WASHINGTON — Federal regulators' plan to rein in incentive-based compensation for top bank executives and designate certain risk-takers at large institutions is riddled with loopholes that allow firms to escape the harshest penalties envisioned in the proposal, according to financial industry critics.

In comment letters to the banking agencies, several reform organizations took aim at various aspects of an April proposal that they consider too lax.

Chief among them is the implementation language that would lay out when firms might "consider" reclaiming compensation from executives who engaged in misconduct, fraud or intentional misrepresentation. Critics argued that the voluntary nature of the "clawback" provision undercuts the proposal.

"Leaving the use of clawbacks completely to the discretion of the regulated industry, without even specifying required procedures or guidelines, severely weakens the clawback provision in the re-proposal," said Dennis Kelleher, president of the advocacy group Better Markets. "Without question, the result will be cases where executives are able to retain incentive-based compensation even though it led to a material financial loss to the firm."

Americans for Financial Reform, meanwhile, said that by limiting the types of activities that might cause a board of directors to even consider implementing clawbacks, the proposal further buffers boards of directors from actually taking compensation back. Misconduct is notoriously vague, the letter said, and makes no consideration for whether executives would be only held accountable for their own misconduct or that of their subordinates — creating a sort of plausible deniability for executives suspected of wrongdoing. Fraud and intentional misrepresentation require proof of intent, which is difficult to demonstrate.

"A close reading of this rule shows that at multiple points the agencies have inserted 'back doors' that would permit large financial institutions to escape full compliance with key requirements to hold incentive pay at risk long-term," the AFR letter said. "These loopholes could potentially allow financial firms to pay the great majority or all of bonus compensation to key personnel even if inappropriate risk-taking or misconduct occurred."

The agencies reissued the joint proposal in April after the initial plan, which was published in 2011, foundered for almost five years. The proposal implements Section 956 of the Dodd-Frank Act and is meant to curb the kinds of incentive-based compensation packages that were widely criticized as contributing to a culture of excessive risk-taking leading up to the financial crisis. President Obama in March pressed the agencies to finish the rule during a press event at the White House.

The proposal laid out three tiers of regulation based on a financial firm's asset size — the most stringent requirements are reserved for institutions with more than $250 billion in assets, followed by firms with assets of $50 billion to $250 billion, and finally those with assets of $1 billion to $50 billion. Firms with less than $1 billion in assets are exempt.

Within those tiers, certain executives and other "significant risk-takers" would be subject to prescribed deferrals of compensation, with the more senior executives and the largest firms having to push back a larger portion of compensation for a longer period.

The groups also targeted other provisions of the plan. Public Citizen argued that the draft did not explicitly bar "hedging" of deferred compensation packages — arrangements whereby executives can take out a sort of insurance policy on their deferred compensation. Such an arrangement effectively makes any clawbacks or other forfeiture of compensation moot, Public Citizen said.

"If a manager can purchase an insurance contract that protects against loss of future income … then incentive-based compensation is rendered useless," Public Citizen said in its letter. "These contracts should be written such that any proceeds from an illicit insurance claim would be returned in even shares to the insurance company, the bank, and any whistleblower upon detection."

For its part, the financial industry lambasted the proposal as being too harsh on financial firms. In a letter signed by the American Bankers Association, the Center for Executive Compensation, the Financial Services Roundtable, the Securities Industry and Financial Markets Association, the Clearing House Association and the U.S. Chamber of Commerce, industry groups said the proposal as written would effectively drive qualified, competent executives out of the sector entirely and into other industries where these restrictions were not in place. Reducing the quality of the talent at the top of the U.S. financial system would do little to improve its resilience, the letter argued.

"It is difficult to overstate the significance of any rule that places artificial, non-market-based restraints on the fiercely competitive global market for the services of talented professionals," the coalition letter said. "The likely result of a failure to revisit much of the structure of the re-proposal is that professionals may flee covered businesses in favor of others or seek opportunities at financial services firms which are not covered by Section 956 or outside the industry altogether."

Kenneth Bentsen, SIFMA's president and CEO, said in a separate comment letter that the main concern is the "formulaic" approach that regulators had taken to writing the proposal, making little consideration for the differences between covered firms. What might be acceptable or competitive for a bank may not be workable for a hedge fund or broker-dealer, Bentsen said, and so the agencies should repropose rules that take the particularities of their jurisdictions into account, using principles-based approach that has prevailed to date.

"The financial services industry will inevitably evolve, and prescriptive requirements that remain fixed will, in the long term, fail to properly address the policy objectives of Section 956 in this changing landscape," Bentsen said.

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