Boardman & Clark LLP—Banking Group

Federal Reserve and FDIC Advance Proposals Regarding Incentive Compensation Structures for Banks

The Federal Reserve and the FDIC have both recently submitted proposals in response to perceived risks created by incentive compensation in the banking industry. On October 27, 2009, the Federal Reserve published proposed guidance on sound incentive compensation arrangements at banks, under which banks are expected to review their incentive compensation arrangements and implement the certain principles when structuring incentive compensation arrangements. On January 19, 2010, the FDIC published an advanced notice of proposed rule making seeking comments on tying incentive compensation to deposit insurance rates. The FDIC proposal is intended to complement the Federal Reserve's proposal, but aims to provide incentives to institutions to exceed the minimum standards. To facilitate this goal, FDIC sets forth a proposed compensation model intended to reduce risk created by incentive compensation programs and suggests that banks which include elements of the proposed model in their compensation arrangements may receive lower deposit insurance rates.

Federal Register's Proposed Rulemaking

The Federal Reserve's proposal expects all banks, not just banks participating in the Troubled Asset Relief Fund, to evaluate and immediately address deficiencies in their incentive compensation arrangements. Evaluations should include incentive compensation arrangements for all executive and non-executive employees who, either individually or as part of a group, have the ability to expose the bank to material amounts of risk.

The Federal Reserve's proposed guidance does not establish specific caps, formulas or limits on compensation on banks when structuring incentive compensation arrangements, but focuses on three principles of "safety and soundness." To be consistent with safety and soundness, the Federal Reserve believes that sound compensation practices should include the following three principles:

1. Take a balanced approach. Provide employees incentives that do not encourage excessive risk taking beyond the bank's ability to effectively identify and manage risk.
• Fed Example: Two employees who generate the same amount of short term revenue or profit for a bank should not receive the same amount of incentive compensation if the risks taken by the employees in generating that revenue or profit differ materially. The employee whose activities create materially larger risks for the bank should receive less than the other employee, all else being equal.
2. Be compatible with effective controls and risk management.
• Fed Example: Incentive compensation arrangement policies and procedures should:
• identify and describe the role(s) of the personnel, business units and control units authorized to be involved in the design implementation and monitoring of the arrangement;
• identify the source of significant risk-related inputs to these processes and establish appropriate controls governing the development and approval of these inputs to help ensure their integrity; and
• identify the individual(s) and control unit(s) whose approval is necessary for the establishment of new incentive compensation arrangements or modification of existing arrangements.
• Be supported by strong corporate governance, including active and effective oversight by the bank's board of directors.
• Fed Example: Small banks' supervisory staff should review incentive compensation arrangements as part of the regular, risk-focused supervisory process. These reviews should be conducted in connection with the review of the bank's risk management, internal controls and corporate governance. A small bank that uses incentive compensation arrangements on a limited basis is not expected to have as formalized, extensive and detailed policies, procedures and systems governing its incentive compensation as a large complex bank.

In addition to the three principles, the Federal Reserve intends to commence two supervisory initiatives:

1. A special horizontal review of incentive compensation practices at large, complex banks. These banks will be expected to provide the Federal Reserve with plans to reduce risk-taking behavior associated with their incentive compensation plans.
2. A review of incentive compensation practices at all other banks as part of the Federal Reserve's regular risk-focused examination process.

The comment period for the Federal Reserve's proposed guidance ended November 28, 2009. The actual text of the Federal Reserve's proposal is found at: http://edocket.access.gpo.gov/2009/pdf/E9-25766.pdf.

FDIC's Proposed Rulemaking

Section 7 of the Federal Deposit Insurance Act requires the FDIC to base a bank's deposit insurance rate on the probability that the Deposit Insurance Fund will incur a loss with regard to that bank. This requires the FDIC to set risk-based assessments for insured depository institutions. Based on Material Loss Reviews conducted in 2009, the FDIC believes that risks presented by incentive compensation programs are an appropriate factor to be considered by the FDIC. The FDIC's proposal suggests that banks which meet certain criteria outlined in the proposal may receive lower deposit insurance rates or, alternatively, that banks that do not meet the criteria may be subject to increased rates.

The FDIC has indicated that it will look to apply the following criteria in evaluating the risks presented by incentive compensation programs:

1. A significant portion of compensation for employees whose business activities can present significant risk to the bank and who also receive a portion of their compensation according to formulas based on meeting performance goals should be compromised of restricted, non-discounted company stock. Such employees would include the bank's senior management, among others. Restricted, non-discounted stock is stock that becomes available to the employee at intervals over a period of years.
2. Significant awards of company stock should only become vested over a multi-year period and should be subject to a look-back or claw-back mechanism designed to account for the outcome of risks assumed in earlier periods.
3. The bank's compensation program should be administered by a committee of the board composed of independent directors with input from independent compensation professionals.

The FDIC's board agreed by a 3 to 2 margin to seek comment on the proposal. Two board members expressed strong objections to the proposal. The objecting board members, John Dugan who heads the OCC and John Bowman, the director of the OTS, argued that the proposal was premature and possibly outside of the FDIC's authority. They also took issue with addressing risky compensation arrangements through deposit insurance rate increases. Consequently, given the objections, it is not certain what shape the final FDIC policy on incentive compensation will take.

Comments on FDIC's proposal are due by February 18, 2010. The actual text of the FDIC's proposal is found at http://www.fdic.gov/regulations/laws/federal/2010/10proposeAD56.pdf.