Some of the Fed's compensation guidance should be considered more broadly

By Cydney Posner

The Federal Reserve has recently proposed guidance designed to ensure that the incentive compensation policies of banking organizations do not undermine the safety and soundness of their organizations. But the notion that inappropriate bonus or other compensation practices can incent employees at almost all levels to take imprudent risks that significantly and adversely affect their companies is clearly not limited to banks. With that in mind, several commentators have suggested that we heed those aspects of the new guidance that may have more general application, and, in fact, many of the recommendations have long been standard fare. As noted below, the Treasury's Special Master has applied some of these concepts to TARP recipients.

1. Balanced Risk-Taking Incentives

Incentive compensation arrangements should balance, in both design and implementation, risk and financial results to avoid incenting employees to take excessive risks on behalf of the organization. Incentives to achieve short-term revenue or profit can be problematic because the risk outcomes may become clear only over time. Activities that carry higher risk typically yield higher short-term revenue, and an employee who is given incentives to increase short-term revenue or profit, without regard to risk, will naturally be attracted to opportunities to take more risk. Under a balanced incentive compensation arrangement, two employees who generate the same amount of short-term revenue or profit for an organization should not receive the same amount of incentive compensation if the risks taken by the employees in generating that revenue or profit differ materially. Similarly, if employees receive substantially all of their potential incentive compensation even when risk or risk outcomes are materially worse than expected, employees have less incentive to avoid excessively risky activities.

While banks are generally concerned with credit, market, liquidity, operational, legal, compliance, and reputational risks, many of these risk areas also apply to companies in other industries. Measure of risk can be both quantitative and qualitative. Where judgment plays a significant role in the design or operation of an incentive compensation arrangement, strong internal controls and follow-up monitoring of incentive compensation payments relative to actual risk outcomes are particularly important to help ensure that the arrangements as implemented do not encourage excessive risk-taking.

Four methods currently are often used to make compensation more sensitive to risk, although these are not exclusive:

• Risk Adjustment of Awards, where the amount of the award is adjusted based on quantitative or subjective qualitative measures that take into account the risk the employee's activities pose to the organization. Deferral of Payment, where the actual payout is delayed or subject to "claw back" significantly beyond the end of the performance period, and the amounts paid adjusted for actual results that become clear during the deferral period.
• Longer Performance Periods, where the time period covered by the performance measures used in determining an employee's award is extended (for example, from one year to two years), allowing awards or payments to be made after some or all risk outcomes are realized or better known.
• Reduced Sensitivity to Short-Term Performance, where, as opposed to mitigating or offsetting risk-taking incentives associated with the use of short-term performance measures, the magnitude of the short-term incentives is reduced. Employees may be particularly motivated to take excessive risk in order to reach performance targets that are aggressive, but potentially achievable, such as incentives for increments of performance that are above the target or that provide that awards only if a target is met or exceeded.
• Where reliable risk measures exist (which may be more prevalent at banks than at non-bank companies), risk adjustment of awards may be more effective than deferral of payment in reducing incentives for excessive risk-taking. However, deferral of payment may be more effective when risks (such as the risks of new activities or products), are hard to measure, particularly if these risks are likely to be realized during the deferral period. In some cases, methods may need to be combined or tailored to account for different employee levels or groups within organizations. For example, deferred equity incentive compensation that vests over a multi-year period may be more effective in restraining risk-taking by senior executives and other employees whose activities may have a material effect on the overall financial performance of the firm than by lower-level employees who may believe that their actions are unlikely to materially affect the organization's stock price.

The guidelines suggest that incentive compensation arrangements for senior executives are likely to be better balanced if they involve deferral of a substantial portion of the executives' incentive compensation over a multi-year period in a way that reduces the amount received in the event of poor performance, substantial use of multi-year performance periods, or both. Similarly, a significant portion of the incentive compensation of these executives should be paid in equity that vests over multiple years, with the amount ultimately received dependent on the performance of the firm during the deferral period.

Golden parachutes and vesting arrangements for deferred compensation have the potential to affect the risk-taking behavior of employees while still at their firms. Arrangements that, upon departure or change in control, provide large additional payments or accelerated payment of deferred amounts without regard to risk or risk outcomes can provide significant incentives to engage in undue risk-taking. Similarly, provisions that require an employee (especially senior executives or others in high demand who are able to negotiate a ``golden handshake'' arrangement with their new firms) to forfeit deferred incentive compensation payments upon departure may weaken the effectiveness of the deferral arrangement by removing the employee's financial exposure to the risk outcomes of the employee's activities at the firm.

Organizations need to communicate effectively to employees the ways in which incentive compensation awards and payments will be reduced as risks increase, including examples of how incentive compensation payments may be adjusted to reflect projected or actual risk outcomes.

2. Compatibility With Effective Controls and Risk Management

Risk-management processes and internal controls should reinforce and support the development and maintenance of balanced incentive compensation arrangements. Employees may seek to evade established processes or influence the risk measures or other measures in ways designed to increase their pay, and these actions can have an especially damaging effect on the organization. Regular internal reviews should be conducted to ensure that processes for achieving and maintaining balanced incentive compensation arrangements are consistently followed. Risk-management personnel should have an appropriate role in the processes for designing incentive compensation arrangements and for assessing their effectiveness in restraining excessive risk-taking. Control, HR and finance functions can also play an important role. Compensation for employees in risk management and control functions should be sufficient to attract and retain qualified personnel and should avoid conflicts of interest (i.e., should not be based predominately on the financial performance of the business units that they review). Effectiveness of incentive compensation arrangements should be monitored and revised as necessary.

3. Strong Corporate Governance

The board of directors (or relevant committees) should actively oversee the development and operation of incentive compensation arrangements and systems and related control processes. For example, the board should review and approve the overall goals and purposes of the firm's incentive compensation system and provide clear direction to management to ensure that its policies and procedures are carried out in a manner that achieves balance and is consistent with safety and

soundness. The board should approve and document any material exceptions or adjustments to the incentive compensation arrangements for senior executives and monitor the effects of any approved exceptions or adjustments on the balance of the arrangement, the risk-taking incentives of the senior executive, and the safety and soundness of the organization. Monitoring incentive compensation payments to senior executives and their sensitivity to risk outcomes should include the review of both backward-looking and forward-looking scenario analyses for senior executives separate from other employees. Boards should have sufficient information to

determine if clawback provisions have been triggered. While boards need to monitor new developments in compensation at other firms, each board is responsible for ensuring that the incentive compensation arrangements for its organization do not encourage employees to take risks that are beyond the firm's ability to manage

effectively, regardless of the practices employed by other firms. Where feasible, at least one director should have an appropriate level of expertise and experience in risk management and compensation practices. Boards should have authority to select and compensate outside counsel, consultants or other experts with expertise in incentive compensation and risk management, avoiding potential conflicts of interest. Organizations should provide appropriate disclosure regarding incentive compensation arrangements and related risk management, control and governance processes to allow shareholders to monitor and, where appropriate, take actions to restrain the potential for excessive risk-taking.

A systematic approach should be adopted that would provide for the following:

• Identify employees who are eligible to receive incentive compensation and whose activities may expose the organization to material risks, including senior executives and others responsible for oversight of firm-wide activities or material business lines, individual employees whose activities may expose the firm to material amounts of risk, and groups of employees who are subject to the same or similar incentive compensation arrangements and who, in the aggregate, may expose the firm to material amounts of risk;
• Identify the types and time horizons of risks to the organization from the activities of these employees;
• Assess the potential for the incentive performance measures selected to encourage these employees to take excessive risks;
• Include measures such as risk adjustments or deferral periods that are reasonably designed to ensure balanced arrangements;
• Communicate to the employees the ways in which their incentive compensation awards or payments will be risk-adjusted; and
• Monitor incentive compensation awards, payments, risks taken and risk outcomes for these employees and modify the relevant arrangements if payments made are not appropriately sensitive to risk and risk outcomes.

The following press release describes how Treasury's Special Master implemented some of these concepts for TARP recipients. These included rejecting cash bonus payments based on short-term performance, restructuring "guaranteed" cash payments into long-term stock, paying portions of salary in immediately vested stock that may be sold only in annual increments over a three-year period that begins in two years, paying incentive compensation in time-vested and performance-based restricted stock, restrictions on golden parachutes and perquisites and freezing of SERPs.