On April 21, 2016, the National Credit Union Administration (collectively, with the Office of the Comptroller of the Currency, Treasury, Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Federal Housing Finance Agency, and U.S. Securities and Exchange Commission, the “Regulators”), issued a proposed rule (the “Proposed Rule”) designed to ensure that the incentive compensation policies of banking organizations do not undermine the safety and soundness of those organizations under Section 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”).
Section 956 of the Dodd-Frank Act generally requires that the Regulators jointly issue regulations or guidelines: (i) prohibiting incentive-based payment arrangements that the Regulators determine encourage inappropriate risks by certain financial institutions by providing excessive compensation or that could lead to a material financial loss; and (ii) requiring those financial institutions to disclose information concerning incentive-based compensation arrangements to the appropriate Regulator. Accordingly, the Regulators take the position that an incentive-based compensation arrangement encourages inappropriate risks that could lead to material financial loss for the institution, unless the arrangement (i) appropriately balances risk and reward; (ii) is compatible with effective risk management and controls; and (iii) is supported by effective governance.
2011 Rule. The Proposed Rule revises the prior proposed rule the Regulators published in 2011 (the “2011 Rule”), implements section 956 of the Dodd-Frank Act, and attempts to strengthen supervision of banking organizations. While the Proposed Rule is stronger and broader than the 2011 Rule, the Proposed Rule largely mirrors the industry trends in executive compensation the banks have been implementing over the past few years, but its breadth means it will impact more employees than just the top executives.
Like the 2011 Rule, the Proposed Rule would prohibit incentive-based compensation arrangements at covered financial institutions (see discussion below) that could encourage inappropriate risks by providing excessive compensation or that could lead to a material financial loss. However, the Proposed Rule reflects the Regulators’ collective supervisory experiences since they recommended the 2011 Rule. These supervisory experiences have allowed the Regulators to assert a rule that incorporates practices that financial institutions and foreign regulators have adopted to address the deficiencies in incentive-based compensation practices that helped contribute to the previous financial crisis. For that reason, the Proposed Rule differs in some respects from the 2011 Rule.
Covered Persons. The Proposed Rule would apply to any “covered persons” who hold the title or, without regard to title, salary, or compensation, perform the function of one or more of the following positions for any period of time in the relevant performance period: (i) president, (ii) chief executive officer, (iii) executive chairman, (iv) chief operating officer, (v) chief financial officer, (vi) chief investment officer, (vii) chief legal officer, (viii) chief lending officer, (ix) chief risk officer, (x) chief compliance officer, (xi) chief audit executive, (xii) chief credit officer, (xiii) chief accounting officer, or (xiv) head of a major business line or control function.
Covered Financial Institutions. The Proposed Rule would establish a uniform set of enforceable standards that apply to a larger group of financial institutions than the 2011 Rule. Financial institutions covered under this rule include:
- Depository institutions
- Depository institution holding companies
- Registered broker-dealers
- Credit unions
- Investment advisers
- Fannie Mae and Freddie Mac
- Any other financial institution that the Regulators, jointly, by rule, determine should be treated as a covered financial institution under the Proposed Rule
The Proposed Rule identifies three categories of covered institutions based on average total consolidated assets:
- 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)
A covered institution’s category would be based on average total consolidated assets as of the beginning of the first quarter that starts after final rules are published in the Federal Register. The Regulators have tailored the requirements of the Proposed Rule to the size and complexity of the covered institutions. While the basic set of prohibitions and disclosure requirements apply to all covered institutions, the most stringent requirements apply only to Level 1 and Level 2 covered institutions.
Significant Risk-Takers. The Proposed Rule would create a new category of covered person called “significant risk-takers,” which is intended to capture individuals who are not senior executive officers, but are in a position to put a Level 1 or Level 2 institution at risk of material financial loss. A significant risk-taker is someone who receives at least one-third of his or her total compensation (annual base salary and incentive compensation) in incentive compensation and who (i) was in the highest 5 percent (for Level 1 covered institutions) or top 2 percent (for Level 2 covered institutions) in annual base salary and incentive-based compensation among all covered persons (excluding senior executive officers), or (ii) may commit or expose 0.5 percent or more of the net worth or total capital of the institution.
Deferral. The Proposed Rule would require Level 1 and Level 2 covered institutions to defer the vesting of a certain portion of all incentive compensation awarded to senior executive officers or significant risk-takers for a minimum specified period of time. For example, at least 60 percent of each senior executive officer’s qualifying incentive compensation would be deferred for at least four years (for Level 1 covered institutions), and at least 50 percent would be deferred for at least three years (for Level 2 covered institutions). The deferral requirement allows compensation amounts to be adjusted for actual losses and other aspects of performance that crystallize during the deferral period.
Effective Date. Although the Proposed Rule is subject to comment until July 22, 2016, the effective date of the Proposed Rule would be no later than the beginning of the first calendar quarter that begins at least 540 days after a final rule is published in the Federal Register. Any plan with a performance period that began before the effective date would be grandfathered.