The Advisors' Blog

– Broc Romanek, CompensationStandards.com

Below is news from Cleary Gottlieb (here is related WaPo article):

Yesterday, the Federal Reserve (the “FRB”), the Office of the Comptroller of the Currency, the Office of Thrift Supervision and the Federal Deposit Insurance Corporation (collectively, the “Agencies”) jointly issued final guidance on sound incentive compensation policies (the “Final Guidance”). The Final Guidance follows the FRB’s publication of proposed guidance on sound incentive compensation policies (the “Proposed Guidance”) in October 2009. The Final Guidance states that it is “designed to help ensure that incentive compensation policies at banking organization do not encourage imprudent risk-taking and are consistent with the safety and soundness of the organization” and is structured around three key principles:

– Incentive compensation arrangements at a banking organization should provide employees incentives that appropriately balance risk and financial results in a manner that does not encourage employees to expose their organizations to imprudent risk;
– These arrangements should be compatible with effective controls and risk-management; and
– These arrangements should be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors.

The Agencies’ joint press release first notes four areas that the FRB had found to be “deficient” at large, complex banking organizations (the “LCBOs”) during its horizontal review of incentive compensation practices at those firms that has occurred so far in 2010. The press release stated that:

– “Many firms need better ways to identify which employees, either individually or as a group, can expose banking organizations to material risk.”
– “While many firms are using or are considering various methods to make incentive compensation more risk sensitive, many are not fully capturing the risks involved and are not applying such methods to enough employees.”
– “Many firms are using deferral arrangements to adjust for risk, but they are taking a ‘one-size-fits-all’ approach and are not tailoring these deferral arrangements according to the type or duration of risk.”
– “Many firms do not have adequate mechanisms to evaluate whether established practices are successful in balancing risk.”

The Agencies expect to follow up with the LCBOs on these and other areas for improvement as the horizontal review process continues in 2010.

The Final Guidance is largely consistent with the Proposed Guidance in terms of its substance but contains a number of important clarifications and observations that help elucidate the Final Guidance’s three principles described above. These include:

– Maintaining a principles-based framework, rather than adopting a more formulaic rules-based approach, such as that adopted in European jurisdictions such as the UK and France;
– With respect to foreign banking organizations with US operations, reaffirming a deference to such organizations’ home country supervisors, while at the same time asserting that the incentive compensation policies and practices of a foreign bank’s US operations should be consistent with the Final Guidance;
– Re-emphasizing that different employees (and different groups of employees) should have compensation arrangements that differ based on the type and level of risk that such employees create;
– Providing a specific baseline definition of employees who constitute “senior executives” and therefore fall within the first category of “covered employees” subject to the Final Guidance;
– Emphasizing that a firm’s “risk-management procedures and risk controls that ordinarily limit risk-taking do not obviate the need for incentive compensation arrangements to properly balance risk-taking incentives”;
– Providing a strong indication that senior executives should have a substantial portion of their compensation deferred over a multi-year period and based on company-wide financial performance with the actual number of equity-based instruments ultimately received dependent on the firm’s (or “ideally” the executive’s) performance;
– Declining to specifically prohibit golden parachutes, but suggesting that organizations consider including “balancing features” such as risk adjustment or deferral requirements extending beyond an employee’s departure in such arrangements; and
– Highlighting the regulatory challenges inherent in addressing the risk implications of golden handshake arrangements, particularly in circumstances where the hiring organization is not subject to supervision by the Agencies.

The Final Guidance also contains a number of suggested procedural steps for covered “large banking organizations” which should be familiar to those LCBOs currently undergoing the FRB’s horizontal review. These procedural steps include:

– Identifying employees who are eligible to receive incentive compensation and whose activities may expose the organization to material risks (including the three categories of “covered employees” described in the Final Guidance);
– Identifying the types and time horizons of risks to the organization from the activities of these employees;
– Assessing the potential for the performance measures included in the incentive compensation arrangements for these employees to encourage the employees to take imprudent risks;
– Including balancing elements, such as risk adjustments or deferral periods, within the incentive compensation arrangements for these employees that are reasonably designed to ensure that the arrangement will be balanced in light of the size, type, and time horizon of the inherent risks of the employees’ activities;
– Communicating to the employees the ways in which their incentive compensation awards or payments will be adjusted to reflect the risks of their activities to the organization; and
– Monitoring incentive compensation awards, payments, risks
taken, and risk outcomes for these employees and modifying the relevant arrangements if payments made are not appropriately sensitive to risk and risk outcomes.

More specifically, the Final Guidance suggests that the board of a large banking organization take a particularly active role in reviewing incentive compensation arrangements. Suggested steps include:

– Reviewing, on at least an annual basis, an assessment by management, with appropriate input by risk-management personnel, of the effectiveness of the design and operation of the firm’s incentive compensation system with respect to appropriately incentivizing risk-taking; and
– Periodically reviewing both backward-looking reports reviewing incentive compensation payouts relative to risk outcomes and forward-looking simulation analyses of compensation based on a range of performance levels, risk outcomes and the amounts of risk taken.

The Final Guidance notes that the Agencies “intend to actively monitor the actions being taken by banking organizations with respect to incentive compensation arrangements and will review and update this guidance as appropriate to incorporate best practices that emerge.” Furthermore, the FRB will be preparing a report on trends and developments in compensation practices at banking organizations “after the conclusion of 2010.”