Here We Go Again: Regulators Versus The Law on Bank Compensation

News reports suggest that some federal financial regulators are planning to resurrect a 2016 proposed rule on executive compensation.^[1] Limits on banker pay continue to play well politically in some quarters as a way of punishing banks or their executives for failings or misbehavior, or simply to lower compensation for bankers in general.

That enthusiasm, however, may eventually be governed by what Congress has by law actually empowered the federal banking agencies to do, and why.

The rumored compensation limits would apply to banks but generally not to hedge funds, private equity funds, private debt funds, payday lenders, fintechs or the host of other financial firms that now control more than half of U.S. financial assets; while broker-dealers and some investment advisors are covered, the SEC may not be joining the fun.^[2] The lucky many excluded from the proposal also are not subject to the wide range of civil money penalties and debarments that the federal banking agencies are already empowered to impose and frequently do. Any comptroller, cyber executive or senior lawyer at a bank wishing to live a more carefree existence would have easy options. Of course, no other industry - be it aerospace or pharmaceuticals - sees the government setting executive pay.

Perhaps reflecting that concern, Congress never authorized the agencies to do what they proposed in 2016 and what they reportedly are planning to do now.

First, the relevant statute (Section 956 of the Dodd-Frank Act) only authorizes the agencies to prohibit a narrowly defined set of bad practices; it does not authorize the agencies to design a single, uniform system of compensation that all firms must use in paying their employees. It makes no reference to clawbacks, deferrals or any other politically popular means of restricting compensation.^[3] Second, Section 956 does not actually cover executive compensation; rather, the statute addresses only one form of compensation: incentive compensation - that is, bonuses or other compensation tied to performance.

Let's start with the statutory language of Section 956.

[T]he appropriate Federal regulators shall jointly prescribe regulations or guidelines that prohibit any types of incentive-based payment arrangement, or any feature of any such arrangement, that the regulators determine encourages inappropriate risks by covered financial institutions-

(1) by providing an executive officer, employee, director, or principal shareholder of the covered financial institution with excessive compensation, fees, or benefits; or

(2) that could lead to material financial loss to the covered financial institution.^[4]

Section 956 is thus straightforward in its grant of authority to the agencies: the statute authorizes the agencies to prohibitincentive-based payment arrangements that either (i) encourage inappropriate risks by certain financial institutions by providing excessive compensation, or (ii) encourage inappropriate risks that could lead to material financial loss.

The 2016 interagency proposal ignored the clear statutory directive of Section 956. The rule did not identify bad practices and prohibit those; instead, it devised a single, uniform incentive compensation regime applicable to a wide range of employees.

The 2016 proposal imposed various prescriptive requirements, including restrictions on maximum payouts above pre-set incentive compensation targets, how long a period incentive compensation must be deferred before payment and how and when incentive compensation must be clawed back. None of the specifics, however, were grounded in any cited experience; rather, the proposal relied on a series of academic articles making the rather obvious point that someone being compensated for long-term performance rather than short-term performance is more likely to focus on long-term performance than short-term performance. Similarly, the proposal covered a wide range of employees, including those in legal, audit and technology, but the agencies provided no evidence that the compensation of such employees has ever been relevant to a material financial loss.

Thus, the proposal effectively presumed that any compensation arrangement that did not meet its detailed requirements, by definition, encouraged inappropriate risks that could lead to material financial loss. As a matter of legal leaps, it was more pole vault than high jump.

The proposal takes a similar approach to the prong of the requirement proscribing "excessive" compensation. The proposal includes no clear definition of "excessive" and presents no data to determine at what level or on what terms compensation is excessive. Bank boards routinely rely on such data, compiled by consultancies who specialize in this area, but the agencies did no similar work.

Doubtless some of the motivation for this proposal is political reaction to the failure of Silicon Valley Bank and the fact that its CEO was permitted to keep compensation he had previously earned, even as his substantial stock holdings went to zero. But Section 956 is not an enforcement tool, and the agencies have any number of statutes to pursue any wrongdoing, which at this point appears to be absent. So, the question is whether he and SVB's senior management team (and their examiners?) would have been better incentivized to identify fatal interest rate risk and depositor concentration if they had been subject to a clawback (in addition to losing their jobs, their reputations and the equity they held in the firm). That seems a hard case to make. Looking more broadly, as the Federal Reserve raised rates, was it the case that firms with clawbacks had lower unrealized losses on their securities portfolios than those without them? These are the sorts of things one would need to demonstrate clearly before depriving tens of thousands of people of the right to be secure in their past earnings.

Indeed, it is important to note that the primary victims of overly prescriptive and broad incentive compensation rules ultimately are not the banks themselves but individuals who might be expected to sue to vindicate their liberty and property interests. Having the government set major terms of their compensation is no small thing - and one with no precedent. If ever there was a major question where one would have expected Congress to be specific, it is the government deciding private sector pay.^[5]

That said, banks do have an interest in paying their employees well. They try to innovate in compensation and compete for talent by designing attractive compensation packages; over the years, for certain employees, many banks do provide for deferred compensation and clawbacks, but they do so while balancing employee recruitment and retention. The 2016 proposal weighted no costs against its putative benefits. Bank employees already must deal with massive and growing demands from agency examiners and the threat of dismissal if those examiners lose confidence in them; they also face civil money penalties and debarment. Banks are losing good people in areas like cybersecurity to firms where none of these perils are present. They do not wish to lose more.

The agencies' 2016 proposal^[6] was never finalized - almost certainly because it was clearly inconsistent with the statute and destined for a successful legal challenge if adopted in final form. Eight years later, in the midst of another election year, perhaps that risk is seen as relatively unimportant.

[1] 81 Fed. Reg. 37,670 (proposed June 10, 2016).

[2] The law also applies to credit unions, government sponsored agencies and broker-dealers, but the SEC is reportedly not joining the forthcoming proposal. The statute also gives the agencies the authority to jointly, by rule, subject other financial institutions to the law. Financial institutions with less than $1,000,000,000 in assets are exempt from the statute.

[3] The agencies proposed to define "Incentive-based compensation" as "any variable compensation, fees, or benefits that serve as an incentive or reward for performance" in the 2016 proposed rule.

[4] 12 U.S.C. § 5641(b).

[5] Congress also required clearly that any rule under Section 956 be jointly issued by a specific set of agencies, which makes one wonder how a subset of the required agencies could proceed without the rest. Here it is worth noting that the agencies in 2016 cited as authority for their rule not only Section 956 but also their authority to ban unsafe and unsound practices. Of course, this suggests that Congress need never have enacted Section 956. But more importantly, if one were looking for a hopeless cause to highlight, one could do no better than arguing that the authority to prohibit unsafe and unsound banking practices includes the right to determine how bank employees are paid.

[6] The 2016 proposal was the second attempt by the agencies to implement Section 956. See 76 Fed. Reg. 72 (proposed April 14, 2011).

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