Interagency Proposed Rule on Incentive-Based Compensation Arrangements (Dodd-Frank Section 956)

On Monday, February 7, the Board of the FDIC voted to approve a joint proposed rulemaking to implement Section 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”).  The other agencies are expected to approve the proposed rule for comment in the near future.

 

What Agencies are jointly issuing this Proposed Rule?

OCC, FRB, FDIC, OTS, NCUA, SEC (broker-dealers and investment advisors), and FHFA (Fannie, Freddie, FHLBs & Office of Finance)

 

Why is the Proposed Rule being issued?

Section 956 of the Act requires that the Agencies prohibit incentive-based payment arrangements, or any features of such arrangements, at a “covered financial institution” that may encourage inappropriate risks (i) by providing excessive compensation or (ii) that could lead to a material financial loss.  The Proposed Rule provides the framework by which the Agencies plan to carry out this mandate.

 

What entities are considered “covered financial institutions”?

The Act defines “covered financial institution” to include any of the following types of institutions that have $1 billion or more in total assets: depository institutions, credit unions, broker-dealers, investment advisers, Fannie, Freddie, FHLBs, Office of Finance, and any other financial institutions the Agencies jointly determine should be treated as a covered financial institution for these purposes.

 

How does the Proposed Rule differ from the Interagency Guidance on Sound Incentive Compensation Policies (the “Guidance”)?

The Proposed Rule supplements (does not replace) existing rules and guidance adopted by the Agencies regarding compensation and incentive-based arrangements.  The Agencies elected to propose rules rather than guidelines and, therefore, the Proposed Rule is more prescriptive than the Guidance:

·         Specifically references the Guidance, and proposes to adopt standards consistent with its key principles for determining whether incentive-based arrangements encourage inappropriate risk-taking;

·         Expands/modifies/clarifies definition of incentive-based compensation arrangement to include equity instruments that are subject to any future vesting or deferral conditions (irrespective of whether such deferral is mandatory);

·         Requires that covered financial institutions maintain policies and procedures appropriate to their size, complexity, and use of incentive-based compensation to help ensure compliance with the requirements and prohibitions;

·         Requires covered financial institutions to submit an annual report to their appropriate Federal regulator(s) concerning their incentive-based arrangements for covered persons;

·         Places additional requirements on “large financial institutions” (generally, assets over $50 billion), including mandatory deferral of at least 50% of incentive-based compensation awarded to executive officers, over a period of at least three years.

 

 What would the Proposed Rule require a covered financial institution to include in the annual report to its Federal regulator(s)?

·         A clear narrative description of the components of the institution’s incentive-based compensation arrangements applicable to covered persons and specifying the types of covered persons to which they apply;

·         A succinct description of the institution’s policies and procedures governing its incentive-based compensation arrangements;

·         Any material changes to the institution’s incentive-based compensation arrangements and policies and procedures made since the last report was submitted; and

·         The specific reasons the institution believes the structure of its incentive-based compensation plan does not provide covered persons incentives to engage in behavior that is likely to cause the institution to suffer a material financial loss, and does not provide covered persons with excessive compensation.

 

How would the Proposed Rule define “excessive compensation”?

As required under section 956 of the Act, the Agencies are required to ensure that any compensation standards established under the Rule be consistent with section 39 of the FDIA.  Specifically, under the Proposed Rule, compensation for a covered person would be considered excessive when amounts paid are unreasonable or disproportionate to, among other things, the amount, nature, quality, and scope of services performed by the covered person.  In making such a determination, the Agencies will consider:

·         The combined value of all cash and non-cash benefits provided to the covered person;

·         The compensation history of the covered person and other individuals with comparable expertise at the institution;

·         The financial condition of the institution;

·         Comparable compensation practices at comparable institutions, based upon such factors as asset size, geographic location, and the complexity of the institution’s operations and assets;

·         For post-employment benefits, the projected total cost and benefit to the covered financial institution;

·         Any connection between the individual and any fraudulent act or omission, breach of trust or fiduciary duty, or insider abuse with regard to the institution; and

·         Any other factors the Agency determines to be relevant.

 

What standards would the Agencies use under the Proposed Rule to determine whether a covered institution’s incentive-based arrangements encourage inappropriate risk-taking?

Banks and thrifts should already be familiar with the standards identified in the Propose Rule because they are nearly identical to the key principles of the Interagency Guidance on Sound Incentive Compensation Policies, which became effective June 25, 2010.  Covered financial institutions other than banks and thrifts will need to get up to speed on these standards prior to the effective date of the final rule.

 

What policies and procedures would the Proposed Rule require of covered financial institutions?

The Proposed Rule would require that the institution maintain policies and procedures that:

·         Promote compliance and accountability regarding the practices that the Agencies propose to prohibit;

·         Foster transparency of the institution’s incentive-based compensation practices; and

·         Are appropriate to the size and complexity of the institution.

 

When would the Final Rule be effective?

There will be a 45 day comment period following the publication of the Proposed Rule in the Federal Register.  The Agencies will then develop the “final rule” after their review of the comments.  The Agencies propose to make the provisions of the Proposed Rule effective six months after publication of the final rule in the Federal Register.

 

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