For a second time, federal banking regulators are seeking comment on a jointly proposed rule that would impose restrictions on incentive-based pay arrangements.

What happened

A similar proposal was released in 2011 but never acted upon. Now, the Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency (OCC), and the Federal Reserve Board, joined by the Securities and Exchange Commission (SEC), the Federal Housing Finance Agency (FHFA), and the National Credit Union Administration (NCUA), are moving forward with a rule to implement Section 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act that would apply in varying degrees to covered institutions (including banks, bank holding companies, credit unions, broker-dealers and investment advisers) with total assets of $1 billion or more.

Pursuant to the rule, covered institutions would be broken down into three categories based on assets: those with $250 billion and above in Level 1, those with $50 billion to $250 billion in Level 2, and those with $1 billion to $50 billion in Level 3.

All covered institutions would be prohibited from offering any incentive-based compensation arrangements that would "encourage inappropriate risks" by providing a "covered person" with compensation deemed "excessive" or that "could lead to material financial loss" to the covered institution.

The regulators defined "excessive" as amounts paid that are "unreasonable or disproportionate" to the value of services performed by the covered persons, consistent with the compensation standards in Section 39(c) of the Federal Deposit Insurance Act. Covered entities could satisfy the rule's prohibition on incentive-based compensation arrangements that "encourage inappropriate risks that could lead to material financial loss" by ensuring the arrangement appropriately balances risk and reward, is compatible with effective risk management and controls, and is supported by effective governance.

An incentive-based compensation arrangement would not be considered to appropriately balance risk and reward unless it considers financial and nonfinancial measures of performance, is designed to allow nonfinancial 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 nonfinancial performance.

Boards of directors would be required to oversee and approve incentive-based compensation programs and arrangements, and covered institutions would be required to meet recordkeeping and disclosure requirements to document the structure of the arrangements and to demonstrate compliance with the proposed rule.

Additional requirements would apply to entities that fall within Level 1 and Level 2. This includes deferral, downward adjustment, forfeiture and clawback requirements that would apply to incentive compensation arrangements of senior executive officers and "significant risk-takers" (SRTs).

Senior executive officers would include president, executive chairman, CEO, COO, CFO, chief investment officer, chief legal officer, chief lending officer, chief risk officer, chief compliance officer, chief audit executive, chief credit officer, chief accounting officer and head of any major business line or control function. An individual who is not a senior executive officer would be considered a SRT if either the individual is among the top 5% highest-paid persons for Level 1 institutions or top 2% for Level 2 institutions, or the individual has the ability to commit or expose 0.5% or more of the covered institution's equity capital. In either case, an individual would be a SRT only if at least one-third of his or her compensation is incentive-based.

The deferral provision would require at least 60% of a senior executive officer's qualifying incentive-based compensation and 50% of a SRT's qualifying compensation to be deferred for at least four years for Level 1 institutions, and at least 50% of a senior executive officer's qualifying incentive-based compensation and 40% of a SRT's to be deferred for at least three years for Level 2 institutions. Similar percentages of long-term incentive compensation for such employees would be deferred for at least two years after the end of the performance period for Level 1 institutions and at least one year for Level 2 institutions. Deferred incentive compensation could vest no faster than on a pro rata annual basis and vesting could not accelerate except on death or disability.

Level 1 and Level 2 covered institutions would be required to reduce incentive-based compensation for SRTs and senior executive officers for certain triggering events, such as poor financial performance, inappropriate risk-taking or material risk management or control failure. A "downward adjustment" would reduce compensation not yet awarded for a performance period that already had begun while "forfeiture" would reduce deferred compensation awarded but not yet vested.

The new proposal would require covered institutions in Level 1 and Level 2 to include clawback provisions in incentive compensation arrangements with senior executive officers and SRTs allowing recovery of vested incentive-based compensation if the senior executive officer or SRT 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 compensation. The institution would have seven years to recover the compensation after vesting.

The new proposal also would prohibit covered institutions in Level 1 and Level 2 from allowing hedging against incentive compensation, providing volume-driven incentive compensation, basing incentive compensation solely on peer group performance and exceeding a maximum incentive compensation limit above target.

Comments on the proposal are being accepted through July 22, 2016.

To read the proposed rule, click here.

Why it matters

If adopted—with the earliest effective date likely to be for performance periods beginning in 2019—the proposed rule would have a major impact on the compensation practices of all covered institutions with a higher level of regulation and requirement at the country's largest institutions. "This is perhaps the most important Dodd-Frank rulemaking remaining to be implemented," FDIC Chairman Martin J. Gruenberg said in a statement after the regulators approved the new rule. "Material Loss Reviews of failed institutions issued by the inspectors general for the three federal banking agencies found that, in a number of instances, poor compensation practices were a contributing factor to the institution's failure. When poor compensation practices involve the largest financial institutions, the negative impacts of inappropriate risk-taking can have broader consequences for the financial system."