11/10/11

Client Alert: Fed Report Offers Insight into Compliance with Interagency Guidance on Sound Incentive Compensation Practices

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In June 2010, the federal banking regulators jointly issued guidance (the “Interagency Guidance”) recommending that all banking organizations organize their incentive compensation programs for covered employees around the following three principles:

In October 2011, the Federal Reserve released a report describing the results of a “horizontal review” assessing the compliance by 25 large banking organizations with the Interagency Guidance.  This report offers insight into the regulatory expectations for complying with, as well as the practical experiences of banking organizations in implementing, the Interagency Guidance. 

Results of Report

The report contains a number of useful observations regarding implementation of the Interagency Guidance, particularly with respect to the identification of covered employees and the use of various “balancing” mechanisms to make incentive compensation programs more risk sensitive. These observations are discussed in greater detail below.

Identification of Covered Employees

The compensation of the following “covered employees” must be evaluated under the Interagency Guidance:

The report noted that many organizations struggled to identify groups of mid- and lower-level employees, such as mortgage originators, commercial lending
officers and traders with large positions, whose compensation programs must be evaluated under the Interagency Guidance. 

The report endorses the following two methods to identify covered employees:

Generally, the report dismisses the use of mechanical materiality thresholds (such the ability to commit capital or compensation) to determine covered employees as excluding employees who influence risk but do not make final risk decisions and groups of employees who may affect risk.

Balancing Compensation Programs

The Interagency Guidance requires that the compensation programs of covered employees appropriately balance risk-taking and financial reward. 

The Interagency Guidance specifically identifies the following four methods that can be used to make compensation programs more risk sensitive:

Of these four methods, the report notes that most organizations adjusted payouts based on risk outcomes and deferred payments. The report concluded that lengthening performance periods or reducing sensitivity to short-term performance did not effectively balance risk-taking incentives unless used in conjunction with another balancing method.

The report notes that effective risk-based adjustments: 

When deferral is used as a balancing method, the report concludes that the deferred payouts must be adjusted to account for risks that become known during the deferral period.  With respect to deferred awards:

The report dismissed the use of clawback policies as a balancing mechanism, noting that most risk outcomes do not result in recovery (i.e., clawback is triggered by malfeasance, etc.).

Next Steps

The large banking organizations that are the subject of the report are expected to be in compliance with the Interagency Guidance by December 31. Compliance by other banking organizations will be addressed through the annual bank examination process.

Vorys provides specialized advice to banking organizations relating to compensation practices, including on compliance with the Interagency Guidance.  Vorys can assist banking organizations:

If you would like more information about the Interagency Guidance or would like to have a Vorys attorney speak to your management team, Board of Directors or Compensation Committee, please contact your Vorys relationship attorney.