In the wake of its fraudulent account scandal, Wells Fargo announced in April 2017 that it would claw back additional compensation from former CEO John Stumpf and former head of community banking Carrie Tolstedt. All told, the total amount of clawed back compensation at Wells Fargo has now reached $180 million.
However, such clawbacks remain the exception rather than the norm. Unlike most financial firms, Wells Fargo has a particularly powerful clawback policy on its books. Furthermore, the Wells Fargo clawbacks only occurred almost three years after the Board of Directors became aware of the malfeasance, and only in response to intense shareholder pressure against the Board of Directors.
As John Coffee and others have pointed out, extreme incentive compensation has led to many of the financial industry scandals that we have seen in recent years. Even the possibility of clawbacks does not seem to be changing the corporate culture in large financial institutions. As a result, it may be time to reconsider a stronger alternative to clawbacks: more widespread use of deferred compensation.
A basic blueprint for a deferred compensation regime, as well as the rationales behind such a regime, can be found in an October 20, 2014 speech by William Dudley—the President and Chief Executive Officer of the Federal Reserve Bank of New York (“New York Fed”)—delivered a to a number of executives in the financial services industry. Dudley’s remarks, part of a workshop at the New York Fed entitled “Reforming Culture and Behavior in the Financial Services Industry,” focused on a number of ways to better align incentives for large financial institutions and their employees.
While Dudley’s speech also contained suggestions for lower-level employees, he primarily focused on the need for senior executives to take the lead on reform. To that end, Dudley argued that increased use of deferred compensation for firm leadership could effectively force financial executives to internalize the long-term consequences of their decisions and actions. While Dudley did not propose a one-size-fits-all solution, he did note that the underlying transactions generating the compensation could affect the degree to which some—or all—compensation should be deferred: The length of deferral should be “set at a horizon longer than the life of the” transactions.
Beyond compensation pegged to particular transactions, Dudley also observed that unethical and illegal behavior often is not detected and addressed until relatively far into the future. With this in mind, Dudley proposed that some portion of compensation for senior leadership should be deferred for a definite period of time, and then paid out during subsequent vesting periods contingent on the non-existence of illegal activity. According to Dudley, “a decade would seem to be a reasonable timeframe to provide sufficient time and space for any illegal actions or violations of the firm’s culture to materialize and fines and legal penalties realized.” Furthermore, if this deferred compensation were held and eventually paid out in the form of debt rather than equity, it could be used in the interim to recapitalize a failing bank if necessary—thereby incentivizing the bank’s leadership to avoid unnecessary, unwarranted risks.
Implementation of this type of deferred compensation would effectively create “performance bonds” for financial executives. Performance bonds—similar to security deposits—are used to make sure that one party to a contract has the incentive to create and maintain value for both parties during the tenure of the relationship. As envisioned by Dudley, deferred compensation would help ensure that financial executives do not prioritize short-term gains at the expense of the long-term health—legal or economic (or both)—of their firms. Thus, the incentives of shareholders and management would be realigned in order to generate the highest long-term value responsibly possible.
While Dudley neglected to discuss implementation procedures for establishing deferred compensation policies, it appears that he envisioned such changes would come internally from the financial industry rather than from overarching government regulation. Dudley’s speech, while touching on the possibility of future government action to break up large financial institutions, emphasized the importance of “effective self-policing.” At least as Dudley saw it then, financial institutions should have had sufficient incentive to implement these changes themselves.
The financial industry did not receive Dudley’s proposal positively. According to press reports of Dudley’s speech, some financial executives in the audience were “unnerved” and a “bit shell-shocked” by Dudley’s comments. Other executives immediately noted that Dudley’s suggestions would be difficult to implement. Since then, there have been a number of proxy proposals endorsing Dudley’s viewpoint and calling for a move toward increased deferred compensation at large financial institutions.
Despite Dudley’s apparent optimism that financial institutions—of their own volition—would increasingly shift to deferred compensation for senior executives, there are reasons to be skeptical. First, proxy proposals seeking to implement these policies have been generally unsuccessful. Second, given some of the concerns of industry members, the only way to implement something resembling Dudley’s proposal might be through government intervention. Large financial institutions are concerned with losing the best talent—including among executives—to competitors. Thus, there could be a first-mover disadvantage if only a select number of firms decide to employ compensation regimes utilizing performance bonds. If the government were to impose some type of performance requirement on all large financial institutions, this first-mover problem would disappear. Third, there may be problems with firms implementing a shift toward deferred compensation—in the absence of governmental action—through contract modifications. Indeed, a proposal in Great Britain similar to Dudley’s encountered resistance due to the possibility that such contractual modifications would be deemed unenforceable. Accordingly, it seems that regulatory action may be the best option for achieving such reforms.
All told, the potential positives (PDF: 200 KB) of increased use of deferred compensation as performance bonds would outweigh the negatives. Given the absence of private progress on these issues and continued scandals at institutions like Wells Fargo, it may be time to consider a more regulation-oriented approach. Indeed, there are proposed rules that seek to mandate deferred compensation for some incentive-based payments by certain financial institutions. It remains to be seen whether such regulations would go far enough (PDF: 185 KB)—or even if they will be finalized at all. Either way, the basic framework of Dudley’s proposal presents an attractive option for reducing moral hazard and changing the culture of the financial sector.
Carmi Schickler is a Student Fellow with the Program on Corporate Compliance and Enforcement and a graduate of NYU School of Law, Class of 2017. He also served as Managing Editor of Production for the New York University Law Review.