Introduction

On May 6, 2024, several federal financial regulators re-proposed a 2016 rule outlining acceptable practices for incentive-based compensation at certain banks. The rule is required by Section 956 of the Dodd-Frank Act and has been in the works for well over a decade. Regulators initially proposed principles-based rules in 2011 and proposed revised, more prescriptive rules in 2016. The new proposed rules are identical to the rules proposed in 2016; however, regulators have also requested comment on specific alternatives to the 2016 rules.

To-date, four agencies, including the Federal Deposit Insurance Corp. (FDIC), Office of the Comptroller of the Currency (OCC), the Federal Housing Finance Agency (FHFA), and the National Credit Union Administration (NCUA), have issued rules. Notably, the Securities and Exchange Commission (SEC) and the Federal Reserve have not yet issued rules. The SEC is expected to follow the four agencies that have already issued rules. The Federal Reserve’s view on the proposed rulemaking is less clear. The rules must be issued jointly by all six regulators, including the Federal Reserve.

This article summarizes the proposed rules and highlights the 2024 alternatives on which regulators are seeking feedback.

Requirements And Prohibitions Applicable To All Covered Institutions

The proposed rules restrict all covered institutions from establishing or maintaining incentive based compensation arrangements that encourage inappropriate risk taking and providing covered persons with excessive compensation, fees, or benefits that could lead to material financial loss to the covered institution. A covered institution is one with at least $1 billion in assets.

Excessive Compensation: Compensation, fees, and benefits will be viewed as excessive when amounts paid are unreasonable or disproportionate to the services provided by a covered person, considering all factors, including:

• Combined value of all compensation, fees and benefits to a covered person;
• The compensation history of the covered person and other individuals with comparable expertise at the covered institution;
• The financial condition of the covered institution;
• Compensation at comparable institutions (specific criteria described in the proposal);
• For post-employment benefits, the potential cost and benefit to the covered institution;
• 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.

Risk Balancing: An incentive-based compensation arrangement will be considered to encourage inappropriate risks that could lead to material financial loss to the covered institution, unless the arrangement:

• Appropriately balances risk and reward;
• Is compatible with effective risk management and controls;
• Is supported by effective governance;
• Includes financial and non-financial measures of performance;
• Is designed to let non-financial measures of performance override financial measures of performance, when appropriate; and
• Is subject to adjustment to reflect actual losses, inappropriate risks taken, compliance deficiencies, or other measures or aspects of financial and nonfinancial performance.

Board Oversight: The proposed rule requires that the Board of Directors:

• Conduct oversight of the covered institution’s incentive –based compensation program;
• Approve incentive-based compensation arrangements for senior executive officers, including amounts of awards, and at the time of vesting, payouts under such arrangements; and
• Approve material exceptions or adjustments to incentive-based compensation policies or arrangements for senior executive officers.

Covered Institution Categories

The proposed rules segment covered institutions into three main categories:

• Level 1: Greater than $250 billion assets
• Level 2: Greater than $50 billion assets, less than $250 billion assets
• Level 3: Greater than $1 billion assets less than $50 billion assets

The requirements of the proposed rule vary by type of institution with the more prescriptive aspects of the rule having the most impact on Level 1 and Level 2 covered institutions which due to their size and complexity are viewed as the most likely organizations to contribute to systemic risk. It should be noted that the Agencies have reserved the authority to require certain Level 3 institutions with assets between $10 billion and $50 billion to comply with the more rigorous requirements applicable to Level 1 and Level 2 organizations if they find that the complexity of operations or compensation practices are comparable to those of a Level 1 or Level 2 covered institution.

Risk Management And Controls

Level 1 and Level 2 institutions would be required to have a risk management framework in place for their incentive-based compensation programs that is independent of any lines of business and includes an independent compliance program to provide controls, testing, monitoring and training of the institution’s policies and procedures. In addition it would require covered institutions to:

• Provide individuals in control functions with appropriate authority to influence the risk-taking business areas they monitor and ensure that covered persons in control functions would be compensated independently from the areas they monitor; and
• Provide for independent monitoring of whether plans are appropriately risk balanced, events that relate to forfeiture or downward adjustments and compliance with the institution’s policies and procedures

Most large institutions have developed well defined risk management functions that independently oversee/monitor incentive compensation programs and participate in evaluating individual and plan compliance.

Governance

The proposed rule formally requires Level 1 and Level 2 institutions to establish an independent compensation committee (comprised of directors who are not members of management) to assist the Board of Directors in carrying out its responsibilities. It would be expected to obtain input from the institution’s audit and risk committees related to the effectiveness of the institution’s overall program and related processes. Management will be required to submit a written assessment of the effectiveness of the program, compliance and processes that are consistent with the risk profile of the covered institution. Separately, the compensation committee would also be required to annually obtain a similar written assessment from the audit or risk management function. Level 1 and Level 2 institutions have generally integrated their processes for reviewing compensation programs and individual decision making with the risk (and audit) committee at least annually. Additionally, compensation committees receive reports on a periodic basis from internal risk management. The rules provide a more detailed set of processes and documentation for these activities.

Disclosure And Record Keeping Requirements

The proposed rule requires all Level 1 and Level 2 covered institutions to create annually, and retain for seven years, documents that cover the following:

• Senior executives and significant risk-takers (listed by legal entity, job function, organizational hierarchy, and line of business)
• Incentive-based compensation arrangements for senior executives and significant risktakers, including percentage of incentive-based compensation deferred and the form of award
• Any forfeiture, downward adjustments, or claw back reviews and decisions for senior executives and significant risk-takers
• Any material changes to the covered institution’s incentive-based compensation arrangements or policies

Based on our experience, in their interactions with regulators, most covered institutions have been required to develop and maintain extensive record keeping around their incentive compensation arrangements, so the main new requirements are the specific content of the record keeping and the seven year retention period.

Covered Persons

The proposed rule describes specific employees that will be subject to the proposed rule labeled as senior executive officers and significant risk-takers. These categories are roughly equivalent to Category 1 and Category 2 employees under the original 2011 proposed rules; however, they were expanded somewhat in 2016 and the rules for defining significant risk-takers are somewhat more prescriptive.

Senior Executive Officers:

• The following positions:
  • President, Chief Executive Officer, Executive Chairman, Chief Operating 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 Executive, or head of a major business line or control function
  • Anyone performing the equivalent function to the above titles

Significant Risk-Taker:

There are two main tests to determine whether someone is a significant risk taker. If either test is met, the employee is a significant risk-taker

• Relative Compensation Test: For a Level 1 institution, are they among the 5 percent highest compensated covered persons; for a Level 2 institution are they among the 2 percent highest compensated covered persons
• Exposure Test: Does the covered person have the authority to commit more than 0.5% of the capital of the covered institution
• One-Third Threshold: A covered person will only be considered a significant risk-taker if 1/3 or more of their total compensation is incentive-based compensation

We suspect that many covered institutions will find that their current list of Category 2 employees has significant overlap with who will ultimately be considered significant risk-takers. However, organizations that have spent the past few years developing rigorous criteria for identifying Category 2 employees may find it frustrating to have to comply with a new set of criteria, particularly since the new criteria appear to be more sweeping and less tailored to the nature of specific institutions’ lines of business.

Deferral, Incentive Vehicles, And Goal-Setting

• Deferral Period: Deferrals cannot vest any faster than a pro rata basis over the full deferral period (i.e., for a Level 1 Senior Executive, the deferral of a short-term incentive cannot vest any faster that 25% per year over the four anniversaries of the award date; for a long-term award deferral commences at the end of the performance period).
• Form of Deferral: Under the proposed rules, incentive-based compensation will be deferred in cash and equity like instruments. While the rules do not propose specific percentages for each form, they expect a degree of balance between the two. The rules are specific as to how much incentive-based compensation can be deferred in the form of stock options.
• Stock Options: Under the proposed rules, stock options cannot represent more than 15% of the total incentive compensation used to meet the minimum required deferred compensation awarded for that period.
• Acceleration of Deferrals: Level 1 and Level 2 covered institutions are prohibited from accelerating deferrals in any circumstances other than the death or disability of the covered person (i.e., no ability to accelerate upon other termination scenarios as is common today).

The more challenging aspects of the new requirements will be the mandatory deferral of both cash and equity in proportionate amounts, long-term performance plan payouts and the prohibition of the acceleration of deferrals. Companies may reconsider the amount of deferred compensation delivered in long-term performance plans if the new rules remain in place, as it will potentially diminish the value associated with plans due to the longer vesting period and increase the complexity of compensation programs. Many of these plans among Level 1 institutions have only recently been adopted and are well-received by long-term investors. In addition, it is a fairly common practice to accelerate payouts of deferred compensation upon a termination of employment following a change in control or other termination scenarios (e.g., involuntary termination without cause or retirement).

Forfeiture And Downward Adjustment

The guidance defines two new terms for practices that many covered institutions have already implemented in response to the original 2011 proposed guidance:

• Forfeiture: A reduction of the amount of deferred incentive-based compensation that has been awarded but not yet vested.
• Downward Adjustment: A reduction of the incentive-based compensation not yet awarded to a covered person for a performance period that has already begun.

Under the proposed rules all deferred incentive-based compensation will be subject to forfeiture and all not yet awarded incentive-based compensation will be subject to downward adjustment under the following circumstances:

• Poor financial performance attributable to a significant deviation from the covered institution’s risk parameters set forth in the covered institution’s policies and procedures;
• Inappropriate risk-taking, regardless of the impact on financial performance;
• Material risk management or control failures;
• Non-compliance with statutory, regulatory, or supervisory standards resulting in enforcement or legal action brought by a federal or state regulator or agency, or a requirement that the covered institution report a restatement of a financial statement to correct a material error; and
• Other aspects of conduct or poor performance as defined by the covered institution.

Under the proposal, the covered institution can exercise discretion in determining how much, if any, of an award will be impacted by forfeiture or downward adjustment. However, in the proposal, there are specific factors that should be considered in making the determination, including the intent of the covered person, the covered person’s responsibility or awareness of the circumstances around the triggering event, actions that could have been taken to prevent the triggering event, the financial and reputational impact of the event, the cause of the events and any other relevant information related to the event, including past behavior of the covered person. Based on our experiences with covered institutions, we expect this portion of the rule to be straightforward to comply with as most organizations have developed rigorous processes to cover forfeiture and downward adjustments over the past few years.

Clawback

The proposed rules include a clawback provision covering any incentive compensation (cash and equity) for seven years from the time that the award vests. This would mean that some forms of deferred compensation could potentially be subject to claw back for more than ten years from the date that they were originally awarded. The claw back will apply to a current or former senior executive officer or significant risk-taker. While the timeframe for the new provision is long in duration, the triggering events for a claw back are described more narrowly than the events that would trigger a review for forfeiture or downward adjustment. Specifically, the triggering events for a claw back are defined as:

• Misconduct that resulted in significant financial or reputational harm to the covered institution;
• Fraud;
• Intentional misrepresentation of information used to determine the senior executive officer’s or significant risk-taker’s incentive-based compensation.

2024 Alternative For Comment:

Clawback: The Agencies are considering making the clawback a requirement rather than an option. Similar to the mandating of forfeiture or downward adjustment, this change would require definition of the triggers for the claw back and a methodology for determining the amount to be clawed back.

Hedging

The proposed rule will prohibit covered institutions from purchasing hedging instruments on behalf of covered persons. As a practical matter, many financial institutions go further than this as they prohibit executives from engaging in hedging activities on their own behalf.

2024 Alternative For Comment:

Hedging: The Agencies are considering an alternative to prohibit institutions from offering incentive-based plans that allow individuals to personally hedge their compensation.

Maximum Incentive-Based Compensation Opportunity (Also Referred To As Leverage)

Since proposing the original rule in 2011, regulators have raised concerns with covered institutions over the degree of leverage in short-term and long-term incentive compensation arrangements. While many companies had incentive compensation arrangements with upside leverage of 200% of the target incentive opportunity when the 2011 rules were issued, most now have upside leverage of either 150% of target or 125% of target for their formulaic incentive-based compensation arrangements. The new proposed rule explicitly limits the upside leverage allowed for Level 1 and Level 2 institutions:

• Senior Executives: 125% of the target incentive opportunity
• Significant Risk-Takers: 150% of the target incentive opportunity

The professed intent is not to create a ceiling on incentive compensation but to constrain a plan feature that may contribute to inappropriate risk taking. However, it will likely be viewed by institutions as weakening their ability to align pay with performance on the downside and the upside and as an uncompetitive feature when compared to other non-covered financial service firms or other companies.

Volume-Driven Incentive-Based Compensation

The proposed rules prohibit incentive compensation for Level 1 and Level 2 senior executive officers and significant risk-takers based on volume-based performance measures without regard to the quality of the products sold or compliance with sound risk management. This restriction is more likely to have implications for incentive-compensation plans for significant risk-takers than for senior executive officers. In practice, most institutions have added assessments of compliance with risk management and credit quality to individual evaluations for incentive-based compensation so this may be more of a formality in terms of going forward compliance.

Conclusion

Many aspects of the 2024 proposal (essentially the 2016 Proposal), will require significant changes from covered financial institutions, particularly the claw back provisions, deferral of long-term incentives and increased deferral percentages and longer deferral periods. Of particular concern in the revised proposal is that almost all of the alternatives raised by the regulators will result in less Committee or Board flexibility and discretion in governing incentive compensation. For example, the alternative for comment that calls for approving incentive plan performance targets prior to the beginning of a performance period is a major departure from current practice and may have unintended consequences (e.g., less robust performance goals, fewer pre-defined performance goals). We expect that the regulatory agencies will receive robust comments on the proposal, including the new alternatives for comment. Given the political environment and the past history with implementing Dodd-Frank 956, we expect that this will be challenging to bring to the finish line.

For questions or more information, please contact CAP’s banking team:

Eric Hosken
Partner
[email protected]
212-921-9363

Kelly Malafis
Partner
[email protected]
212-921-9357

Shaun Bisman
Principal
[email protected]
212-921-9365

Mike Bonner
Principal
[email protected]
646-486-9744