On February 7, 2011, the Board of Directors of the Federal Deposit Insurance Corporation (the FDIC) approved a joint proposed rulemaking (the Proposed Rule) to implement Section 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the Act) governing incentive compensation.
Generally, the Proposed Rule prohibits incentive compensation arrangements that encourage inappropriate risk taking at covered financial institutions by either providing a covered person with the potential for excessive compensation or having the potential to lead to material financial loss to the institution. The Proposed Rule also requires that covered financial institutions file an annual report with the FDIC regarding the covered financial institution's incentive compensation arrangements and maintain policies and procedures to ensure that all incentive compensation arrangements (and the risks posed by their incentivized behavior) are commensurate with the size and complexity of the institution.
The Proposed Rule does not apply to financial institutions with total consolidated assets of less than $1 billion and provides heightened standards for institutions with $50 billion or more in consolidated assets ("larger covered financial institutions"). Specifically, at least fifty percent of the annual incentive compensation of executive officers at larger covered financial institutions must be deferred over a period of no less than 3 years. In addition, incentive compensation arrangements for certain specified persons who could expose the institution to substantial losses must be approved by the larger covered financial institution's board of directors (or a committee thereof) (the "Board").
What you need to know
Aside from the requirement to defer fifty percent of the incentive compensation owed to certain individuals for a three-year period and the requirement to file an annual report with regard to certain incentive compensation arrangements, the Proposed Rule provides no specific definition of what constitutes "excessive compensation" or what types of arrangements would have the potential to lead to a material financial loss. Instead of concrete, rules-based regulatory guidance, financial institutions covered by the Proposed Rule are being provided with principles-based regulations similar to those contained in the Interagency Guidance on Sound Incentive Compensation Policies issued on June 21, 2010 which urge institutions to balance risks and rewards in compensation practices as well as increase corporate governance measures to oversee compensation practices. For a more comprehensive discussion of the Interagency Guidance on Sound Incentive Compensation Policies, please see our June 23, 2010 alert.
While the principles-based regulatory requirements of the Proposed Rule (and the Interagency Guidance on Sound Incentive Compensation Policies) theoretically provide a financial institution with more flexibility, these requirements actually provide very little practical guidance to institutions on their implementation and on-going compliance obligations. However, these principles-based requirements will provide the applicable regulators with more latitude in interpretation and enforcement. Although arguments can be made that this enforcement flexibility is needed for regulators to adjust to changing circumstances and specific situations, it would appear that the practical result of such principles-based requirements could be a lack of uniformity in application to financial institutions depending upon the federal regulator and even the regional office within a single regulator.
The FDIC is the first Federal regulatory agency to approve the Proposed Rule. Because this is a joint rule, it will not be published in the Federal Register until it has been approved by each of the other six Federal regulators involved (i.e., the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, the FDIC, the Director of the Office of Thrift Supervision, the National Credit Union Administration Board, the Securities and Exchange Commission (the "SEC") and the Federal Housing Finance Agency). Comments on the proposed rule will be accepted for 45 days after publication and the proposed rule is intended to become effective six months after publication. Accordingly, it is unlikely that the Proposed Rule will be finalized until late 2011 at the earliest. If adopted, the Proposed Rule will supplement existing rules and guidance previously adopted by the appropriate Federal regulators.
Section 956 of the Act requires that, not later than April 21, 2011, the "appropriate Federal regulators" jointly prescribe regulations or guidelines:
- That prohibit any types of incentive-based payment arrangement, or any feature of any such arrangement, that the regulators determine encourages inappropriate risks by a covered financial institution by providing excessive compensation or that could lead to a material financial loss; and
- That require each covered financial institution to disclose to the appropriate Federal regulator the structures of its incentive-based compensation arrangements in a specified manner.
As previously noted, the "appropriate Federal regulators" for this purpose are the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, the FDIC, the Director of the Office of Thrift Supervision, the National Credit Union Administration Board, the SEC and the Federal Housing Finance Agency.
A covered financial institution is any of the following institutions with assets of $1 billion or more:
- Depository institutions or depository institution holding companies;
- Credit unions;
- Investment advisors;
- Fannie Mae;
- Freddie Mac; and
- Any other financial institution that the appropriate Federal regulators, jointly, by rule, determine should be treated as a covered financial institution.
For a discussion of the other executive compensation provisions of the Act, please see our July 23, 2010 alert.
Excessive compensation & material financial loss prohibitions
The Proposed Rule prohibits the establishment or maintenance by a covered financial institution of any type of incentive-based compensation arrangement, or any feature of any such arrangement, that encourages inappropriate risks by the institution by:
- Providing covered persons (executive officers, employees, directors, or principal shareholders) with excessive compensation; or
- Providing incentive-based compensation to covered persons, either individually or as part of a group of persons subject to the same (or similar) incentive-based compensation arrangements, that could lead to material financial loss to the institution.
An incentive-based compensation arrangement provides excessive compensation if amounts paid are unreasonable or disproportionate to the services performed by the covered person, taking into consideration a number of factors including:
- All cash and non-cash benefits provided to the covered persons;
- 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;
- For postemployment benefits, the projected total cost and benefit to the 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 FDIC determines to be relevant.
Material financial loss
Incentive-based compensation arrangements will be deemed to lead to material financial loss unless they:
- Balance risk and financial rewards (e.g., by using deferral of payments, risk adjustment of awards, reduced sensitivity to short-term performance, or extended performance periods);
- Are compatible with effective controls and risk management; and
- Are supported by strong corporate governance, including active and effective oversight by the institution's Board.
As noted above, these standards are intended to be consistent with the key principles established for incentive compensation in the Interagency Guidance on Sound Incentive Compensation Policies. For a discussion of the Interagency Guidance on Sound Incentive Compensation Policies, please see our June 23, 2010 alert.
Additional restrictions on larger covered financial institutions
As defined above, larger covered financial institutions include all covered financial institutions with $50 billion or more in consolidated assets. In addition, all credit unions and Federal Home Loan Banks with total consolidated assets of $1 billion or more are included.
Executive officers: To balance risk and financial rewards, incentive-based compensation arrangements for executive officers of larger covered financial institutions must provide that at least fifty percent of the annual incentive-based compensation of the executive officer will be deferred over a period of no less than 3 years. The release of these deferred amounts may not occur faster than on a pro rata basis and the amount deferred must be adjusted to reflect actual losses or other measures or aspects of performance that are realized or become better known during the deferral period.
Other identified persons: In addition, the Board must identify those covered persons other than executive officers who individually have the ability to expose the institution to substantial losses (e.g., traders with large position limits, individuals who have the authority to place at risk a substantial part of the institution's capital, etc.) and must approve any incentive-based compensation arrangements for these identified persons. This approval should be documented by the Board.
To approve such an arrangement, the Board must determine that the arrangement, including the method of paying compensation, effectively balances the financial rewards to the employee and the range and time horizon of risks associated with the employee's activities. To come to this balance, arrangements should employ appropriate methods for ensuring risk sensitivity, such as deferral of payments, risk adjustment of awards, reduced sensitivity to short-term performance, or extended performance goals.
The Board must also evaluate the overall effectiveness of the balancing methods used in reducing incentives for inappropriate risk taking. The Board should consider the method's suitability to ensure payments balance the full range of risks presented by that covered person's activities and the methods' ability to make payments sensitive to all the risks arising from the employee's activities, including those that may be difficult to predict, measure or model.
Annual reports to regulators
Under the Proposed Rule, all covered financial institutions will be required to submit a report to the FDIC annually, in a format directed by the FDIC, that describes the structure of the institution's incentive-based compensation arrangements for covered persons. This description must be sufficient to allow an assessment of whether the compensation structure or features of those arrangements provide, or are likely to provide, covered persons with excessive compensation, fees, or benefits or could lead to material financial loss to the institution.
The annual report must include:
- A clear narrative description of the incentive-based compensation arrangements applicable to covered persons and 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 for covered persons;
- Any material changes to the institution's incentive-based compensation arrangements and policies and procedures made since the last annual report; and
- The specific reasons why the institution believes the structure of its incentive-based compensation plan does not encourage inappropriate risks.
For larger covered financial institutions, the annual report must also include a succinct description of incentive-based compensation policies and procedures specific to the institution's executive officers and other covered persons identified by the Board as individually having the ability to expose the institution to substantial losses.
Covered financial institutions will not be required to report the actual compensation of particular covered persons as part of this report. In addition, no disclosure will be required under this provision for incentive-based compensation arrangements that do not apply to covered persons.
Policies and procedures
The Proposed Rule requires that any incentive-based compensation arrangement, or any feature of any such arrangement, be adopted in a manner that complies with policies and procedures, developed and maintained by the institution and approved by its Board, that are reasonably designed to ensure and monitor compliance with the requirements of the Act.
At a minimum, a covered institution's policies and procedures must:
- Be consistent with the prohibitions and reporting requirements of the Proposed Rule;
- Ensure that risk-management, risk-oversight and internal control personnel have an appropriate role in the institution's process for designing incentive-based compensation arrangements and for assessing their effectiveness in restraining inappropriate risk-taking;
- Provide for the monitoring by a group or person independent of the covered person (where practicable) of incentive-based compensation awards and payments, risks taken, and actual risk outcomes to determine whether incentive compensation payments are reduced to reflect adverse risk outcomes or high levels of risk taken;
- Provide for the Board to receive data and analysis from management and other sources sufficient to allow the Board to assess whether the overall design and performance of the institution's incentive-based compensation arrangements are consistent with the Act;
- Ensure that documentation of the institution's process for establishing, implementing, modifying and monitoring incentive-based compensation arrangements is maintained that is sufficient to enable the FDIC to determine the institution's compliance with the Act and the Proposed Rule;
- Where deferral is used in connection with an incentive-based compensation arrangement, provide for deferral in amounts and for periods appropriate to the duties and responsibilities of the covered persons, the risk associated with those duties and responsibilities and the size and complexity of the institution, and provide that the deferral amounts paid are adjusted to reflect actual losses or other measure or aspects of performance that are realized or become better known during the deferral period; and
- Subject any incentive-based compensation arrangement to a corporate governance framework that provides for ongoing oversight by the Board, including the approval by the Board of incentive-based compensation to executive officers.
The scope of the policies and procedures required by the Proposed Rule will be determined by the size, complexity and use of incentive-based compensation by the covered institution.