Seven federal regulators of financial institutions jointly issued proposed rules ("Proposed Rules") on March 30, 2011 which would implement the requirements of section 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank Act"). The Proposed Rules were issued jointly by the Securities and Exchange Commission ("SEC"), the National Credit Union Administration ("NCUA"), the Federal Deposit Insurance Corporation ("FDIC"), the Office of the Comptroller of the Currency ("OCC"), the Board of Governors of the Federal Reserve System ("FRB"), the Office of Thrift Supervision ("OTS"), and the Federal Housing Finance Agency ("FHFA") (the "Agencies"). These rules, if enacted, would prohibit "covered financial institutions" with total consolidated assets of $1 billion or more ("Covered Entities") from providing incentive-based compensation arrangements which encourage inappropriate risk by providing excessive compensation or which could lead to material financial loss of the Covered Entity.

What You Need to Know - and Do - Now

Many Covered Entities are already subject to the Sound Incentive Compensation Policies (‘Sound Compensation Policies") issued jointly by the FRB, the OCC, the OTS and the FDIC on June 21, 2010 and/or reporting requirements of the SEC. However, the Proposed Rules cover a far broader group of financial institutions, including brokers, dealers and investment advisors. Covered Entities will want to:

  • Inventory and review their incentive-based compensation arrangements (if they have not yet done so) in order to determine whether programs would be viewed as encouraging excessive risk-taking
  • Educate their compensation committees and boards on their responsibilities
  • Begin to consider what additional policies and procedures will be required to ensure compliance with the Proposed Rules

In addition, the Proposed Rules would require annual reporting of incentive-based compensation arrangements to the applicable regulatory agency and require a careful review of, and possible changes to, existing corporate governance for incentive-based compensation. More stringent proposed rules apply to "larger covered financial institutions", which are generally those with total consolidated assets of $50 billion or more.

Once finalized, the rules would become effective 6 months after publication in the Federal Register. Final rules could be effective as soon as late 2011 or early 2012. The Proposed Rules could result in profound changes to incentive compensation paid to executive officers, employees, directors, or principal shareholders of Covered Entities. Accordingly, Covered Entities should review the Proposed Rules carefully in order to determine their impact on compensation practices, corporate governance, and regulatory reporting.

Entities Covered

Each of the following would be a Covered Entity if its consolidated assets were $1 billion (with the regulatory agency providing guidance on how consolidated assets is defined) or more:

  • A state chartered bank or its holding company
  • A national bank or its holding company
  • A Federal savings association or a savings and loan holding company
  • A federally insured credit union or credit union eligible to be one
  • A broker or dealer registered under section 15 of the Securities Exchange Act of 1934
  • An investment advisor as defined in section 202(a)(11) of the Investment Advisors Act of 1940
  • The Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), any Federal Home Loan Bank and the Federal Home Loan Bank System’s Office of Finance
  • Any other financial institutions that the appropriate federal regulators jointly by rule determine should be treated as a Covered Entity

A Covered Entity includes the subsidiaries of the Covered Entity.

U.S. Operations of Foreign Banks

As required by the Dodd-Frank Act, the Proposed Rules apply to insured U.S. branches of a foreign bank. In addition, the Proposed Rules expand the coverage from that under Section 956 of the Dodd-Frank Act to include:

  • Uninsured branches and agencies of a foreign bank
  • Other U.S. operations of foreign banking organizations that are treated as bank holding companies under section 8(a) of the International Banking Act of 1978

These offices and operations currently are subject to the Sound Compensation Policies and Section 8 of the Federal Deposit Insurance Act, which prohibits institutions from engaging in unsafe and unsound practices to the same extent as insured depository institutions and bank holding companies.

Relationship to Other Rules

While the Proposed Rules are generally similar as proposed by each Agency, there are slight variations among the Agencies. The SEC, FDIC and NCUA had already announced that they would adopt similar rules prior to the joint issuance of the Proposed Rules.

Covered Entities subject to the Sound Compensation Policies or SEC reporting requirements (other than for smaller reporting companies), or both, will find that these rules are closely related to already-issued rules that apply to them. The preamble to the Proposed Rules notes that they supplement the Sound Compensation Policies, the compensation-related disclosure requirements of the SEC for public companies, the Standards for Safety and Soundness adopted by the federal banking agencies and compensation and specific rules adopted by the FHFA and NCUA.

Since the SEC requires disclosure of risk management compensation policies and practices in a narrative in 2010 proxy statements, public companies will have a rubric for compensation committees to consider and address risk issues in compensation.

Whose Compensation is Affected?

The Proposed Rules affect incentive-based compensation paid to executive officers, employees, directors or principal shareholders ("Covered Persons"). Incentive-based compensation is defined as any variable compensation that serves as an incentive for performance, with compensation being broadly defined. Salary and stock owned outright by the Covered Person should not be included as incentive-based compensation.

Comment: Gathering information on who is covered by incentive-based compensation arrangements can be complicated and time-consuming. Human resource, legal and compliance departments may all need to be involved, as well as outside advisors.

Excessive Compensation

The Proposed Rules provide that a Covered Entity may not establish or maintain any incentive-based compensation arrangement that encourages inappropriate risks by the Covered Entity by providing a Covered Person with excessive compensation. Incentive based compensation for a Covered Person would be considered excessive when amounts paid are unreasonable or disproportionate to, the amount, nature, quality and scope of services performed by the Covered Person, considering the following:

  • The combined value of all cash and non-cash benefits provided to the Covered Person
  • The history of compensation to the Covered Person and other individuals with similar expertise at the Covered Entity
  • The financial condition of the Covered Entity
  • Comparable compensation practices at similar institutions
  • For post-employment benefits, the projected total cost and benefit to the Covered Entity
  • Any connection between the Covered Person and any fraudulent act or omission, breach of trust or fiduciary duty, or insider abuse
  • Any other factors that the Agencies determine to be relevant

Material Financial Loss

The Proposed Rules provide that a Covered Entity may not establish or maintain any incentive-based compensation that encourages inappropriate risks by the Covered Entity by providing incentive-based compensation to Covered Persons, either individually or as part of a group covered by the same arrangement, that could lead to material financial loss to the Covered Entity. The incentive-based compensation must:

  • Balance risk and financial rewards (the Proposed Rules use as examples of balance the deferral of payments, risk adjustment of awards, reduced sensitivity to short-term performance or longer performance periods)
  • Be compatible with effective controls and risk management
  • Be supported by strong corporate governance, which includes effective and active oversight by the Covered Entity’s board or directors or a committee of the board

The Proposed Rules apply to only those incentive-based compensation arrangements for individual and Covered Persons, or groups of Covered Persons, whose activities may expose the Covered Entity to material financial loss. Such Covered Persons could include:

  • Executive officers and other Covered Persons who are responsible for oversight of firm-wide activities or a material business line
  • Other Covered Persons whose activities may expose the Covered Entity to material financial loss (for example, traders with large position limits compared to the Covered Entity’s risk tolerance)
  • Groups of Covered Persons who have similar incentive-based compensation arrangements and who, in the aggregate, could expose the Covered Entity to material financial loss (for example, loan origination officers of loans that are a material amount of the credit risk of the Covered Entity)

Comment: While the Proposed Rules would be in addition to other existing regulation of compensation by the Agencies, entities subject to regulatory review and examination by the FRB, OCC, OTS and FDIC may find that they already meet some of the requirements since the Agencies note that their intent is to adopt standards (i) for determining whether the incentive-based compensation may encourage inappropriate risk that is consistent with the key principals in the Sound Compensation Policies and (ii) comparable to those under section 39 of the FDIA for purposes of determining whether incentive-based compensation is excessive.

What are the Effects on Corporate Governance?

 Policies and Procedures

In order to promote transparency of the incentive-based compensation practices and to encourage compliance with the Proposed Rules, Covered Entities would be required to create and maintain policies and procedures which are designed to monitor compliance with the Proposed Rules commensurate with the size and complexity of the Covered Entity.

These policies and procedures would be required to:

  • Ensure that appropriate risk management and oversight personnel have a role in designing incentive-based compensation arrangements and assessing the effectiveness of such arrangements
  • Provide for monitoring by an independent body of risks taken and actual outcomes to determine whether incentive-based arrangements should be reduced
  • Provide for the board of directors or an appropriate committee to receive sufficient data and analysis to determine whether the Covered Entity’s incentive-based arrangements are consistent with the Proposed Rules ■Ensure that the Covered Entity’s documentation of its processes for creating, implementing and maintaining incentive-based compensation arrangements are sufficient for the applicable Agency to determine compliance with the Proposed Rules
  • Subject any incentive-based compensation arrangement to a corporate governance framework that provides for ongoing oversight by the board of directors or an appropriate committee

Comment: These rules will require Covered Entities to carefully examine the role of risk officers in reviewing and adopting new incentive-compensation arrangements. Board-level compensation committees may need additional data and analysis by risk and human resource officers as they consider current arrangements and adopt new ones.

Annual Report Required

These rules require an annual report to be provided to the regulatory Agency sufficient for the Agency to determine compliance with these requirements. The information includes:

  • A clear narrative of the component parts of the incentive-based compensation arrangements as well as information on the types of covered persons under each arrangement (but not specific information on the employees covered) and material changes from the last report
  • A description of the procedures and policies governing the arrangements
  • A description of the reasons why the Covered Entity believes that the structure of the arrangements do not provide excessive compensation and do not provide incentive to engage in behavior that could lead to a material financial loss

 Larger Covered Financial Institutions, as discussed below, would also be required to provide a description of any specific policies and procedures for executive officers and any employee who has the ability to expose the institution to possible substantial losses.

The rules note that the annual report would be expected to be commensurate with the complexity and the size of the Covered Entities, so that smaller companies with fewer incentive-based compensation arrangements would be likely to provide less detail.

The Proposed Rules state that the purpose of the annual report is to provide the Agencies with specific information to permit them to effectively identity and address areas of concern, and they will generally keep the information confidential to the extent permitted by law.

Comment: Keeping the information confidential may be particularly important to non-public companies who will not be providing similar information in a proxy statement.

Other Special Rules for Larger Covered Financial Institutions

For these Larger Covered Financial Institutions:

Deferral Required

The entity:

  • Must require that at least 50% of the incentive-based compensation of an executive officer (as previously defined) be deferred over a period of at least 3 years, with release no faster than on a pro rata basis
  • Must adjust the deferred amounts paid to reflect actual losses of the entity or other measures or aspects of performance that are realized or become better known during the deferral period

Special Review and Approval

The board of directors or committee of the board:

  • Must identify the Covered Persons (other than executive officers) who individually have the ability to expose the institution to possible losses substantial in relation to size, capital or overall risk tolerance
  • May not approve incentive-based compensation arrangements for any person so identified unless the board or committee determines that the arrangement and method of paying compensation effectively balances the financial rewards to the Covered Person and the range and time horizon or risks associated with their activities
  • Must evaluate the overall effectiveness of the balancing methods in reducing incentives for inappropriate risk

Effect on Compensation Now

Compensation and human resource professionals at Covered Entities will want to become familiar with these Proposed Rules so they can begin the process of inventorying incentive-based compensation and determining the effect on their current compensation structure, as well as considering them in adopting any new compensation arrangements. They will need to involve risk managers if they are not already involved in the review of incentive-based compensation. They will also need to consider what additional policies and procedures will be required to ensure compliance with the Proposed Rules.