Over dissenting votes from two key federal regulators, the Federal Deposit Insurance Corporation (“FDIC”) issued an advance notice of proposed rulemaking (“ANPR”) on January 12, 2010, to incorporate employee compensation criteria into the FDIC’s risk assessment system. The heads of the Office of the Comptroller of the Currency (“OCC”) and the Office of Thrift Supervision (“OTS”), both FDIC board members, voted against the proposal, which they deemed premature in light of pending efforts in Congress and at the Federal Reserve Board (“FRB”) to impose regulatory limits on compensation programs that encourage risk taking by financial institution employees. The ANPR will be open for a 30-day public comment period with formal FDIC action expected later in the year.

The FDIC approach to the risk dimension of bank compensation relies on the agency’s authority over the level of assessments banks pay as part of the deposit insurance system. Specifically, the FDIC has authority to adjust the level of assessment for individual institutions based on the perceived risk they pose to the insurance system.

Noting a relatively high correlation between improper compensation incentives and bank failures in its investigation of the reasons banks failed in 2009, the ANPR proposes an adjustment to the risk-based assessment rates “to adequately compensate the [Deposit Insurance Fund] for the risks presented by certain compensation programs.” In simple terms, banks with compliant compensation programs would pay lower assessments than those institutions that rely on programs that encourage greater risk taking by employees seeking greater financial rewards. The proposal would also encourage the avoidance of compensation programs that create risk by using the assessment system to provide incentives for the introduction of programs that (i) align employees’ interests with those of other stakeholders, including the FDIC and (ii) reward employees for focusing on risk management.

Consistent with prior Treasury and regulatory agency pronouncements, the FDIC notes that the goals of the ANPR may be met by compensation techniques such as the use of restricted stock with multi-year vesting periods and clawback provisions. The ANPR also emphasizes the administration of compensation programs by independent directors with assistance from independent compensation professionals.

While the ANPR identifies the general framework under consideration at the FDIC, it does not set forth a specific regulatory structure for implementation of a system that factors compensation program design into the risk-based assessment system. Rather, the agency is seeking comments on, among other things, (i) whether and how adjustments should be made to assessments based on perceived risks, (ii) whether compliant institutions should benefit from lower assessments, (iii) whether a future regulation should be limited in application to larger institutions or be extended to cover all insured depositary institutions, (iv) which employees should be subject to the compensation criteria that affect the adjustment of assessments and (v) whether the use of certain compensation practices - such as guaranteed bonuses, bonuses that are greatly disproportionate to base salary or bonuses paid in full without any deferral element - should result in automatic upward adjustments.

With the FDIC release, two bank regulatory agencies (FDIC and FRB) have weighed in with their versions of a regulatory regime for oversight of the risk element in bank compensation practices. It is likely that additional guidance will be forthcoming from the OCC and the OTS and that Congress will also address this subject in financial reform legislation. We will be monitoring these efforts carefully as we work with our clients to develop compensation programs that are consistent with their business needs and compliant with regulatory mandates.

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