Wednesday, July 20, 2016

CII seeks stronger clawback language in incentive-based compensation proposal

By John Filar Atwood

The Council of Institutional Investors (CII) expressed wide support for the proposed rule on incentive-based executive compensation, but asked the sponsoring entities to consider adding instances where clawbacks would be mandatory. CII expressed its views in a comment letter to the agencies that developed the proposal, which are the SEC, the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corp., the Federal Housing Finance Agency, and the National Credit Union Administration.

The proposal would implement Section 956 of the Dodd-Frank Act, which requires that the agencies jointly issue regulations or guidelines prohibiting incentive-based payment arrangements that the agencies determine encourage inappropriate risks by certain financial institutions by providing excessive compensation or that could lead to material financial loss. It also requires the financial institutions to disclose information concerning incentive-based compensation arrangements to the appropriate regulator.

CII said in its comment letter that it believes that the proposed rule represents a meaningful response to some of the lessons learned from the financial crisis. The proposal preserves a role for incentive-based compensation at financial institutions, CII noted, but with a greater emphasis on risk management and long-term outcomes.

CII said that it supports the proposed rule’s over-arching requirements that incentive-based compensation arrangements at covered financial institutions appropriately balance risk and reward, and bar arrangements that could encourage inappropriate risks. CII also approves of the rule’s recognition that the board should oversee incentive-based compensation programs.

Clawback mechanism. The proposed rule would require systemically important financial institutions to adopt clawback mechanisms by which they could seek to recover incentive-based pay for seven years after such compensation has vested. The policies would provide for optional recovery in the event of misconduct resulting in significant financial or reputational harm, fraud or intentional misrepresentation of information used to determine incentive-based pay.

CII notes that the proposed rule does not identify any circumstances in which forfeiture, downward adjustment or clawback is mandatory. In light of the failure of some compensation committees to seek appropriate clawbacks in the past and the importance of systemic risk posed by covered financial institutions, CII urged the agencies to consider identifying in the final rule some circumstances when forfeiture, downward adjustment or clawback of incentive-based compensation is mandatory, while preserving discretion for less conclusive situations.

In addition, CII does not view seven years after vesting as an unreasonable period to adopt, but notes that CII policies provide that all incentive-based compensation should remain subject to recovery for at least three years following discovery of the basis for recovery.

Risk takers. The proposed rule applies to senior executive officers at financial institutions holding at least $1 billion in average total consolidated assets, and significant risk takers at financial institutions holding at least $50 billion in assets. CII expressed concern that under the proposed definition, employees that are not senior executive officers but place billions of dollars at risk at systemically important financial institutions would avoid automatic significant risk taker status. CII said that the final rule would better serve investors if the significant risk taker definition were revised to more broadly cover non-executive significant risk takers.

Risk/reward balance. The proposed rule provides that incentive-based compensation will not be considered to balance appropriately risk and reward unless three conditions are met: (1) inclusion of financial and non-financial measures to measure performance; (2) allowance of non-financial measures to override financial measures when appropriate, and (3) permission to make any amount awarded subject to adjustment to reflect actual losses, inappropriate risks taken, compliance deficiencies, or other measures. CII stated that while the three conditions do not ensure a balance of risk and reward, CII is satisfied that the guidance increases the likelihood of an appropriate balance.

Deferrals of pay. For systemically important financial institutions, the proposed rule mandates deferral of 40 percent to 60 percent of incentive-based pay, with short-term incentive-based pay requiring longer deferral than long-term incentive-based pay. CII said that it supports revisions to the proposed rule that would further increase the percentages of annual incentive-based compensation subject to mandatory deferral.

CII said that it opposes hedging by executives and discourages companies from allowing other employees to hedge equity-based awards or other stock holdings. Accordingly, CII supports the proposed rule’s provision preventing covered institutions from hedging on employees’ behalf to limit their risk associated with incentive-based compensation. However, CII believes that rule could be improved if it also barred senior executive officers and significant risk takers from directly engaging in hedging activity to offset risk connected with their incentive-based compensation.