Locke Lord QuickStudy: Reports Emanate From Washington That Financial Regulators Poised To Promulgate New Restrictions On Community Bank Executive Compensation

Locke Lord LLP
March 28, 2016

In June of 2010 bank regulatory agencies issued final guidance relating to incentive compensation arrangements at all financial institutions. Shortly thereafter in July, President Obama signed into law the Dodd-Frank Act. Section 956 of the Act directs the banking agencies to issue regulations, within 9 months, requiring disclosure of the structure of all incentive based compensation sufficient to determine whether the structure provided a director, officer, employee or principal shareholder with excessive compensation or could lead to a material financial loss by the insured institution. It also prohibits incentive compensation that encourages inappropriate risks. It prescribes that the agencies use existing law to prescribe standards for safety and soundness of compensation arrangements. It applies to private as well as public companies. That section excepted from its provisions banks under $1 billion in assets.

While the Act directed new rules be adopted 9 months after passage, the agencies have not done so but relied on the pre Act June 2010 guidance. The June 2010 Guidance applied to all financial institutions regardless of asset size but only those with “significant use” of incentive compensation. The Guidance is detailed and requires balanced risks by risk adjustment of awards, claw back provisions, multi-year performance measurement periods reduced reliance on high hurdles for award targets and deferral of payments. In addition, it discourages severance arrangements, payout arrangements and other strategies such as the “golden handshake” that allow an employee to substantially mitigate risk exposure to the organization. In practice, the agencies have not been aggressive in applying these guidelines reserving most of their attention for compensation of banks with egregious practices or with over $50 billion in assets or SIFI banks.

Also the SEC is expected to adopt its proposed claw back rules in April implementing Section 10D of the Exchange Act. Under the rules proposed in July of 2015, responsibility is shifted from the SEC to the registrant for recouping certain compensation; registrants are required to recoup any excess compensation based on erroneous data. They also create a no fault standard as opposed to the SOX “misconduct” standard for disgorging compensation, extend the claw back period to 3 years and significantly expand the number of executives subject to the rule. These rules raise various contract and fairness issues that are yet to be resolved and will spawn an entirely new practice area for lawyers as the law pits companies against their own executives even in cases where company deficiencies in financial reporting are through no fault of the employee.

Now reports are coming from the agencies that the President, in a meeting on March 7, 2016 with the agency heads urged completion of the rule making contemplated by Section 956 of the Act. The White House public statement was very vague but it appears that present were agency heads from the Federal Reserve Board, FDIC, SEC, NCUA, FHFA and the OCC. These rules are expected to address holding periods for a significant portion of compensation, and a broaden the scope of the employees subject to them. Further, they are expected to follow generally the principles that the EU has applied to financial companies. What is not yet know is how great a portion of compensation will be required to be withheld and for how long a period. The period under consideration is 3 to 5 years tending toward the longer EU period. The concept of to whom the deferral rule will apply is likely to be modeled after the SEC proposed rule on claw backs with more specialized definitions to cover those employees with the ability to expose the company to the greatest risk. Investment and loan underwriting officers with authority to make significantly sized investments relative to the banks operations are obvious targets for the rule beyond the officers included in the SEC rule. The effect of these provisions would be to subject to a claw back any deferred compensation. The details as to the definition of the triggering event for a claw back are yet to be developed. Unlike the SEC proposed claw back rule which requires a restatement of financial statements as the trigger the agencies may be considering a concept that would involve a financial restatement or a material adverse change in the metrics on which compensation payments are determined without a restatement. What can be expected is the codification of the Guidance such that banks will be required to impose hold backs at resignation or retirement subject to post termination performance of the bank. Assuming some grandfather exception, this would cause the revision of thousands of existing agreements including automatic renewals of employment, stock benefit, phantom stock and severance agreements and numerous other plans and agreements that are customarily employed in executive compensation. It would also have a profound accounting and tax effect in so far as benefits would not be actually or constructively received until the contingencies lapse. Banks must be prepared to do an extensive overhaul to existing agreements and arrangements when and if these rules are proposed. Without grandfathers for existing agreements, there will be a numerous court challenges based on contract rights to any post execution attempt to revise material terms of existing agreements or attempts to claw back vested benefits.

One of the aspects of Section 956 which is inconsistent with the agencies current views on community banking is that at the time the Act was passed Congress did not put any significant thought to defining a “community bank.” Almost as an afterthought, several different asset size thresholds were included in the law. Exemptions from certain requirements were available for some banks under $10 billion in assets (Section 165 (i)(2)(A) [see bottom of linked page] and Section 1025(a)) but for compensation purposes the threshold was set at $1 billion in assets. Since that time the agencies, especially the FDIC, have given considerable thought to the definition of “community bank” and created a definition based on both asset size and the type of business the bank engages in. For most all banks, the relevant measure is the $10 billion asset size since very few engage in the activities that would disqualify them as a community bank. This presents a conflict from what Dodd-Frank contemplates should be subject to heightened compensation standards. Presumably the Dodd –Frank threshold of $1 billion is because at the time Congress saw near systemic risk from unbridled risk taking incentivized by a compensation structure that disconnects bank risk from executive compensation risk (to use FDIC parlance) as a “moral hazard.” Contrast this with the studied development by the agencies of the definition of a community bank, i.e. banks whose size or operations present de minimis systemic risk. 

Reports are that the White House has only distinguished between banks under $50 billion in assets and over $1 billion in assets for less comprehensive rulemaking with the most extensive rulemaking reserved for the SIFI banks over $50 billion. No distinction has been made that would exempt banks under $10 billion, the accepted definition of community banks. Banks in this size range account for most of the banking industry. Similarly only a handful of credit unions have over $10 billion in assets It remains to be seen whether the agencies, most of whom are independent by law (meaning they do not serve at the pleasure of the president), will respond to the President’s urging. Will they propose a robust set of compensation restrictions codifying many of the principles as rules contained in the guidance or will they merely wait it out until the next President? This could be politically risky as the next President could be even more focused on executive compensation restrictions.