Friday, August 17, 2012

Sen. Brown of Ohio Urges SEC and Fed to Timely Adopt Enhanced Incentive Compensation Regulations under Dodd-Frank

In a letter to the SEC and the Fed and FDIC, Senator Sherrod Brown (D-OH) urged the expeditious adoption of enhanced incentive-based compensation regulations under Section 956 of the Dodd-Frank Act. The SEC and the banking agencies proposed regulations implementing Section 956 in April of 2011. Senator Brown asked them to timely adopt stronger regulations prohibiting major financial institutions from providing excessive compensation packages or incentive-based compensation that could expose firms to risks resulting in material loss. The Senator’s letter was partially driven by the recent revelation that JP Morgan Chase lost billions of dollars on synthetic derivatives trades that, in his view, once again highlighted the dangers and shortcomings of incentive-based compensation.  Section 956 provides the federal financial regulators with tools to rein in reckless and excessive compensation packages, said Senator Brown, adding that it has been nearly 16 months since the draft regulations were proposed and nearly 16 months since Dodd-Frank required their adoption.

The proposed regulations would regulate incentive-based compensation and help prevent the practices that encouraged excessive risk-taking and short-term rewards, acknowledged Senator Brown, but he views the proposals as establishing a baseline of rules to bolster the financial system. The proposed rules must be strengthened, he emphasized, and then implemented in a timely manner.  

For example, in implementing the risk management and corporate governance aspects of the proposed rule, he asked the SEC and banking agencies to pay close attention to the clawback policies of the firms. The Dodd-Frank Act contains clawback provisions in case of materially false financial statements or for executives of an institution placed in orderly liquidation. While acknowledging that these provisions are necessary, Senator Brown said that they are not sufficient since they apply in specific situations and contain limitations. The recent examples of wrongdoing in the financial sector encompass a wide range of behavior, from rate manipulation to falsifying trading positions, which can result in different kinds of short-and long-term losses. Thus, he urged that robust clawback provisions be used as a response to individuals seeking to game compensation policies.

The Senator also pointed out that proposed rules requiring executive officers at large financial firms to defer at least 50 percent of their incentive-based compensation for at least three years do not depart significantly from the pay practices in place during the years preceding the financial crisis. Despite these practices, he noted, it is clear that not enough is being done to tie long-term measurements of profits and losses.

Senator Brown urged the SEC and banking agencies to adopt regulations under Section 956 that are more forward-looking than current industry practices by increasing the percentage of deferred compensation. Stock compensation arrangements for all employees, particularly those that engage in significant economic activities, should be subject to long-term holding periods and pro rata payments should be prohibited, he advised.  Because of the sheer size of executive compensation, he reasoned, allowing bonuses to be paid out in pro rata shares over the mandated three-year retention period will not have a substantial impact on risk taking behavior.

What needs to be done is to align the economic incentives of employees with the firm overall, said the Senator, and create what Professor Robert Jackson has called a "base of patient capital" to be used either to finance economic activity or to help the institution weather economic difficulties. Implementing such a long-term holding period would be a step toward recreating the incentive structure that existed when Wall Street firms were organized as private partnerships. Because private partnerships put partners' investments directly on the line, he noted, management had a natural incentive to be risk-averse. Unfortunately, in his view, current practices appear to offer inadequate incentives for proper risk management.

When making a determination on whether incentive-based compensation is excessive or could lead to material financial loss, noted Senator Brown, regulators must have access to granular data behind a firm's decisions on bonuses. Under the proposed regulations, financial institutions must provide a clear, narrative description of their incentive-based compensation packages, as well as an overview of the policies and procedures governing compensation decisions. However, given the fact that regulators already have access to general information on the compensation structures at each firm, reasoned the Senator, such a rule is unlikely to yield improved information.
He urged the SEC and bank agencies to require financial institutions to provide specific quantitative data describing the level and nature of the compensation each worker receives. Requiring quantitative data allows regulators to establish metrics and set benchmarks, giving them the ability to analyze both the connection between value created and pay and the aggregate effect of pay structures on institutions and the financial system. The Senator also believes that such information would aid in the enforcement of the compensation provisions of the Volcker Rule prohibition against proprietary trading.

Senator Brown also asked the regulators to ban compensation hedging practices. He said that preventing executives from circumventing incentive-based compensation arrangements through hedging will become particularly important as financial institutions move toward more equity-based pay arrangements with longer retention periods. Indeed, some financial institutions have already recognized that hedging practices distort employee incentives and have banned the practice for their employees. In the Senator’s view, there is no reason for federal regulators to adopt rules that are more lenient than industry best practices.

The proposed regulations would require each board of directors to identify employees who individually have the ability to expose the firm to possible losses that are substantial in relation to the institution's size, capital, or overall risk tolerance, and to approve compensation packages for such employees. Senator Brown has two concerns with the proposal. First, it is unlikely that the board of directors would actually reject executive compensation packages. Second, the proposal sets a low bar and likely provides firms with too much discretion. In order to accomplish the desired effect, Senator Brown urged the SEC and bank regulators to enumerate more specific and more stringent standards that would make an employee's compensation subject to review, not by their board of directors, but by a non-conflicted party, such as the appropriate federal regulator. Alternatively, board member compensation could be subject to clawback for failing to properly execute pay package review responsibilities, thereby providing a powerful incentive for board members to focus their attention on compensation package reviews.

Although executive officers undoubtedly play important roles at financial firms, noted Senator Brown, Federal Reserve General Counsel Scott Alvarez has also recognized that compensation practices can incent even non-executive employees to undertake imprudent risks that can significantly and adversely affect the risk profile of the firm.  Citing reports concerning manipulation of the London Interbank Overnight Rate (LIBOR) showing that derivatives traders at Barclays sought to influence LIBOR submissions in order to benefit their profit and loss numbers and presumably bonuses based upon such figures, Senator Brown said various levels of traders at large firms have the means and the incentives to take excess risk in pursuit of profits that will result in greater compensation. Thus, he suggested that adjustments to the incentives created by compensation arrangements at large financial institutions should be extended to include any employees who could put the firm at substantial risk.