Proposed Guidance to Banks May Have Broader Impact on Incentive Compensation Arrangements

The Board of Governors of the Federal Reserve System recently issued proposed guidance entitled "Proposed Guidance on Sound Incentive Compensation Policies." The goal of the proposed guidance is to ensure that incentive compensation arrangements do not encourage excessive risk-taking or undermine the safety and soundness of banking organizations. The proposed guidance is open for public comment until November 27, 2009. As the guidance is currently written, the Federal Reserve advises all affected banking organizations to immediately review their incentive compensation arrangements in view of the guidance and correct any deficiencies.

Although the proposed guidance is not in final form and would only apply to banks and bank holding companies subject to supervision by the Federal Reserve, it appears likely that other federal banking agencies will follow the Federal Reserve's lead and establish guidelines for other financial institutions that they supervise. Given the timing, it is possible final guidance will be in place for the 2010 proxy season.

Moreover, the concepts expressed in the proposed guidance should be of interest to all public companies. Earlier this year the SEC proposed rules to revise disclosure obligations regarding compensation and corporate governance matters. One of the proposed changes would require disclosure of how a company's compensation policies could result in risks that would have a material adverse effect on the company. The SEC identified a number of situations in which this new type of analysis would be appropriate, and many of those situations would appear to include the situations that the Federal Reserve's proposed guidance is intended to reach.

Federal Reserve Approach

Instead of setting numerical caps on compensation or prohibiting certain types of incentive compensation, the approach taken in the proposed guidance is "principles based." According to the proposed guidance, incentive compensation policies and practices should:

• provide employees incentives but not encourage excessive risk-taking beyond the organization's ability to effectively identify and manage risk;
• be compatible with effective controls of risk management; and
• be supported by strong corporate governance, including active and effective oversight by the board of directors.

Principle 1 – Balancing Risk Taking and Incentives

The goal of the guidance is to balance risk-taking and incentives. Incentive compensation practices must consider not only short-term revenue or profit. Banking organizations should consider the "whole range of risks" associated with an employee's activities and the time horizon over which the risks may be realized. Some risks that might have a low probability of occurrence could have disproportionately negative consequences to the organization if they were realized. The Federal Reserve suggests that incentive compensation practices can be balanced by adding or modifying features that cause the amount ultimately paid to employees to appropriately reflect the risks involved. Examples of balancing mechanisms include:

• adjustments to incentive awards for risks incurred;
• deferral or clawback provisions;
• multi-year performance periods; and
• reduced reliance on high hurdles for target awards and stretch goals above targets.

The list of mechanisms is not exhaustive, and two or more methods may be needed to create an appropriately balanced incentive compensation arrangement.

The guidance recognizes that balancing mechanisms or modifications must be tailored to account for differences between employees-vertically between employees at different authority levels and horizontally between employees in job groups with different risk characteristics -as well as between competing organizations.

The guidance makes it clear that executive incentive compensation arrangements are more likely to be acceptable if a significant portion is paid in equity over a multi-year period and is sensitive to performance in that period. Using restricted stock awards alone (including those that are permissible for top executives at banks participating in the Treasury Department's Troubled Asset Relief Program/Capital Purchase Program) is not likely to be the correct way to reduce risk at all levels of the organization. The guidance specifically criticizes, as incentives that encourage undue risk-taking, severance and deferred compensation arrangements that are triggered or accelerated on a change-in-control.

Principle 2 – Establishing Effective Controls and Risk Management

The guidance requires subject banking organizations to establish effective risk management processes and internal controls. Risk management personnel are expected to be involved in designing incentive arrangements to avoid excessive risk-taking. Employees who are involved in risk management and control functions should be sufficiently compensated so that the banking organization can attract and retain qualified candidates for those positions and their compensation should be designed to avoid conflicts of interest.

Finally, the guidance emphasizes that there should be robust monitoring of how the compensation arrangements perform and, if the payouts do not appropriately reflect risk, that they should be restructured as necessary.

Principle 3 – Strong Corporate Governance

The guidance emphasizes the need for an active board of directors with adequate resources to oversee incentive compensation arrangements. The board or its compensation committee should be composed solely of, or predominated by, independent directors. Members of the committee should have a level of expertise and experience in both risk management and compensation practices. Management should assess incentive compensation on at least an annual basis and report on that assessment to the board or compensation committee. Risk management personnel should be involved in the assessment.

Overlap with SEC Proposals

As stated above, the Federal Reserve's actions come not long after the SEC issued proposed rules in July 2009 that would revise disclosure requirements in the areas of executive compensation and corporate governance. Although final rules have not been issued, there is a substantial likelihood the revisions will apply to the 2010 proxy season.

The impetus for the proposed revisions is the same that prompted the Federal Reserve's proposal-disruption of the banking system and capital markets of the past two years. As proposed, new disclosures would have to be made in the Compensation Discussion and Analysis ("CD&A") section of proxy statements.

The proposed rules would require an analysis of a company's compensation policies and overall actual compensation practices for employees generally, not just for executive officers, if the risks arising from those compensation policies or practices could have a material effect on the company.

Although the disclosure will vary from company to company due to actual compensation policies, the SEC provided several examples of situations that could potentially trigger an analysis of how compensation programs intended to reward and incentivize employees could create undue risk. The situations listed are not the only ones that may require expanded disclosure pursuant to the proposed rules.

Recommended Actions

Even though the proposed guidance is not final, all banking organizations should begin considering how these principles would apply to their own compensation policies and practices. The larger universe of public companies can use the proposed guidance to assist them in preparing disclosure of their incentive compensation arrangements in next year's CD&A. Complying with the proposed guidance will take a significant amount of time on the part of HR and risk-management personnel, senior management and members of compensation committees.

Possible consequences for compensation policies include:

• shorter-term incentive arrangements are likely to become less common as they may not provide the necessary balance with risks; and
• equity awards tied to performance over longer payout periods are likely to become more common.

For persons involved in setting compensation, there are several potential consequences:

• risk managers will be required to take an active role in evaluating compensation arrangements-a task that will be new to them;
• greater burdens will be placed on boards of directors in general and members of compensation committees in particular to analyze the risk consequences of existing compensation practices; and
• compensation committees should require their independent consultants to address the issues of balancing risks and incentives.

For companies working on next year's proxy materials, the following should be noted:

• companies may need to create or modify existing controls over financial matters and disclosure requirements; and
• companies should keep in mind the risk-based analysis in the material from the Federal Reserve and the SEC in drafting the disclosures for incentive compensation in the CD&A.