United States: The Re-Proposed Rule On Incentive-Based Compensation At Financial Institutions: Overview And Observations

To date, five of the six federal regulators (the "Agencies") charged with promulgating rules under Section 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank") have approved a joint proposed rule (the "2016 Proposal") intended to curb inappropriate risk-taking at covered financial institutions.1 Section 956 of Dodd-Frank requires the Agencies to issue jointly regulations or guidelines prohibiting at certain financial institutions incentive-based payment arrangements that the Agencies determine encourage inappropriate risks by certain financial institutions (1) through the provision of excessive compensation or (2) that could lead to material financial loss. In addition, Section 956 requires those financial institutions to disclose information concerning incentive-based compensation arrangements to the appropriate Agency. The 2016 Proposal's restrictions apply to banks and a broader range of financial institutions, including investment advisers, broker-dealers and credit unions.

The 2016 Proposal will be applicable to these and other "covered institutions"2 with average total consolidated assets of over $1 billion. More prescriptive requirements will apply to those institutions with average total consolidated assets greater than or equal to $50 billion but less than $250 billion, and the most rigorous requirements will apply to those covered institutions with average total consolidated assets of $250 billion or more. The 2016 Proposal refers to these larger institutions as Level 2 and Level 1 covered institutions, respectively.

The 2016 Proposal replaces a proposed rule that had been published by the Agencies in 2011 (the "2011 Proposal") and which generated over 10,000 comments. In the interim, the Agencies have been actively reviewing the incentive-based compensation practices in the financial services industry and providing supervisory guidance on how financial institutions can ensure incentive-based compensation arrangements do not encourage imprudent or undue risk-taking.3 Resulting from this supervisory review is a proposed rule that incorporates many of the practices already implemented at large financial institutions but, in certain areas, imposes stricter requirements than what is commonplace. Other financial services institutions may find that implementation of the 2016 Proposal will require significant changes to both their incentive– based compensation programs and their risk governance processes.

Overall, the 2016 Proposal evidences the Agencies' effort to provide flexibility to the covered institutions in developing their incentive-based compensation programs while instituting certain bright-line requirements. In line with this approach, the 2016 Proposal places front line responsibility with the boards of directors and their committees, as well as with management of the covered institution, for implementation of the rule and its principles, while requiring more clearly delineated and documented procedures in each step of the decision-making process to allow Agency oversight and audit. Consistent with the trend both domestically and internationally, the 2016 Proposal imposes increased oversight and governance responsibilities on boards, their committees and management, which will require, in many cases, a rethinking of their organizational structures and procedures.

Compliance with the 2016 Proposal will be required no later than the beginning of the first calendar quarter that begins 540 days after a final rule is published in the Federal Register, but the rule, as proposed, would not apply to any incentive-based compensation plan with a performance period that began prior to that date. Comments on the 2016 Proposal must be received by the appropriate Agency by July 22, 2016.

This publication highlights significant provisions of the 2016 Proposal and some of the challenges covered institutions may face when designing an incentive-based compensation program that balances the rule's focus on safety and soundness with the desires of shareholders to see pay for performance.

Highlights and Observations

  • Requires all incentive-based compensation payable to a "senior executive officer" or "significant-risk  taker" at a Level 1 or Level 2 covered institution to be subject to a 7-year clawback requirement.
  • Requires a substantial portion of incentive-based compensation payable to a "senior executive officer" or "significant-risk taker" at a Level 1 or Level 2 covered institution to be deferred and subject to the risk of forfeiture (up to 60% for "senior executive officers" at Level 1 covered institutions and 50% at Level 2 covered institutions, and up to 50% for "significant risk-takers" at Level 1 covered institutions and 40% at Level 2 covered institutions).
  • Awards that vest solely on the basis of continued employment are not considered incentive-based compensation.
  • Expands the group of executives considered "senior executive officers" under the rule.
  • Prohibits Level 1 and Level 2 covered institutions from accelerating the incentive-based compensation that is required to be deferred, other than in the event of death or disability.
  • Although Level 1 and Level 2 covered institutions may waive continued service requirements when negotiating a separation from service, they may not shorten the deferral period.
  • Limits the amount of incentive-based compensation payable to "senior executive officers" and "significant risk-takers" at Level 1 and Level 2 covered institutions for the attainment of performance measures in excess of target measures (to 125% and 150% of target for "senior executive officers" and "significant risk-takers," respectively).
  • Requires Level 1 and Level 2 covered institutions to implement an independent risk-monitoring framework.
  • Imposes new governance requirements on boards of directors, including requiring the board of directors (or a board committee) to approve all incentive-based compensation payable to "senior executive officers" and to maintain records documenting guidelines for the utilization of discretion in implementing incentive-based compensation-related decisions.
  • Replaces the proposed annual reporting requirements of the 2011 Proposal with a 7-year recordkeeping requirement.

Key Terms

Incentive-based Compensation4

"Incentive-based compensation" is any variable compensation, fees or benefits that serves as an incentive or reward for performance. Compensation, fees or benefits that are awarded solely for, and the payment of which is solely tied to, continued employment would not be incentive-based compensation.5

Level 1 and Level 2 Covered Institutions

As stated above, each covered institution will be placed into one of three categories—or Levels—based on its average total consolidated assets:6 

  • Level 1 covered institutions are those with average total assets of $250 billion or more;
  • Level 2 covered institutions are those with average total assets of at least $50 billion and less than $250 billion;7 and
  • Level 3 covered institutions are those with average total assets of at least $1 billion but less than $50 billion.

The 2016 Proposal includes more prescriptive requirements for Level 1 covered institutions and Level 2 covered institutions.8 These additional requirements are discussed throughout this publication.

Further, to the extent a subsidiary of a covered institution is also a covered institution (including the requirement to have $1 billion in assets), the subsidiary will be defined to be at the same level as the parent, regardless of the size of the subsidiary.9 These subsidiaries, however, would be in compliance with the rule if the parent organization complies in such a way that causes the subsidiary to comply with the requirements.

Senior Executive Officers and Significant Risk-Takers

A number of the additional requirements apply to two subgroups of covered persons,10 "senior executive officers" and "significant risk-takers."

  • Senior Executive Officer. A senior executive officer is a covered person who holds the title or, without regards to title, salary or compensation, performs the function of one or more of the following positions for any period of time during the relevant performance period: (1) president, (2) chief executive officer, (3) executive chairman, (4) chief operating officer, (5) chief financial officer, (6) chief investment officer, (7) chief legal officer, (8) chief lending officer, (9) chief risk officer, (10) chief compliance officer, (11) chief audit executive, (12) chief credit officer, (13) chief accounting officer or (14) head of a major business line or control function.
  • Significant Risk-Taker. A significant risk-taker is any covered person at a Level 1 or Level 2 covered institution who (1) received incentive-based compensation equal to at least 1/3 of the annual base salary and incentive- based compensation received and (2) satisfies either the "relative compensation test" or the "exposure test." For purposes of the 1/3 test, compensation is taken into account if it was received during the calendar year that ended 180 days before the beginning of the performance period for which the significant risk-takers are being identified.11
  • Relative Compensation Test. For Level 1 covered institutions, a covered employee is a significant risk- taker if the individual is among the highest five-percent of all covered persons (excluding senior executive officers) in annual base salary actually paid and incentive-based compensation of the Level 1 covered institution.12 For Level 2 covered institutions, the covered person must be among the highest two-percent.13 As is the case with the 1/3 test, this determination is made on the basis of the compensation that was paid during the calendar year that ended 180 days before the beginning of the performance period for which the significant risk-takers are being identified.
  • Exposure Test. A covered person would be a significant risk-taker with regard to a Level 1 or Level 2 covered institution if the individual was able to commit or expose 0.5% or more of the capital of the covered institution, or in the case of the OCC, the Board, the FDIC and the SEC, any "Section 956" affiliate of the covered institution (regardless of whether the individual is employed by that affiliate), during the same calendar year used to determine whether the covered person meets the 1/3 test. An individual is considered to be in the position to commit or expose capital if the individual has the right to put the capital at risk of loss due to market or credit risk.

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1 The Agencies that have approved the 2016 Proposal are the (1) National Credit Union Administration ("NCUA"), (2) Office of the Comptroller of the Currency ("OCC"), (3) Federal Deposit Insurance Corporation ("FDIC"), (4) Federal Housing Financing Agency ("FHFA") and (5) the Board of Governors of the Federal Reserve System ("Board"). The remaining Agency is the Securities and Exchange Commission ("SEC"). The 2016 Proposal will be published in the Federal Register once all the Agencies have formally granted their approval. The NCUA's draft of the 2016 Proposal can be found at: https://www.ncua.gov/About/Documents/Agenda%20Items/AG20160421Item2b.pdf.

The OCC's draft of the 2016 Proposal can be found at: http://www.occ.gov/news-issuances/news-releases/2016/nr-occ-2016-49a.pdf.

The FDIC's draft of the 2016 Proposal can be found at: https://www.fdic.gov/news/board/2016/2016-04-26_notice_dis_a_fr.pdf.

The FHFA draft of the 2016 Proposal can be found at: https://www.fhfa.gov/SupervisionRegulation/Rules/RuleDocuments/Incentive


The Board's draft of the 2016 Proposal can be found at: http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20160502a2.pdf.

 The Agencies have stated that published versions of the 2016 Proposal might differ from the approved drafts.

2 Each Agency will have its own definition of "covered institution" that describes the covered financial institutions that the Agency regulates. A list of covered institutions categorized by applicable Agency is attached as Appendix A.

3 For example, beginning in 2009, the Board, OCC and FDIC participated in "horizontal reviews" of incentive-based compensation arrangements at large banking organizations and, in 2010, promulgated "Guidance on Sound Incentive Compensation Policies" (the "2010 Guidance").

4 The 2016 Proposal also contains certain related definitions. An incentive-based compensation plan is a document setting forth the terms and conditions governing the opportunity for and the payment of incentive-based compensation payments to one or more covered persons. An incentive-based compensation arrangement is an agreement between a covered institution and a covered person, under which the covered institution provides incentive-based compensation to the covered person, including incentive-based compensation delivered through one or more incentive-based compensation plans. An incentive-based compensation program is a covered institution's framework for incentive-based compensation that governs incentive-based compensation practices and establishes related controls. A covered institution's incentive-based compensation program would include all of the covered institution's incentive-based compensation arrangements and incentive-based compensation plans.

5 Examples of this type of compensation, fees or benefits would include so-called "time-based" restricted stock or restricted stock units which vest solely on the basis of continued employment.

6 Average total consolidated assets means, for institutions other than investment advisors, the average of a regulated institution's total consolidated assets, as reported on the regulated institution's regulatory reports, for the four most recent consecutive quarters. For investment advisors, average total consolidated assets would be determined by the investment advisor's total assets (exclusive of non-proprietary assets) shown on the balance sheet for the advisor's most recent fiscal year end.

7 Under the FHFA's draft of the 2016 Proposal, a Federal Home Loan Bank would always be a Level 2 covered institution (so long as it had assets of at least $1 billion).

8 Each Agency may require a Level 3 covered institution with an average total consolidated assets of at least $10 billion to adhere to some or all of the provisions applicable to Level 1 and Level 2 covered institutions depending on the activities, complexity of operations, risk profile and compensation practices of the Level 3 covered institution (or any other relevant factors).

9 This provision would not apply to covered institutions regulated by the SEC unless the parent is a depository institution holding company. In addition, for the US operations of a foreign banking organization, the level would be determined by the total consolidated US assets of the foreign banking organization (including any of its branches and agencies, as well as its subsidiaries or operations held pursuant to Section 2(h)(2) of the Bank Holding Company Act). The level of an OCC-regulated federal branch or agency of a foreign bank would be determined with reference to the assets of the federal branch or agency.

10 A "covered person" is broadly defined to include any executive officer, employee, director or principal shareholder that receives incentive-based compensation.

11 For purposes of the 1/3 test and the relative compensation test, incentive-based compensation will be counted to the extent it was awarded for a performance period that ended during that calendar year, regardless of when the performance period began.

12 The OCC, Board, FDIC and SEC would also include any "Section 956 affiliates" of the covered institution that are also covered institutions. Each Agency will have its own definition of "Section 956 affiliate."

13 With respect to Level 1 covered institutions, each Agency may substitute 2% for 5% if it determines that the covered institution's activities, complexity of operations, risk profile and compensation practices are similar to a Level 2 covered institution.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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