agency or commercial lending company in the United States. As such, they do not apply to foreign banks without such operations in the United States. Nor do they apply to the non-U.S. operations of a foreign bank that operates a branch, agency, or commercial lending company in the United States. The Proposed Regulations have not been finalized and so have no effect at this point.
Do you anticipate further reform in this area?
There will likely be further reform in this area given that the Guidance is relatively recent and the Proposed Regulations still need to be finalized. Moreover, recent press reports indicate that revised proposed regulations will be issued this year for comment that will take into account recent market practices.
In the Guidance, the banking regulators indicated that they would “review and update this guidance as appropriate to incorporate best practices that emerge from these efforts.” Similarly, any final regulations likely will differ from proposed regulations because the regulators will take into consideration any comments received by the public when finalizing the rule. Even once final regulations are adopted, they are likely to evolve over time as best practices and market pressures within this field develop.
Must an institution’s remuneration policy be disclosed to the regulator?
When enacted, § 956 of Dodd-Frank required that regulators prescribe regulations or Guidance that require covered financial institutions to disclose to their regulators sufficient detail regarding their incentive compensation arrangements to enable the regulators to determine whether such arrangements exposed the institution to inappropriate loss. This requirement is tempered by Dodd-Frank not requiring covered institutions to disclose the actual compensation amount paid to individual covered employees.
With respect to the incentive compensation Guidance, a banking organization’s remuneration policies will be disclosed to the regulators in connection with the regulator’s ordinary safety and soundness supervision.
The Proposed Regulations would introduce a more formal reporting process. Under the Proposed Regulations, covered institutions would be required to file an annual report to their regulators under the reporting format prescribed by the applicable supervisor. Although each regulator ultimately would determine the appropriate report format, the rule also would mandate that certain information would need to be included in the annual report. This mandated information would be required because the regulators determined, at the time of drafting the Proposed Regulations, that such information “would most efficiently assist the relevant Agency in determining whether there are any areas of potential concern with respect to the structure of the covered financial institution’s incentive-based compensation arrangements.” Importantly, the complexity and scale of a covered institution’s disclosure will vary by the scale of the actual institution. As such, smaller institutions that make little use of incentive-based arrangements would likely have less detailed reports than their larger, more complex peers.