Dodd-Frank’s hatchet men: SEC & others go after incentive-based compensation

By Guest Contributor
March 9, 2011

March 8 (Westlaw Business) –  Can Dodd-Frank’s latest anti-risk salvo, a new proposed rule on incentive-based compensation, solve as many questions as it raises? In theory, the idea is a noble one: break the chain of managing for the short-money by curtailing lopsided risks that ultimately soak the taxpayer. But even the SEC and the other agencies involved under the new Dodd-Frank regime admit there will be no shortage of questions.

Section 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act lays the groundwork for the regulation of incentive-based compensation. The statute formally rejects the idea that it “require[s] the reporting of the actual compensation of particular individuals;” likewise, the statute’s scheme thus offered does not apply to otherwise covered institutions lacking incentive-based compensation packages.

The rule itself has been proposed jointly by not only the SEC, but a raft of other federal regulators as well. Generally, the rule explains,

A covered financial institution must not establish or maintain any type of incentive-based compensation arrangement, or any feature of any such arrangement, that encourages inappropriate risks by the covered financial institution, by providing incentive-based compensation to covered persons, either individually or as part of a group of persons who are subject to the same or similar incentive-based compensation arrangements, that could lead to material financial loss to the covered financial institution.

Covered financial institution itself admits a broad range of outfits from banks and thrifts to broker/dealers to Fannie Mae and Freddie Mac.3 As the Rule’s overview explains,

The Proposed Rule would prohibit incentive-based compensation arrangements at a covered financial institution that encourage executive officers, employees, directors, or principal shareholders (“covered persons”) to expose the institution to inappropriate risks by providing the covered person excessive compensation ….4

The Proposed Rule would prohibit a covered financial institution from establishing or maintaining any incentive-based compensation arrangements for covered persons that encourage inappropriate risks by the covered financial institution that could lead to material financial loss.

With thresholds such as “inappropriate risk,” “excessive compensation,” and “material financial loss,” one might be forgiven for wondering how these subjective concepts can possibly admit uniform, or even predictable, application.

In a nutshell, the Rule has two size-based primary thresholds: Covered Institutions with assets greater than $1 billion; and “larger covered financial institutions”—those with assets greater than $50 billion. For the former, the Rule will require all covered financial institutions—including U.S. operations of otherwise covered foreign institutions—to submit for board approval exactly what incentive-based compensation packages have been provided to the employees, officers, directors and principal shareholders. Compensation includes all variable cash and non-cash performance-based awards intended to serve as incentives for performance.

The board must identify those individuals with “the ability to expose the institution to possible losses that are substantial in relation to the institution’s size, capital, or overall risk tolerance.” These boards must also file annual reports with the condign regulator detailing their policies.

For the larger covered institutions, the Rule gets still more stringent. The biggest of the big dogs—the executive officers at institutions with assets $50 billion or greater—will have to defer 50% of their incentive-based compensation for a period of at least three years. “The Proposed Rule also would require that deferred amounts paid be adjusted for actual losses of the covered financial institution or other measures or aspects of performance that are realized or become better known during the deferral period.”

The reason for this last rule seems sound enough: If management’s compensation can be clawed back in the event of lackluster medium term performance, these executives will focus their attention on not only the company’s longer term health, but a fortiori, investment schemes less likely to blow up and impact their own wallets.

To the credit of the SEC and other agencies, they admit that the full universe of knowledge of the Rule’s impact can’t be known at this time. Similarly, they have actively solicited feedback on not only the reasonability of their proposals, but any potentially significant unforeseen consequences in the scheme.

A perfect example, fairly buried within the Rule’s 139 pages, asks: “Do commenters believe that there is a substantial risk that covered financial institutions would reconfigure their operations, structure, or assets in such a manner as to circumvent being classified as a large covered financial institution?” This question reduces much of Dodd-Frank to its essence, i.e., will the Statute’s very sweep ultimately reduce its effectiveness?

Other rules proposed within the Dodd-Frank scheme have openly questioned whether their measures might open the door to regulatory arbitrage.  Might this Proposed Rule relating to incentive-based compensation actually push institutions out of the Act’s purview?

With respect to the incentive-based comp Rule, §248.207 (“Evasion”) provides that “A covered financial institution is prohibited, for the purpose of evading the restrictions of this subpart, from doing directly or indirectly or through or by any other person, any act or thing that it would be unlawful for such covered financial institution to do directly under this subpart.” The Rule, as noted above, applies only to institutions with assets greater than $1 billion. Might institutions lawfully spinoff various arms into smaller companies to get around the prying eyes of regulators? Could some kinds of joint venture or other off-balance sheet entity effect the same end?

Might an institution hovering near the $50 billion threshold (and thus requiring a minimum three-year compensation deferral period), shave off assets to allow executives a freer hand?

Moreover, while the Rule applies to U.S. operations of foreign institutions, what if individuals with the most at stake simply transfer their desks out of the U.S.? The scenario doesn’t seem far-fetched—particularly where millions could be on the line for an individual.

Another potentially troublesome issue goes to the very nature of gauging risk itself. If one thing has been learned from the Great Wall Street Fiasco of ’08, it’s that only a relative handful of people accurately appreciated realities of risk. As numerous commentators have pointed out, before breaking out of the lab like some biological experiment run amok, credit default swaps (CDS) were considered a hedge against risk. Regulators allowed institutions to adjust their capital if their mortgages were insured against default. The once-hallowed role of the ratings agencies has since been exposed. Behavior or compensation schemes that seem low-risk today could look much different ten years down the road.

The Rule notes that in order to remain competitive, some institutions may find themselves paying top execs more in fixed salary, in order to compensate (no pun intended) for options or other awards that become less attractive with the lookback provisions. Although the Rule also posits the likelihood that this might even out as deferred compensation could be diminished, could this mean a whole new fixed-compensation revolution? In effect, does Dodd-Frank, in the interest of mitigating systemic risk, open the vaults to management to return to big-ticket salaries, rather than golden handcuffs and back-dated options? Could the objective of managing for medium-term goals be lost to an incentive-free comp structure?

Elsewhere, the Commission acknowledges the possibility that the proposed rules may reduce the incentive for certain covered persons to switch jobs because would-be new employers that are covered financial institutions would be bound to offer such covered persons compensation packages that comply with the proposed rules. If a lack of turnover results, it might adversely impact competitiveness among firms, but it may also promote institutional stability within firms.

Will the new Rule now tilt the playing field in favour of non-covered institutions? “The Commission believes the proposed rule strikes an appropriate balance in this regard, but requests comment generally on this issue.”

Will the Rule stand up to constitutional challenge? The Rule explains that its terms merely “supplement existing rules and guidance adopted by the Agencies regarding compensation and incentive-based compensation.” It’s one thing to regulate the compensation of executives at Federal Home Loan Banks, but as of September 2008, mighty Goldman Sachs is now a bank holding company and major dollars will be at stake. To the extent employment contracts might still be on the books, could the new Rule somehow impair those contracts?

In addition, those pesky terms like “inappropriate,” “excessive,” “effective” and the like, are at best vague. Could a company successfully challenge the Rule based on the inherent vagueness of the terms? Could a company whose incentive-based compensation scheme that was judged by regulators to unduly encourage excessive risk, have an as-applied basis for challenge if other companies’ plans are not so deemed?

Here, too, “excessive” retains a fluid character. The rule looks at a wide range of factors, including not only an individual’s own earning history, but the overall health of the institution.5 When considering the many individuals who leave government service to take up scandalously lucrative positions at hedge funds and the like, one should also remember that only such incentives deemed to “encourage inappropriate risk” (as opposed to buying high-level connections) will be proscribed.

What litigation doors may be opened by the Rule? What impact will governmental imprimatur have on the Business Judgment Rule? For instance, once a government regulator signs off on a bonus or stock option plan as “not excessively risky,” should things go south, will the company have a litigation shield—a kind of estoppel argument? On the other hand, should a regulator find the Rule violated, would such a judgment give rise to a private right of action?

The fact that proposed rules or legislation admits to uncertainty should be applauded rather than criticized. In the final analysis, the Rule may cause a kind of trouble not imagined at the drafting table. Even if successful, subsequent rules or legislation may not mesh and may even create new loopholes to be exploited. As events have shown, it’s hard to regulate what you can’t grasp.

(This article was first published by ThomsonReuters’ Westlaw Business Currents, a leading provider of legal analysis and news on governance, transactions and legal risk. Visit Westlaw Business Currents online at http://currents.westlawbusiness.com.)

(This article was first published by ThomsonReuters’ Westlaw Business Currents, a leading provider of legal analysis and news on governance, transactions and legal risk. Visit Westlaw Business Currents online at http://currents.westlawbusiness.com.)
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