The National Credit Union Administration, or NCUA, became the first of six Agencies to unveil a revised rule proposal under Section 956 of the Dodd-Frank Act:

  • prohibiting incentive-based payment arrangements that the Agencies determine encourage inappropriate risks by certain financial institutions by providing excessive compensation or that could lead to material financial loss; and
  • requiring those financial institutions to disclose information concerning incentive-based compensation arrangements to the appropriate Federal regulator.

The other five Agencies that will issue the proposed rule are the Office of the Comptroller of the Currency, Treasury (OCC); Board of Governors of the Federal Reserve System (Board); Federal Deposit Insurance Corporation (FDIC); Federal Housing Finance Agency (FHFA); and U.S. Securities and Exchange Commission (SEC).  These five Agencies are expected to issue the proposal in the near future.

Background.

The Agencies proposed a rule in 2011, rather than guidelines, to establish requirements applicable to the incentive-based compensation arrangements of all covered institutions. The 2011 Proposed Rule would have supplemented existing rules, guidance, and ongoing supervisory efforts of the Agencies.

The Agencies are re-proposing a rule, rather than proposing guidelines, to establish general requirements applicable to the incentive-based compensation arrangements of all covered institutions. The proposed rule reflects the Agencies’ collective supervisory experiences since they proposed the 2011 Proposed Rule. These supervisory experiences have allowed the Agencies to propose 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 financial crisis that began in 2007.

Scope and Initial Applicability.

Similar to the 2011 Proposed Rule, the proposed rule would apply to any covered institution with average total consolidated assets greater than or equal to $1 billion that offers incentive-based compensation to covered persons.

The definition of “covered institution” depends on the Agency issuing the rule, but for the most part includes national banks, federal savings associations, state member banks, bank holding companies, credit unions, broker dealers, and the like.

The compliance 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. The proposed rule would not apply to any incentive-based compensation plan with a performance period that begins before the compliance date.

Applicability

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); and
  • Level 3 (greater than or equal to $1 billion and less than $50 billion).

Requirements and Prohibitions Applicable to All Covered Institutions.

Similar to the 2011 Proposed Rule, the proposed rule would prohibit all covered institutions from establishing or maintaining incentive-based compensation arrangements that encourage inappropriate risk by providing covered persons with excessive compensation, fees, or benefits or that could lead to material financial loss to the covered institution.

Also consistent with the 2011 Proposed Rule, the proposed rule provides that compensation, fees, and benefits will be considered excessive when amounts paid are unreasonable or disproportionate to the value of the services performed by a covered person, taking into consideration all relevant factors, including:

  • The combined value of all compensation, fees, or benefits provided 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 practices at comparable institutions, based upon such factors as asset size, geographic location, and the complexity of the covered institution’s operations and assets;
  • For post-employment benefits, the projected total cost and benefit to the covered institution; and
  • 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.

The proposed rule is also similar to the 2011 Proposed Rule in that it provides that 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; and
  • Is supported by effective governance.

However, unlike the 2011 Proposed Rule, the proposed rule specifically provides that an incentive-based compensation arrangement would not be considered to appropriately balance risk and reward unless it:

  • Includes financial and non-financial measures of performance;
  • Is designed to allow non-financial measures of performance to 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 non-financial performance.

The proposed rule also contains requirements for the board of directors of a covered institution that are similar to requirements included in the 2011 Proposed Rule. Under the proposed rule, the board of directors of each covered institution (or a committee thereof) would be required to:

  • 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.

The 2011 Proposed Rule contained an annual reporting requirement, which has been replaced by a recordkeeping requirement in the proposed rule. Covered institutions would be required to create annually and maintain for at least seven years records that document the structure of incentive-based compensation arrangements and that demonstrate compliance with the proposed rule. The records would be required to be disclosed to the covered institution’s appropriate Federal regulator upon request.

Disclosure and Recordkeeping Requirements for Level 1 and Level 2 Covered Institutions.

The proposed rule includes more detailed disclosure and recordkeeping requirements for larger covered institutions than the 2011 Proposed Rule. The proposed rule would require all Level 1 and Level 2 covered institutions to create annually and maintain for at least seven years records that document:

  • the covered institution’s senior executive officers and significant risk-takers, listed by legal entity, job function, organizational hierarchy, and line of business;
  • the incentive-based compensation arrangements for senior executive officers and significant risk-takers, including information on the percentage of incentive-based compensation deferred and form of award;
  • any forfeiture and downward adjustment or clawback reviews and decisions for senior executive officers and significant risk-takers; and
  • any material changes to the covered institution’s incentive-based compensation arrangements and policies. Level 1 and Level 2 covered institutions would be required to create and maintain records in a manner that would allow for an independent audit of incentive-based compensation arrangements, policies, and procedures, and to provide the records described above in such form and frequency as the appropriate Federal regulator requests.

Deferral, Forfeiture and Downward Adjustment, and Clawback Requirements for Level 1 and Level 2 Covered Institutions.

The proposed rule would require incentive-based compensation arrangements that appropriately balance risk and reward. For Level 1 and Level 2 covered institutions, the proposed rule would require that incentive-based compensation arrangements for certain covered persons include deferral of payments, risk of downward adjustment and forfeiture, and clawback to appropriately balance risk and reward. The 2011 Proposed Rule required deferral for three years of 50 percent of annual incentive-based compensation for executive officers of covered financial institutions with $50 billion or more in total consolidated assets.

The proposed rule would apply deferral requirements to significant risk-takers as well as senior executive officers, and, as described below, would require 40, 50, or 60 percent deferral depending on the size of the covered institution and whether the covered person receiving the incentive-based compensation is a senior executive officer or a significant risk-taker.

Unlike the 2011 Proposed Rule, the proposed rule would explicitly require a shorter deferral period for incentive-based compensation awarded under a long-term incentive plan. The proposed rule also provides more detailed requirements and prohibitions than the 2011 Proposed Rule with respect to the measurement, composition, and acceleration of deferred incentive-based compensation; the manner in which deferred incentive-based compensation can vest; increases to the amount of deferred incentive-based compensation; and the amount of deferred incentive-based compensation that can be in the form of options.

Deferral. Under the proposed rule, the mandatory deferral requirements for Level 1 and Level 2 covered institutions for incentive-based compensation awarded each performance period would be as follows:

  • A Level 1 covered institution would be required to defer at least 60 percent of a senior executive officer’s “qualifying incentive-based compensation” (as defined in the proposed rule) and 50 percent of a significant risk-taker’s qualifying incentive-based compensation for at least four years. A Level 1 covered institution also would be required to defer for at least two years after the end of the related performance period at least 60 percent of a senior executive officer’s incentive-based compensation awarded under a “long-term incentive plan” (as defined in the proposed rule) and 50 percent of a significant risk-taker’s incentive-based compensation awarded under a long-term incentive plan. Deferred compensation may vest no faster than on a pro rata annual basis, and, for covered institutions that issue equity or are subsidiaries of covered institutions that issue equity, the deferred amount would be required to consist of substantial amounts of both deferred cash and equity-like instruments throughout the deferral period. Additionally, if a senior executive officer or significant risk-taker receives incentive-based compensation in the form of options for a performance period, the amount of such options used to meet the minimum required deferred compensation may not exceed 15 percent of the amount of total incentive-based compensation awarded for that performance period.
  • A Level 2 covered institution would be required to defer at least 50 percent of a senior executive officer’s qualifying incentive-based compensation and 40 percent of a significant risk-taker’s qualifying incentive-based compensation for at least three years. A Level 2 covered institution also would be required to defer for at least one year after the end of the related performance period at least 50 percent of a senior executive officer’s incentive-based compensation awarded under a long-term incentive plan and 40 percent of a significant risk-taker’s incentive-based compensation awarded under a long-term incentive plan. Deferred compensation may vest no faster than on a pro rata annual basis, and, for covered institutions that issue equity or are subsidiaries of covered institutions that issue equity, the deferred amount would be required to consist of substantial amounts of both deferred cash and equity-like instruments throughout the deferral period. Additionally, if a senior executive officer or significant risk-taker receives incentive-based compensation in the form of options for a performance period, the amount of such options used to meet the minimum required deferred compensation may not exceed 15 percent of the amount of total incentive-based compensation awarded for that performance period.

The proposed rule would also prohibit Level 1 and Level 2 covered institutions from accelerating the payment of a covered person’s deferred incentive-based compensation, except in the case of death or disability of the covered person.

Forfeiture and Downward Adjustment. Compared to the 2011 Proposed Rule, the proposed rule provides more detailed requirements for Level 1 and Level 2 covered institutions to reduce:

  • incentive-based compensation that has not yet been awarded to a senior executive officer or significant risk-taker, and
  • deferred incentive-based compensation of a senior executive officer or significant risk-taker.

Under the proposed rule, “forfeiture” means a reduction of the amount of deferred incentive-based compensation awarded to a person that has not vested. “Downward adjustment” means a reduction of the amount of a covered person’s incentive-based compensation not yet awarded for any performance period that has already begun. The proposed rule would require a Level 1 or Level 2 covered institution to make subject to forfeiture all unvested deferred incentive-based compensation of any senior executive officer or significant risk-taker, including unvested deferred amounts awarded under long-term incentive plans. This forfeiture requirement would apply to all unvested, deferred incentive-based compensation for those individuals, regardless of whether the deferral was required by the proposed rule. Similarly, a Level 1 or Level 2 covered institution would also be required to make subject to downward adjustment all incentive-based compensation amounts not yet awarded to any senior executive officer or significant risk-taker for the current performance period, including amounts payable under long-term incentive plans. A Level 1 or Level 2 covered institution would be required to consider forfeiture or downward adjustment of incentive-based compensation if any of the following adverse outcomes occur:

  • 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.

Clawback. In addition to deferral, downward adjustment, and forfeiture, the proposed rule would require a Level 1 or Level 2 covered institution to include clawback provisions in the incentive-based compensation arrangements for senior executive officers and significant risk-takers. The term “clawback” refers to a mechanism by which a covered institution can recover vested incentive-based compensation from a senior executive officer or significant risk-taker if certain events occur. The proposed rule would require clawback provisions that, at a minimum, allow the covered institution to recover incentive-based compensation from a current or former senior executive officer or significant risk-taker for seven years following the date on which such compensation vests, if the covered institution determines that the senior executive officer or significant risk-taker engaged in misconduct that resulted in significant financial or reputational harm to the covered institution, fraud, or intentional misrepresentation of information used to determine the senior executive officer or significant risk-taker’s incentive-based compensation.

Additional Prohibitions.

The proposed rule contains a number of additional prohibitions for Level 1 and Level 2 covered institutions that were not included in the 2011 Proposed Rule. These prohibitions would apply to:

  • Hedging;
  • Maximum incentive-based compensation opportunity (also referred to as leverage);
  • Relative performance measures; and
  • Volume-driven incentive-based compensation.

Risk Management and Controls.

The proposed rule’s risk management and controls requirements for large covered institutions are generally more extensive than the requirements contained in the 2011 Proposed Rule. The proposed rule would require all Level 1 and Level 2 covered institutions to have a risk management framework for their incentive-based compensation programs 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. In addition, the proposed rule would require Level 1 and Level 2 covered institutions to:

  • Provide individuals in control functions with appropriate authority to influence the risk-taking of the business areas they monitor and ensure covered persons engaged in control functions are compensated independently of the performance of the business areas they monitor; and
  • Provide for independent monitoring of: (1) incentive-based compensation plans to identify whether the plans appropriately balance risk and reward; (2) events related to forfeiture and downward adjustment and decisions of forfeiture and downward adjustment reviews to determine consistency with the proposed rule; and (3) compliance of the incentive-based compensation program with the covered institution’s policies and procedures.

Governance.

Unlike the 2011 Proposed Rule, the proposed rule would require each Level 1 or Level 2 covered institution to establish a compensation committee composed solely of directors who are not senior executive officers to assist the board of directors in carrying out its responsibilities under the proposed rule. The compensation committee would be required to obtain input from the covered institution’s risk and audit committees, or groups performing similar functions, and risk management function on the effectiveness of risk measures and adjustments used to balance incentive-based compensation arrangements. Additionally, management would be required to submit to the compensation committee on an annual or more frequent basis a written assessment of the effectiveness of the covered institution’s incentive-based compensation program and related compliance and control processes in providing risk-taking incentives that are consistent with the risk profile of the covered institution. The compensation committee would also be required to obtain an independent written assessment from the internal audit or risk management function of the effectiveness of the covered institution’s incentive-based compensation program and related compliance and control processes in providing risk-taking incentives that are consistent with the risk profile of the covered institution.

Policies and Procedures.

The proposed rule would require all Level 1 and Level 2 covered institutions to have policies and procedures that, among other requirements:

  • Are consistent with the requirements and prohibitions of the proposed rule;
  • Specify the substantive and procedural criteria for forfeiture and clawback;
  • Document final forfeiture, downward adjustment, and clawback decisions;
  • Specify the substantive and procedural criteria for the acceleration of payments of deferred incentive-based compensation to a covered person;
  • Identify and describe the role of any employees, committees, or groups authorized to make incentive-based compensation decisions, including when discretion is authorized;
  • Describe how discretion is exercised to achieve balance;
  • Require that the covered institution maintain documentation of its processes for the establishment, implementation, modification, and monitoring of incentive-based compensation arrangements;
  • Describe how incentive-based compensation arrangements will be monitored;
  • Specify the substantive and procedural requirements of the independent compliance program; and
  • Ensure appropriate roles for risk management, risk oversight, and other control personnel in the covered institution’s processes for designing incentive-based compensation arrangements and determining awards, deferral amounts, deferral periods, forfeiture, downward adjustment, clawback, and vesting and assessing the effectiveness of incentive-based compensation arrangements in restraining inappropriate risk-taking.

These policies and procedures requirements for Level 1 and Level 2 covered institutions are generally more detailed than the requirements in the 2011 Proposed Rule.

Indirect Actions.

The proposed rule would prohibit covered institutions from doing indirectly, or through or by any other person, anything that would be unlawful for the covered institution to do directly under the proposed rule. This prohibition is similar to the evasion provision contained in the 2011 Proposed Rule.

Enforcement.

For five of the Agencies, the proposed rule would be enforced under section 505 of the Gramm-Leach-Bliley Act, as specified in section 956. For FHFA, the proposed rule would be enforced under subtitle C of the Safety and Soundness Act.