On May 6, the Federal Deposit Insurance Corp. (FDIC), Office of the Comptroller of the Currency (OCC), and Federal Housing Finance Agency (FHFA) issued a Notice of Proposed Rulemaking addressing incentive-based compensation arrangements (the Proposed Rule). The Proposed Rule is designed to implement Section 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). It is a re-proposal of the joint proposed rule issued in 2016 with the identical text, which is summarized in this article. However, the Proposed Rule has a new preamble and a request for comments, seeking feedback on several alternative provisions that could be included in a final rule.

Section 956 of Dodd-Frank requires the FDIC, OCC, FHFA, National Credit Union Administration, Board of Governors of the Federal Reserve System, and Securities and Exchange Commission (collectively, the Agencies) to jointly prescribe regulations or guidelines with respect to incentive-based compensation for “Covered Institutions.” The Proposed Rule will not be published in the Federal Register nor opened for formal public comment until approved by all six of the Agencies. The FDIC, OCC, and FHFA have indicated that until then, they will make the Proposed Rule available on their respective websites and will accept comments.

Section 956 of Dodd-Frank requires the Agencies to jointly prescribe regulations that (1) prohibit incentive-based compensation that encourages inappropriate risks by providing excessive compensation, fees, or benefits, or that could otherwise lead to material financial loss, and (2) require the disclosure of information concerning incentive-based compensation arrangements to the appropriate federal regulators.

What is covered by the Proposed Rule?

The Proposed Rule applies to incentive-based compensation for “Covered Persons” at “Covered Institutions.” Under the Proposed Rule, incentive-based compensation is defined as “any variable compensation, fees or benefits that serve as an incentive or [a] reward for performance.”

A Covered Institution is any of the following that has $1 billion or more in assets: (1) a depository institution and any holding company thereof, (2) a registered broker-dealer, (3) a credit union, (4) an investment adviser, (5) Fannie Mae and Freddie Mac, and (6) other institutions that the Agencies jointly determine should be treated as a Covered Institution. The Proposed Rule uses the following tiered approach, which is based on the entity’s average total consolidated assets, in applying the provisions thereof to Covered Institutions:

Level 1 Greater than or equal to $250 billion

Level 2 Greater than or equal to $50 billion and less than $250 billion

Level 3 Greater than or equal to $1 billion and less than $50 billion

The Proposed Rule applies basic requirements to all Covered Institutions, with enhanced requirements applicable to Level 1 and Level 2 Covered Institutions.

A Covered Person is any executive officer, employee, director, or principal (10% or more) shareholder. Enhanced requirements apply to Level 1 and Level 2 Covered Institutions for incentive-based compensation of Covered Persons who are either “senior executive officers” or “significant risk-takers.” Senior executive officers generally include those holding the title or performing the function of president, CEO, executive chairman, chief operations officer, chief financial officer, chief investment officer, chief legal officer, chief lending officer, chief risk officer, chief compliance officer, chief audit executive, chief credit officer, chief accounting officer, or head of a major business line or control function. Significant risk-takers include those (other than senior executive officers) who received annual base salary and incentive-based compensation for the last calendar year of which at least one-third is incentive-based compensation and (1) are among the highest 5% (for Level 1) or 2% (for Level 2) in annual base salary and incentive-based compensation among all Covered Persons (excluding senior executive officers) or (2) have authority to commit or expose .5% or more of the Covered Institution’s tier 1 capital.

Incentive-based compensation plans with a performance period that begins prior to the date on which compliance with the Proposed Rule is required are grandfathered and not subject to the requirements under the Proposed Rule.

What are the basic requirements under the Proposed Rule?

The basic requirements under the Proposed Rule apply to all Covered Institutions and prohibit a Covered Institution from establishing or maintaining any incentive-based compensation arrangement that encourages inappropriate risk by providing excessive compensation, fees, or benefits to a Covered Person or that could lead to material financial loss.

Compensation, fees, and benefits are considered excessive when amounts paid are unreasonable or disproportionate to the value of the services performed by a Covered Person. The determination of whether an amount is excessive is based on all relevant factors, including but not limited to (1) the combined value of all compensation, fees, or benefits provided to the Covered Person, (2) the compensation history of the Covered Person and other individuals with comparable expertise, (3) the financial condition of the Covered Institution, (4) compensation practices at comparable institutions, (5) the projected total cost and benefit to the Covered Institution of post-employment benefits, and (6) any connection between the Covered Person and any fraudulent act or omission, breach of trust or fiduciary duty, or insider abuse with regard to the Covered Institution.

An incentive-based compensation arrangement encourages inappropriate risks that could lead to material financial loss, unless the arrangement appropriately balances risk and reward, is compatible with effective risk management and controls, and is supported by effective governance. An incentive-based compensation arrangement will not be considered to appropriately balance risk and reward unless it includes both financial and nonfinancial measures of performance, including considerations of risk-taking, that are relevant to a Covered Person and to the type of business in which the Covered Person is engaged and that are appropriately weighted to reflect risk-taking. Further, the incentive-based compensation arrangement must be designed to allow nonfinancial measures of performance to override financial measures of performance when appropriate and provide that amounts to be awarded under the arrangement are subject to adjustment to reflect actual losses, inappropriate risks taken, compliance deficiencies, or other measures or aspects of financial and nonfinancial performance.

The Proposed Rule requires a Covered Institution’s board of directors, or a committee thereof, to conduct oversight of the incentive-based compensation program, approve incentive-based compensation arrangements for senior executive officers, and approve any material exceptions or adjustments to incentive-based compensation policies or arrangements for senior executive officers. The Proposed Rule further requires that records be created and maintained for a period of at least seven years documenting the structure of the incentive-based compensation program and compliance with the provisions of the Proposed Rule, which must be disclosed to the appropriate agency upon request.

What enhanced requirements are applicable to Level 1 and Level 2 Covered Institutions?

The following enhanced requirements are applicable to incentive-based compensation for senior executive officers and significant risk-takers:

1. Required Deferral: At least 60% of incentive-based compensation for senior executive officers and 50% for significant risk-takers must be deferred by a Level 1 Covered Institution. For a Level 2 Covered Institution, the required deferral percentage is 50% and 40%, respectively, for senior executive officers and significant risk-takers. The deferral must be for a period of four years (Level 1) or three years (Level 2), except in the case of a long-term arrangement (having a performance period of at least three years), in which case the minimum deferral period is two years (Level 1) and one year (Level 2). The incentive-based compensation may vest pro rata on an annual basis during the deferral period and vesting may be accelerated in the event of death or disability.
2. Downward Adjustment and Forfeiture: An incentive-based compensation arrangement must place at risk of downward adjustment all incentive-based compensation amounts not yet awarded for the current performance period and must place at risk of forfeiture all unvested deferred incentive-based compensation. Such downward adjustment or forfeiture will be triggered by certain adverse conditions including, but not limited to, poor financial performance, inappropriate risk-taking (regardless of the impact on financial performance), and material risk management or control failures.
3. Clawback: Clawback provisions must be included in incentive-based compensation arrangements that, at a minimum, allow the Covered Institution to recover incentive-based compensation for seven years following the date on which such compensation vests due to misconduct that resulted in significant financial or reputational harm to the Covered Institution, fraud, or intentional misrepresentation of information used to determine the incentive-based compensation.
4. Maximum Opportunity: Incentive-based compensation arrangements must limit awards in excess of the target amount to 125% of the target for a senior executive officer and 150% of the target amount for a significant risk-taker.
5. Other Limitations: (1) The purchase of a hedging or similar instrument by a Covered Institution to hedge or offset any decrease in the value of the incentive-based compensation is prohibited, (2) performance measures for incentive-based compensation may not be based solely on comparisons to peers, and (3) incentive-based compensation that is based solely on transaction revenue or volume without regard to transaction quality or compliance with sound risk management is prohibited.
6. Risk Management and Control: A risk management framework must be in place for the incentive-based compensation program that is independent of any lines of business; includes an independent compliance program that provides for internal controls, testing, monitoring, and training with written policies and procedures; and is commensurate with the size and complexity of the Covered Institution’s operations. Individuals engaged in control functions must have the authority to influence the risk-taking of the business areas they monitor, and Covered Persons engaged in control functions are to be compensated in accordance with the achievement of performance objectives linked to their control functions and independent of the performance of those business areas. Further, the Covered Institution must provide for the independent monitoring of (1) all incentive-based compensation plans in order to identify whether those plans provide incentives that appropriately balance risk and reward, (2) events related to forfeiture and downward adjustment reviews and decisions, and (3) compliance of the incentive-based compensation program with the Covered Institution’s policies and procedures.
7. Governance Requirements: A compensation committee must be established composed solely of directors who are not senior executive officers. The compensation committee must obtain (1) input from the risk and audit committees of the board of directors, or groups performing similar functions, and a risk management function on the effectiveness of risk measures and adjustments used to balance risk and reward in incentive-based compensation arrangements, (2) an annual (or more frequent) written assessment from management and independently from an internal audit or risk management function of the effectiveness of the incentive-based compensation program and related compliance and control processes.
8. Policies and Procedures: The Proposed Rule requires policies and procedures to be developed and implemented for the incentive-based compensation program and sets out a list of requirements that, at a minimum, are required to be covered in such policies and procedures.

What does the new preamble propose?

The new preamble to the Proposed Rule requests comments on alternative provisions that may affect the requirements included in a final rule. These include but are not limited to the following:

• Changing to a two-tiered approach, under which Covered Institutions with average total consolidated assets of more than $50 billion would be subject to the enhanced requirements. This alternative includes a proposal to simplify the deferral amount and deferral period to a single 60% deferral percentage and four-year deferral period for both senior executive officers and significant risk-takers.
• Requiring mandatory forfeiture or downward adjustment and mandatory clawback by a Level 1 or Level 2 Covered Institution in specified circumstances, rather than at the discretion of the Covered Institution.
• Reducing the cap on options from 15% to 10% of senior executive officers’ and significant risk-takers’ total incentive-based compensation.
• Prohibiting agreements with senior executive officers and significant risk-takers from allowing Covered Persons to purchase a hedging instrument to offset any decrease in value of the incentive-based compensation.
• Requiring Covered Institutions to establish performance measures and targets before the beginning of a performance period and prohibiting any changes thereto without documentation and approval by appropriate personnel. Further, any decision regarding deferral, downward adjustment, or forfeiture would have to account for all performance measures.
• Changing the definition of significant risk-taker, subject to minimum standards, to rely on more flexible criteria developed by the Covered Institution and eliminating the exposure test.
• Changing the effective date from 540 days to 365 days after a final rule is published in the Federal Register.

What should Covered Institutions do now?

It is unclear when or if the Proposed Rule will become effective due to the necessity of approval thereof by all six of the Agencies. In the meantime, Covered Institutions should review the Proposed Rule and consider how it may affect the Institution’s incentive-based compensation program. Covered Institutions should consider commenting on the Proposed Rule, including the questions and alternatives addressed in the new preamble that may affect a final rule. While, as noted above, the official public comment period will not commence until the Proposed Rule is approved by all six of the Agencies and published in the Federal Register, the FDIC, OCC, and FHFA are currently soliciting comments. Stay alert for further developments on the Proposed Rule.