Royal Bank of Scotland Executives Received Up to 70 Percent of Incentive-Based Bonuses Based on HM Treasury-Set Targets

On February 20, The Times reported that more than 50 senior bankers from Royal Bank of Scotland (RBA) “had large chunks of their annual bonuses tied to targets set by a government agency,” HM Treasury’s Asset Protection Agency (APA).  For example, multiple bankers in RBS’s controversial Global Restructuring Group (GRG) had 70 per cent of their 2010 annual bonuses evaluated against APA-established “performance targets.”  They included former GRG head Derek Sach, former GRG finance director Declan Hourican, former GRG UK head Laura Barlow, former GRG head of recoveries and litigation Joy McAdam, and the heads of GRG’s Ireland, Asia Pacific, and Americas divisions.

Although GRG was reportedly designed to help business customers of RBS in financial difficulty, the United Kingdom’s Financial Authority commissioned an investigation by Promontory Financial Group of RBS’s treatment of certain small and medium enterprises by GRG.  That investigation “found that between 2008 and 2013 GRG had focused on extracting money from thousands of companies.  Many business owners handled by the unit claim that RBS damaged their livelihoods.”

The 50 RBS executives who received exceptionally high incentive-based bonuses per the APA targets also included officials outside GRG.  Stephen Hester, then the RBS Chief Executive Officer, had 28 per cent of his bonus tied to APA-established targets.

The APA, which ended operations in 2012, exercised this authority in connection with its operation of the United Kingdom’s Asset Protection Scheme (APS).  The APS was designed

to support the stability of the UK financial system, increase confidence and capacity to lend, and thus support the UK economy by protecting financial institutions participating in the Scheme against exceptional credit losses on certain portfolios of assets in exchange for a fee. . . . The APS was designed, in effect, to isolate problem assets in a virtual “bad bank”. The toxic assets were insured but stayed on the balance sheet of the bank, which continued to be the first line of management for the assets in question. The insurance cover acted as a substitute for equity capital as it was recognised by the FSA as regulatory capital for the purposes of capital adequacy assessments.

Under the APS, RBS — the only financial institution participant in the APS after November 2009 — got the benefit of having problem or “toxic” assets isolated in a virtual “bad bank.”  This arrangement provided insurance for those assets, while leaving the toxic assets on RBS’s balance sheet and RBS serving as first- line of management for those assets.

The Times report, however, stated that “[i]t was not clear what agency targets had to be met for bonus conditions to accrue, but the agency’s goals included pushing the bank to ‘seek and identify potential disposals’ of customer assets.”

Note:  In the wake of the 2008 financial crisis, RBS management undoubtedly faced what the APA characterized as an “extremely challenging task” in turning RBS around and restoring its viability.  But it is highly troubling that a temporary agency, with no experience in setting executive compensation, apparently saw fit to make incentive-based compensation a significant (in some cases dominant) component of RBS executives’ bonuses, without any clear criteria for awarding of those bonuses or sustained oversight of the bonus-award process.

Both before and after the financial crisis of 2008–2009, as one expert consultant put it, “there have been numerous examples of incentive compensation programs motivating behaviors and activities that resulted in unintended consequences that damaged company reputations, financially harmed companies and their shareholders, and culminated in employee and executive terminations.”  On the basis of that hard-won knowledge, no company – and certainly no government agency – should  adopt any employee incentive-compensation arrangements unless they address the following points:

1. Clear statements of the targets for particular levels of incentive compensation. In response to the Times’s reporting, an RBS spokesman stated: ““Compliance with the asset protection scheme was a key objective for the bank. The pay of senior executives and other relevant employees was aligned to ensure the bank met this objective.”  With respect, compliance with the APS was not just “a key objective” for RBS, but a minimum requirement for RBS to obtain the benefits that it did from the APS.  Stating that senior executives’ pay was aligned to ensure that RBS complied with the APS implies that executives were given substantial bonuses for doing what they were obligated to do under any circumstances, rather than for superior performance.
2. Specifying the performance criteria for such targets. While the Promontory investigation did not discuss the particulars of RBS executives’ compensation, other incentive-compensation programs have foundered when performance criteria were not specified and subordinates were made to understand that their compensation was dependent on making “the numbers” that senior management dictated.  In GRG’s case, RBS’s training aids included a memorandum that told GRG employees, “Sometimes you need to let customers hang themselves. You have then gained their trust and they know what’s coming when they fail to deliver. . . . Missed opportunities will mean missed bonuses.”
3. Conducting regular incentive-compensation risk assessments. In the United States, since 2010 the Securities and Exchange Commission has required that publicly traded companies conduct risk reviews and make proxy statement disclosures if the “features of a company’s compensation policies and practices have the potential to incentivize its employees to create risks that are reasonably likely to have a material adverse effect on the company.”  While no company, absent extreme circumstances, would ever choose to make such a disclosure, the SEC standard should prompt companies to engage in periodic risk assessments of their incentive-compensation programs – at the least, to minimize the possibility that any of those programs would come close to creating such risks.  Those risk assessments, like other types of risk assessments, should take pains to identify a company’s inherent risk, evaluate existing controls to mitigate that risk, and determine residual risk
4. Actively managing the risks that particular incentive-compensation arrangements may create.  Moreover, once that residual risk has been determined, companies must take specific steps to address and manage those risks on a continuing basis.  Merely identifying the risks without further action will do nothing to protect the company in the event that the compensation program with which those risks are associated later leads to regulatory enforcement or reputational damage.