There’s a great deal of anxiety over the Dodd-Frank Act’s compensation provisions. Don’t wait to start reassessing your bank’s situation, experts warn.
With Dodd-Frank pay rules pending, there are more questions than answers. But there are steps banks can, and should, take now
By Steve Cocheo, executive editor,
When Charles Elson considers the jubilation expressed by backers of the governance and executive compensation provisions of the Dodd-Frank Act, he finds it ironic. At best, says Elson, a governance expert, they won a pyrrhic victory.
True, the law authorized long-sought proxy access for shareholders, which the Securities and Exchange Commission has already implemented. But much of what Dodd-Frank contains regarding compensation, Elson says, “effectively neuters the Compensation Committee.”
Elaborating, he says, “it will make the Compensation Committee a tool of federal regulatory mandates, rather than an instrument of promoting shareholder value.” He sees the publicly held banking company’s comp committee increasingly becoming tied up in compliance, not constructive efforts.
“The board [working through the comp committee] can’t be the kind of monitor that we should be able to expect,” says Elson, who holds the Edgar S. Woolard, Jr., chair in corporate governance at the University of Delaware and is director of the university’s John L. Weinberg Center for Corporate Governance.
So, to those who cheered when these aspects of Dodd-Frank passed, Elson offers this: “Congratulations, now you can elect a director. But are you just electing that director to an impotent board?”
Elson’s view seems pretty grim. Other experts, while in no way denying Dodd-Frank will be a bear in compensation, see things differently, if not quite positively.
Time of governance evolution
“We’ve got a new set of lenses and have to look at things differently,” says Susan O’Donnell, managing director at Pearl Meyer & Partners, a consulting firm that works with many banks. “That’s not necessarily a bad thing.”
“There seems to be a continuing momentum for bank boards to be more involved than they were in the past,” adds Patrick Cole, Crowe Horwath, LLP. “With the Compensation Committee members I work with, there is a sense of urgency to become more knowledgeable and more involved, and not to be so dependent on others to say if they are fulfilling their duties.”
Cole agrees with Elson that the Comp Committee’s role is changing, but sees the metamorphosis differently. “That job is becoming much more than just an advisory responsibility,” says Cole. “It’s becoming a fiduciary responsibility. That’s a bigger job than those directors signed up for.” Yet, he says, they soldier on to get it right.
Some question whether Congress really nailed the right issue in targeting comp, rather than risky behavior.
“Compensation is easier to change,” Brian Dunn, observes wryly. Dunn, president of McLagan, a subsidiary of AON Corp., and CEO of Global Compensation for AON Consulting Worldwide, says that “at the end of the day, changing comp is not sufficient. It’s a great sound bite, for Congress, though, to be able to say, ‘We took care of those fat-cat bankers’.”
Compensation keeps on brewing
As those comments indicate, not all experts agree that things are quite as gray as Elson paints them. But they do agree that challenges lie ahead, and that the role of the Compensation Committee, and, by extension, the board, will swell in importance.
Initially, the extent of the change hinges on bank ownership structure and size, though experts expect to see changes gradually trickle down to smaller players, much as seen in the wake of the Sarbanes-Oxley Act. For a time, Elson actually sees some advantages to being a less-regulated smaller institution, though trickle-down will eclipse that before long.
Banks participating in TARP in some ways have had an unenviable advance-seating at the table that other institutions will be joining with the meal in progress. “Say on pay,” for instance, is something public TARP banks have lived with from the get-go.
Another issue is “brain drain.” ABA predicted that this situation would grow if TARP-type restrictions became part of Dodd-Frank. “We have heard from our bankers about losing talented people to industries and companies where compensation isn’t under a microscope,” says Sarah Miller, senior vice-president and head of ABA’s Center for Securities, Trust, and Investments. Pearl Meyer’s O’Donnell adds that attracting talent into such an environment “has been extremely hard.”
What you’re up against
ABA’s Miller and other experts suggest that bankers had better strap in for increasing pay scrutiny. Banking compensation, a hot topic for the last year or two, continues to boil, and no development can be treated in a vacuum. Here is a rundown of key developments:
Regulatory guidance. Just before Dodd-Frank passed, the Federal Reserve, FDIC, Comptroller’s Office, and Office of Thrift Supervision jointly issued “Guidance on Sound Incentive Compensation Policies.” The guidance establishes a two-tier approach, one covering very large institutions and the other covering the rest. (Reports indicate FDIC’s proposal to tie assessments in part to perceived riskiness of compensation is not actually dead, either.)
Overall, this is the spirit of the guidance: “Banking organizations too often rewarded employees for increasing the organization’s revenue or short-term profit without adequate recognition of the risks the employees’ activities posed to the organization.”
While “guidance,” it shouldn’t be underestimated.
“TARP rules had no impact below the top 25 people,” says AON’s Brian Dunn. “But a lot of what the federal agencies are doing will absolutely impact everyone, including rank and file. It will require more thoughtful design of plans, with better controls.”
Basel III impact. As finalized in mid-September, and supported by U.S. regulators, the Basel III capital agreement would permit covered institutions to maintain a lower “conservation buffer” in their capital structure provided that they agree to hold down comp and pay no dividends until the buffer is restored. So, once again, “compensation has to take a hit,” says ABA’s Sarah Miller. It’s way too early to do more than be aware that this is coming down the road; but that alone is sobering.
Dodd-Frank Act. The giant law will be implemented in stages, and some parts solely affect public companies. Among them:
• “Say on pay,” which gives shareholders the right to a nonbinding vote on executive pay, and a separate right regarding votes on golden parachutes for executives.
• Pay versus results—proxies will have to disclose the relationship between executive pay and company performance.
• Mandatory clawback policies, in a form that goes beyond the Sarbanes-Oxley Act. Where SOX required wrongdoing to trigger recovery of rewards from executives, Dodd-Frank allows recovery due to accounting restatements arising from noncompliance with financial reporting mandates.
• Compensation Committee requirements will become stiffer. Independence standards will resemble those applicable to Audit Committees under federal law. Rules will govern hiring and payment of advisors.
• Provisions covering all banks of $1 billion or more in assets are to be issued by banking and other regulators by April 21, 2011. They will include disclosure of the structure of all incentive compensation arrangements. Further, any plan deemed by regulators to encourage inappropriate risks by providing “excessive” compensation, fees, or benefits, is to be prohibited. This will include not only executive pay, but incentive plans for employees, directors, and even principal shareholders.
Given all this, what’s the most common question bankers are asking about Dodd-Frank implementation? Brian Dunn chuckles, and says: “They ask, ‘What’s everyone else doing?’ Nobody wants to be an early adopter. Nobody’s blazing any new trails.”
Opportunity to get ready
Right now, banks large and small face a situation that Dunn characterizes as “radio silence.” Having put out their June guidance, and having nine months from enactment of Dodd-Frank to come out with what amounts to “Act Two”—proposed rules implementing the law—the regulators have pretty much clammed up, apart from Basel III.
“There’s a lot of uncertainty out there,” says Dunn. “So there’s not a lot of change being made ahead of that.”
That’s a reasonable response for banks, but not making changes isn’t the same as putting things in “park.” Indeed, says O’Donnell, “I tell my clients to show that they are ahead of the curve.”
Crowe Horwath’s Patrick Cole says Compensation Committees may start driving that impetus.
“They’re saying, ‘We’re not going to wait to have someone knock on our door. We’re going to get ahead of this’,” Cole reports.
Consultants say banks can start by getting their compensation house in order now, and by doing some rethinking of the fundamentals before deadlines loom.
In any event, O’Donnell points out that the June regulatory guidance is in effect now, so that whenever examiners next visit the bank, they will be expecting progress.
Setting interim priorities
To prepare for implementing the Dodd-Frank pay elements, experts suggest that banks review existing incentive programs at all levels.
This is necessary to ensure compliance with the spirit of the June guidance, which exempts no type of plan nor level of employee. Unchecked risk, wherever it arises, is regulators’ target. The three main principles in the guidance are:
1. Pay programs should balance risk and results in a way to avoid encouraging employees to expose the bank to “imprudent risk.”
2. Programs must be compatible with effective corporate controls.
3. Programs must be supported by robust corporate governance, including effective board oversight.
The guidance details four possible, but not exclusive, ways for banks to rein in comp risk. They include adjusting compensation based on risk factors; deferring payment in some way and degree until the business proves out; shifting away from an annual perspective on performance, to a longer view; and reducing sensitivity to short-term results in favor of long-term results.
Getting down to specifics
Beyond that general advice, experts suggest some detailed points to examine while awaiting proposed regulations.
• Look at the composition of the Comp Committee. Independence and qualifications may be due for a review in any bank. “Why wouldn’t you want to look at the composition of the board and decide on the capability of those people to be part of the conversation?” asks Christie Summervill, principal, Balanced Compensation.
• Figure out who your risk takers are. Reflecting the fact that most of the concern is about risk, AON’s Brian Dunn recommends banks become clear about this: “Who are the people able to put the institution at material risk?”
• Get the whole picture. Especially in larger organizations, the right hand may still not know what the left hand is doing in regard to incentive pay and risk, says O’Donnell. She says now is the time to unify oversight and coordination of all incentive plans across all parts of the organization.
• Reconsider your metrics. The regulatory guidance provides some food for thought here. Especially in a time of slow-growth, there’s an opportunity to revisit just what constitutes performance to be incented.
“It’s hard to build incentive plans when coming out just level would be wonderful,” notes Balanced Compensation’s Christie Summervill.
Clearly, regulators are concerned about risk, and a chief source is the assets a bank puts on its books, reasons Brian Dunn.
If that is the case, Dunn continues, does it make sense to solely base executive compensation on such measures as earnings per share and return on equity? Such measures only reflect the state of the bank’s assets when something has already gone wrong.
“Certainly, in this environment, you don’t want to have your eggs all in one metric,” says O’Donnell. “Any single measure is unbalanced, and in this environment, you want balance.”
• Explore a multiyear view, or a project view. Dunn points to financial industry models that don’t have an allegiance to the calendar. In the private-equity business, for instance, it is typical for an executive’s incentive pay to be hinged to the deal he or she is working on. When the deal produces for the firm, the executive reaps.
• Don’t go overboard. While this is a time to review, before the regulatory buffeting resumes, O’Donnell advocates some moderation. She worries that community banks, many of which didn’t engage in anything remotely like what caused the industry’s troubles, not throw out a good program because of fear of what regulators will say. Examiners will clearly be looking at lender programs, for instance. But even those shouldn’t just be shut down.
“Incentive pay is a very good way to drive compensation,” she says. Don’t ditch a useful carrot.
“Excessive” compensation: A sleeper?
Hanging out there with the “Act Two” regulatory effort mandated by Dodd-Frank is its tenet concerning “excessive compensation.”
“That is troubling,” says ABA’s Sarah Miller. “How can regulators make a determination as to what is ‘excessive’? What works for one bank may not work for another.”
The very slight silver lining (no pun intended), says Miller, is that while this provision will apply to all banks, not just public ones. In addition, it will apply to certain other types of financial institutions not regulated by banking agencies. SEC and other agencies will be working on that.
However, some types of competitors will not be affected, Miller adds. Where this will leave the competitive mix—in the wake of a law that in part resulted from the errors of the “shadow banking system” and its comparatively unregulated players—can only be guessed at. •
The electronic version of this article available at: http://www.nxtbook.com/nxtbooks/sb/ababj1010/index.php?startid=52