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By Dennis P. Duffy, Patrick T. Lewis and Keesha N. Warmsby of Baker Hostetler



In the fall of 2016, the United States was rocked by the disclosure that employees of a large national bank, allegedly in an effort to meet sales goals, opened two million customer accounts without customer authorization. Regulators and others identified the bank's incentive compensation program for its employees as a cause of this cultural practice. At the time the news broke, the bank's compensation was structured in part upon accounts opened - regardless of whether an account was active.


This disclosure serves as a reminder of the consequences that result when compensation incentives conflict with the goals of shareholders and customers, and the safety and soundness of the bank. In the wake of that incident, some banks are re-evaluating their incentive compensation programs. This Quick Overview is intended to provide a thumbnail sketch of some of the laws and regulations impacting incentive compensation for retail bankers, mortgage loan originators, insurance agents, and brokers and dealers, and to provide some practical tips regarding the design of incentive compensation plans.


Retail Bank Employees


Banks looking for guidance regarding incentive compensation plans for employees may look to the Interagency Guidance on Sound Incentive Compensation of 2010 (Guidance). Issued by the Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System (Board), the Federal Deposit Insurance Corporation (FDIC) and Office of Thrift Supervision, the Guidance was passed in response to the financial crisis that began in 2007 and is premised on three key principles for incentive compensation plans: (1) provide employees incentives that do not encourage excessive risk-taking beyond the organization's ability to effectively identify and manage risk; (2) be compatible with effective controls and risk management; and (3) be supported by strong corporate governance, including active and effective oversight by the organization's board of directors.


While primarily designed for executive incentive compensation arrangements, the Guidance also applies to employees who individually or collectively have the ability to expose the bank to material amounts of risk. Although the Guidance may not have been written with retail bankers in mind, recent events have demonstrated that employees - especially those in direct contact with customers - have the ability to expose a bank to significant risk.


Going forward, banks may expect additional regulatory requirements. Section 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) directs six agencies to jointly issue regulations or guidelines that would apply to financial institutions with total assets of $1 billion or more (covered institutions). On or about May 16, 2016, the OCC, the Board, the FDIC, the National Credit Union Administration (NCUA), the Securities and Exchange Commission (SEC), and the Federal Housing Finance Agency (FHFA) (collectively, the Agencies) issued a notice of proposed rulemaking (NPRM) to revise the proposed rule issued by the Agencies on April 14, 2011.


Under the NPRM, Covered Institutions would be subject to general prohibitions on incentive-based compensation arrangements that could encourage inappropriate risk-taking by providing excessive compensation or that could lead to a material financial loss. The comment period, which remained open through July 22, 2016, elicited comments from various industry stakeholders. The Agencies have yet to issue a final rule.


Mortgage Loan Originators


The mortgage industry is no stranger to regulation. Dodd-Frank made significant changes to the industry following the housing collapse. Most notably, Dodd-Frank directed the Consumer Financial Protection Bureau (CFPB) to issue detailed rules concerning mortgage loan originator compensation.


Issued under the Truth in Lending Act and implemented by Regulation Z, the Loan Originator Compensation Rule or LO Comp Rule, as it is often called, prohibits mortgage loan originators from receiving compensation that is based on any term of transaction, or a proxy of a term of a transaction. Most importantly, the LO Comp Rule prohibits "steering," a practice in which the consumer is "steered" to a particular transaction in which the loan originator will receive greater compensation than another transaction that the loan originator could have directed the consumer toward and would have been in the consumer's interest. Additionally, the regulations generally prohibit dual compensation of the originator by making it illegal for the originator to receive compensation from a third party and for any person to pay compensation to an originator, if that originator has already received compensation from the consumer.


The LO Comp Rule defines a "loan originator" as a "person who, in the expectation of direct or indirect compensation or other monetary gain, performs any of the following activities: takes an application, offers, arranges, assists a consumer in obtaining or applying to obtain, negotiates, or otherwise obtains an extension of consumer credit for another person; or through advertising or other means of communication represents to the public that such person can or will perform these activities." 12 CFR § 1026.36(a)(1). Thus, an employee may be considered a loan originator and therefore required to be compensated in accordance with the rule regardless of the employee's title if he or she undertakes any of these duties.


Insurance Agents/Brokers


Insurance agents generally receive commissions from an insurer, often expressed as a percentage of the written premium on policies produced by the agent. The agency agreement may also contain contingent commission provisions, which provide additional compensation to the agent based upon the volume of business produced or the underlying profitability of the business produced.


For the most part, insurance regulation is a state law issue, and the laws and regulations governing compensation vary from state to state. The National Association of Insurance Commissioners (the NAIC), however, has offered a model for compensation disclosure regulation in section 18 of its Producer Licensing Model Act (2005). Under this provision, if an insurance producer has received compensation from a customer, the producer must fulfill two requirements in order to receive additional compensation from an insurer or third party:
  1. The producer must obtain the customer's documented acknowledgement that the producer will receive compensation by an insurer or third party; and The producer must also provide the amount of compensation from the insurer or other third party for the placement if known, and if not known, the producer must disclose the method for computing the compensation.
A number of states either have adopted the Model Act provision or have compensation laws or regulations that are similar to its requirements. For example, Texas has a substantially similar compensation disclosure law, Texas Insurance Code § 4005.004.
New York, going beyond section 18, has stringent laws regarding compensation disclosure. Regulation 194, 11 NYCRR § 30, requires insurance producers to make certain mandatory disclosures to purchasers of insurance products regarding the method of the producer's compensation. Under Regulation 194, insurance producers must generally disclose a description of the producer's role in the sale, whether the producer will receive compensation from the insurer or another third party, that the compensation paid to the producer may vary depending on a number of factors, including what insurer is selected and the volume of business the producer provides to that insurer, and that the purchaser may obtain additional information about the compensation the insurance producer expects from the sale.


In addition to the compensation disclosure requirements, states typically prohibit insurers and agents from making inducements and/or rebates to incentivize customers to purchase insurance. As an example, Section 3933.01 of the Ohio Revised Code prohibits giving valuable consideration for the inducement of certain insurance business.


Registered Representatives of Broker-Dealers


Many of these same concepts can also be found in recent regulatory efforts around compensation programs for registered representatives of broker-dealers. Broker-dealers owe their customers a general duty of fair dealing that stems from the Securities Exchange Act of 1934's anti-fraud provisions and the SEC rules promulgated pursuant thereto. FINRA has promulgated a general rule of conduct, Rule 2010, stating that "a member, in the conduct of its business, shall observe high standards of commercial honor and just and equitable principles of trade."


In recent years, flowing in part from these general principles, Financial Industry Regulatory Authority (FINRA) has noted that potential conflicts of interest may arise if a firm's compensation plan creates an incentive for registered representatives to recommend one product over another. FINRA has reviewed firms' compensation plans through the lens of whether firms have reasonable supervisory systems and procedures in place to analyze and address such potential conflicts of interest. In its 2016 Regulatory and Examinations Priorities Letter, FINRA described its ongoing review of firms regarding these issues as focused on "firms' conflict mitigation processes regarding compensation plans for registered representatives, and firms' approaches to mitigating conflicts of interest that arise through the sale of proprietary or affiliated products, or products for which a firm receives third-party payments (e.g., revenue sharing)." Subsequently, in November 2016, FINRA brought disciplinary action against VALIC Investment Advisors in an Acceptance and Waiver Consent (AWC) that imposed a fine in part because FINRA found the firm's supervisory system did not identify and mitigate an alleged conflict of interest created by a compensation policy that gave registered representatives an incentive to steer certain customers to products offered by the firm. In that instance, the firm was found to have a compensation policy that prohibited registered representatives from receiving compensation if they recommended that certain clients move funds to non-VALIC products. The firm was also found to have failed to train supervisory personnel to ensure that any such conflict did not compromise recommendations offered by those representatives.


Finally, a note: The Department of Labor's new fiduciary rule, 18 Fed. Reg. 20946, may significantly impact certain compensation programs. However, the rule remains somewhat uncertain, as it is the subject of litigation and a Feb. 3, 2017, executive order by President Trump directing its re-examination. More details on the fiduciary rule can be found on the DOL's website.




One common thread that emerges from the frameworks described above is an attempt to encourage financial services industries to manage the risk that incentive compensation programs create perverse incentives, including excessive risk-taking by employees, and concerns that employees may inappropriately "steer" customers to a given product or service. How can companies be sure that the employee performance goals and incentives they are setting do not encourage (or appear to encourage) unethical or illegal behavior?


They should start by making sure that employee rewards and recognition programs are anchored in the company's underlying corporate values. Incentives should be clear, measurable and tied to employee performance behavior that is reasonably achievable and consistent with the company's underlying ethics. Tying compensation or job security to business goals that are unrealistically high or not tied to positive employee performance may intentionally or unintentionally encourage unethical or illegal conduct (or at least create the appearance of doing so in the eyes of regulators or the public). Companies using incentives should implement appropriate business controls to monitor individual employee compliance/noncompliance with the incentives to ensure that employees are not sacrificing quality (or compliance with law or company policies) to achieve the incentive goals. These controls can include, among other things, random audits or checks of transactions and records relating to the incentive, by managers outside the employees' line of supervision and by personnel who do not themselves have an actual or perceived financial interest in the employee's achievement of the incentive goal. And the existence of these controls should be open and transparent to employees; employees who are aware that the company will audit their compliance will be less likely to attempt to "game" the system. Particular attention should be paid to customer/client complaints that might suggest inappropriate employee behavior with respect to the incentive program.


Additional Resources


Region: United States
The information in any resource collected in this virtual library should not be construed as legal advice or legal opinion on specific facts and should not be considered representative of the views of its authors, its sponsors, and/or ACC. These resources are not intended as a definitive statement on the subject addressed. Rather, they are intended to serve as a tool providing practical advice and references for the busy in-house practitioner and other readers.

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