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.