US to introduce new rules to regulate variable pay in financial sector – should Sri Lanka follow?

By Theja Silva 

We have been treated to another incident of alleged misuse of a performance-based incentive system at a reputed international financial institution operating in Sri Lanka. This is not a new phenomenon and similar incidents keep happening over and over again in many different jurisdictions and in organisations of varying sizes with not so pleasant consequences. However despite this the financial world seems to be reluctant to implement any meaningful measures to address the root cause of the problem voluntarily. 

Consequent to the 2008 financial crisis the Dodd Frank Act enabled the financial regulators (in the USA) to jointly issue rules or guidelines covering incentives. Accordingly US federal financial regulators are planning to implement a revised rule under the Dodd-Frank Act aimed at prohibiting covered institutions from awarding incentive-based compensation that is believed to encourage inappropriate risks. It also seeks to impose mandatory deferral and claw-back provisions and certain disclosure obligations relating to such incentive-based compensation arrangements.

The proposed rules contain improvements to a rule that was released in 2011. Therefore it is obvious that even in the aftermath of a major crisis, US has not been able to implement a rule quickly enough. The proposed rule prohibits all covered institutions from having incentive based compensation arrangements that would encourage inappropriate risk by providing covered persons with excessive compensation, fees or benefits that could lead to financial loss to the institution.

Proposed rule categorises the covered institutions into three categories and have different standards for the three categories while there are common rules that apply to all categories. 

The aim of the rules proposed in the USA seem to be to safeguard the covered institution from undue risk taking by employees who may be tempted to consider short term gains due to the advantages they may personally derive through such incentive based compensation system. Hence concepts like deferment, forfeiture, downward adjustment and claw-back are being brought in to ensure that the long term interests of institution is not compromised by those who are entitled to such incentives based computerisation. 

As with many other US rules the proposed rules bring in a lot of complexities which might not be practical for a market like Sri Lanka. However the concept and the professed aim is not one irrelevant to Sri Lanka and its financial sector. 

The definitions of covered employees who are considered significant risk takers may also have to be relaxed considerably in the Sri Lankan context. In Sri Lanka sometimes it is not only the complicated risk taking employees who are subject to incentive based variable compensation. Day to day inherent risk taking employees are also sometimes placed under incentive based compensation schemes carrying with it a risk of encouraging excessive risk taking in day to day activities. This is especially so when the base pay is minimal. 

Under the proposed Rule in the US, certain senior positions have been specifically named as falling within the ambit of the rules and in addition a criteria has been specified based on the compensation received to identify employees as significant risk takers. Proposed US rules also give the regulator the power to specify an employee as a significant risk taker (and therefore falling within the purview of the rules) if that person has the ability to expose the covered institution to risks that could lead to material financial loss in relation to the institution’s size, capital or overall risk tolerance

‘Incentive-based compensation’ for the purpose of the Rules means any variable compensation, fees or benefits that serve as an incentive or reward for performance. 

The proposed rule seeks to prevent covered institutions from establishing or maintaining incentive-based compensation arrangements that encourage inappropriate risks by the covered institutions that could lead to material financial loss. Incentive-based compensation will not be permitted unless such compensation appropriately balances risk and financial rewards and is compatible with effective risk management and controls and is also supported by effective governance, including active oversight by the board of directors 

These rules also impose an obligation on institutions to ensure that their incentive-based compensation arrangements includes both financial and non-financial measures of performance and is designed to allow non-financial measures of performance to override financial measures of performance, when appropriate. They are also required to ensure that such schemes are subject to adjustment to reflect actual losses, inappropriate risks taken, compliance deficiencies or other measures or aspects of financial and non-financial compliance.

One of the major concerns of US regulators seem to be that incentive based compensation arrangements that are tied to short terms revenue or profit generation fails to take into account longer terms risks associated with the business so generated. Hence when rewarding performance full range of current and potential risks that a covered persons activities pose to an institution should be taken into account. 

The proposed rule would require all covered institutions to maintain for at least seven years, records that document the structure of incentive-based compensation arrangements and demonstrate compliance with the proposed rule. At a minimum, the records must include:

ncopies of all incentive-based compensation plans;

na record of who is subject to each plan; and

na description of how the incentive-based compensation programme is compatible with effective risk management and controls.

Proposed rules also make it compulsory for such compensation schemes to incorporate concepts like deferral, downward adjustment, forfeiture and claw-back. Rules define and provide more information on these concepts which are basically measures that would ensure that employees will not benefit unduly from such schemes at the risk of future loss whether financial or otherwise. 

For example a level one covered institution would be required to defer at least 50% of a significant risk taker’s qualifying incentive-based compensation for at least four years. 

The proposed rule would also require certain institutions to consider reducing some or all of the incentive-based compensation when the covered institution becomes aware of inappropriate risk taking or other behaviour that could lead to a material financial loss. Significantly these instances that would lead to forfeiture cover not only poor financial performance and financial risk taking but also include noncompliance with statutory, regulatory or supervisory standards resulting in enforcement by regulatory agencies as well.

A significant addition to the earlier rule is the introduction of claw-back provisions. The proposed rule would require covered institutions to include claw-back provisions in the incentive-based compensation arrangements. This would enable the institutions to recover vested incentive-based compensation from such persons if certain events occur. 

At a minimum, there should be ability to recover vested incentives based compensation from a current or former employee within a period of seven years from the date on which such compensation vests if the covered institution determines that the particular employee had engaged in, misconduct that results in significant financial or reputational harm to the institution, fraud, or intentional misrepresentation of information used to determine that officers (the one who received such compensation) incentive based compensation.

Additionally these rules also provides for establishment of appropriate risk management and compliance mechanisms and a governance frameworks for such compensation schemes. They also provide for the 

According to Sunday Times of 22 May, the Central Bank of Sri Lanka too has sought the details of remuneration paid to Directors and top officials of Banks. Whether the request is also a pre – curser to a rule or guidance similar to what is being proposed in US is not known. However from the point of view of investors including shareholders, it would not be a bad idea for the Central Bank of Sri Lanka as the regulator for a majority of financial services providers in the country to move in sooner rather than later to look into incentive based variable compensation schemes that are in use in financial service companies in Sri Lanka. 

The Central Bank has already issued certain directions to commercial Banks in Sri Lanka that required the commercial banks to introduce claw back arrangements in performance based remuneration to those who are engaged in foreign exchange. Even though this direction was issued in September 2012 enforcement has been difficult due to market inequalities and absence of uniform practises among the market players.

[The writer, LL.B (Hons), LL.M, MICA, Attorney-at-Law, started his career teaching law at the Faculty of Law of the University of Colombo and is currently the Head of Legal and Company Secretary of Nations Trust Bank Ltd. The views expressed are however that of the writer and does not reflect the views of the institutions he represents.]