On April 14, 2011, a proposed rule regarding incentive-based compensation paid by certain financial institutions (the Proposed Rule) was published in the Federal Register. The Proposed Rule was jointly proposed by seven Federal agencies to implement Section 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Section 956). Each of the seven agencies, the Board of Governors of the Federal Reserve System (the Federal Reserve), the Federal Deposit Insurance Corporation (the FDIC), the Federal Housing Finance Agency (the FHFA), the National Credit Union Administration (the NCUA), the Office of the Comptroller of the Currency (the OCC), the Office of Thrift Supervision (the OTS) and the Securities and Exchange Commission (the SEC) (collectively, the Agencies), released its own version of the Proposed Rule, but the differences between the versions are slight and relate only to differences among the regulated entities.1
The stated goal of Section 956 and the Proposed Rule is to ensure that covered financial institutions consider the effect that incentive-based compensation arrangements have on risk-taking by the institution. According to the preamble to the Proposed Rule (the Preamble), the Agencies believe that flawed incentive compensation practices in the financial industry were one of the many factors contributing to the financial crisis that began in 2007. The Agencies stated that they believe supervision and regulation of incentive compensation can play an important role in helping ensure that incentive compensation practices at covered financial institutions do not threaten their safety and soundness.
The Proposed Rule has three main components that apply to all covered financial institutions:
- Incentive-based compensation arrangements that encourage inappropriate risks by the covered financial institution by providing a covered person with "excessive" compensation are prohibited.
- Incentive-based compensation arrangements that encourage inappropriate risks that could lead to material financial loss to the covered financial institution are prohibited.
- Policies and Procedures: Covered financial institutions are required to maintain policies and procedures appropriate to their size, complexity and use of incentive-based compensation to ensure compliance with the rule.
- Annual Reports: Covered financial institutions are required to provide annual reports on their incentive-based compensation arrangements to the applicable Agency.
In addition, certain larger covered financial institutions are subject to additional requirements, including mandatory deferral of at least 50 percent of the incentive-based compensation paid to executive officers and approval by the board of directors (or a committee of the board) of incentive-based compensation arrangements for individuals identified by the board (or a committee of the board) as having the ability to expose the institution to a material financial loss.
Section 956 and the Proposed Rule significantly expand the regulatory grasp of the Agencies. The Proposed Rule represents the first time the Agencies have established specific prescriptions on pay other than for institutions receiving financial assistance from the government. It is also the first time that investment advisers and broker-dealers will be subject to Federal compensation standards. Because many provisions of the Proposed Rule are unprecedented, it is not clear how the Proposed Rule will be enforced and, in particular, whether or not each of the seven Agencies will interpret, administer and enforce the new rules in a uniform manner.
Covered Financial Institution. The Proposed Rule will apply to a "covered financial institution," which is defined separately in each Agency’s version of the Proposed Rule to include only financial institutions regulated by such Agency. The Proposed Rule covers the following types of institutions that have $1 billion or more in assets:
- In the case of the Federal Reserve, a state member bank, a bank holding company, a state-licensed uninsured branch or agency of a foreign bank, and the US operations of a foreign bank with more than $1 billion of US assets that is treated as a bank holding company pursuant to Section 8(a) of the International Banking Act of 1978.
- In the case of the FDIC, a state nonmember bank and an insured US branch of a foreign bank.
- In the case of the FHFA, Fannie Mae, Freddie Mac, the Federal Home Loan Banks and the Office of Finance.
- In the case of the NCUA, a credit union, as described in section 19(b)(1)(A)(iv) of the Federal Reserve Act.
- In the case of the OCC, a national bank or a Federal branch or agency of a foreign bank.
- In the case of the OTS, a savings association as defined 12 U.S.C. 1813(b) and a savings and loan holding company as defined in 12 U.S.C. 1467a(a).
- In the case of the SEC, a broker-dealer registered under Section 15 of the Securities Exchange Act of 1934 (the Exchange Act) and an investment adviser, as defined in Section 202(a)(11) of the Investment Advisers Act of 1940 (including both registered and unregistered advisers).
This definition of "covered financial institution" is broader than those specifically identified in Section 956. The Proposed Rule contains specific guidelines for determining how to calculate assets for these purposes, generally based on a rolling four-quarter average of assets as reported in the financial institution’s four most recent reports (with the exception of the SEC’s and the FHFA’s versions). Under the SEC’s version, the thresholds for broker-dealers are based on the total consolidated assets reported on the most recent year-end balance sheet filed by the regulated entity pursuant to Rule 17a-5 under the Exchange Act. For investment advisers, the thresholds are based on the total consolidated assets reported on the most recent year-end balance sheet, reflecting those assets that would be required to be reported on Form ADV Part 1A, as proposed to be amended. It appears that the definition of covered financial institution may be applied separately to each entity within a financial institution’s affiliated group, so different legal entities within a single large financial institution could be separately subject to the Proposed Rule (so long as the entity’s assets exceed the $1 billion threshold).
Larger Covered Financial Institutions. Enhanced requirements are imposed upon "larger covered financial institutions," which are defined as: (i) in the case of the Federal banking agencies and the SEC, those covered financial institutions with total consolidated assets of $50 billion or more, (ii) in the case of the NCUA, all credit unions with total consolidated assets of $10 billion or more and (iii) in the case of the FHFA, Fannie Mae, Freddie Mac and all Federal Home Loan Banks with total consolidated assets of $1 billion or more (generally, all the entities FHFA regulates).
Incentive-Based Compensation. The Proposed Rule defines "incentive-based compensation" as any variable compensation that serves as an incentive for performance. The form of payment, whether cash, equity or other property, does not affect whether compensation meets this definition. The Preamble provides that compensation that is provided solely for continued employment, such as salary, would not be considered incentive-based compensation. The Preamble notes that the proposed definition does not include dividends paid or appreciation realized on equity instruments that are owned outright by a covered person. However, such equity instruments would not be considered owned outright while subject to any vesting or deferral arrangement.
Covered Persons. "Covered persons" consist generally of executive officers, directors,2 principal shareholders (generally, individuals who control 10 percent or more of any class of voting securities of the institution)3 and employees. An "executive officer" is defined generally as a person who holds the title or, without regard to title, salary or compensation, performs the function of one or more of the following positions: president, chief executive officer, executive chairman, chief operating officer, chief financial officer, chief investment officer, chief legal officer, chief lending officer, chief risk officer or head of a major business line.4 It should be noted that the entire Proposed Rule does not apply to all covered persons. As described below, certain parts of the Proposed Rule apply to only specified covered persons.
Components of the Proposed Rule That Apply to All Covered Financial Institutions
Prohibition on Excessive Compensation
The Proposed Rule prohibits covered financial institutions from maintaining any incentive-based compensation arrangement that encourages inappropriate risks by the covered financial institution by providing a covered person with "excessive" compensation. Compensation is considered excessive when it is unreasonable or disproportionate to the amount, nature, quality and scope of services performed by the covered person.
The factors the Agencies will consider in deciding whether an incentive-based compensation arrangement provides excessive compensation are:
- The combined value of all cash and non-cash benefits provided to the covered person.
- 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 financial institutions (based on asset size, geographic location and the complexity of the covered financial institution’s operations and assets).
- The total cost and benefit to the financial institution of any post-employment benefits.
- 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 financial institution.
- Any other factors the Agencies determine to be relevant.5
Prohibition on Incentive-Based Compensation Policies That Could Expose the Institution to a Material Financial Loss
The Proposed Rule prohibits covered financial institutions from maintaining incentive-based compensation arrangements that encourage inappropriate risks by providing incentive-based compensation to covered persons that could lead to material financial loss to the covered financial institution. This prohibition would apply only to those covered persons whose activities, either individually or collectively, could expose the institution to a material financial loss. The Preamble cites as examples, executive officers and other covered persons who are responsible for oversight of the institution’s firm-wide activities or material business lines and traders with large position limits. Others potentially covered are groups of covered persons who are subject to similar compensation arrangements and who, in the aggregate, could expose the institution to material financial loss, even if no individual covered person could expose the covered financial institution to material financial loss (e.g., loan officers who, as a group, originate loans that account for a material amount of the covered financial institution’s credit risk).
In order to comply with this part of the Proposed Rule, a covered financial institution’s incentive-based compensation arrangements must: (i) balance risks (including credit, market, liquidity, operational, legal, compliance and reputational risks) and financial rewards, (ii) be compatible with effective controls and risk management and (iii) be supported by strong corporate governance, including active and effective oversight by the covered financial institution’s board of directors or a committee of the board.6
The Proposed Rule provides examples of methods that can be used to balance risks and financial rewards, and the Preamble expands upon these examples. Under one method, the amount of the covered person’s incentive-based compensation award could be adjusted based on quantitative or qualitative measures that take into account the risk that the covered person’s activities pose to the covered financial institution.
Under a second method, the actual payout of an award to a covered person could be delayed significantly beyond the end of the performance period, and the amounts paid could be adjusted for actual losses to the covered financial institution or other aspects of performance that become clear only during the deferral period. The Preamble notes that, to be most effective in ensuring balance, the deferral period should be sufficiently long to allow for the realization of a substantial portion of the risks from the covered person’s activities, and the measures of loss should be clearly explained to the covered person and closely tied to his or her activities during the relevant performance period.
The Proposed Rule also notes that risks and rewards could be balanced by lengthening the time period covered by the performance measures used in determining a covered person’s award and/or by reducing the rate at which awards increase as a covered person achieves higher levels of the relevant performance measures.
Policies and Procedures
Pursuant to the Proposed Rule, any incentive-based compensation arrangement is prohibited unless it is adopted pursuant to policies and procedures reasonably designed to ensure and monitor compliance with the requirements of the rules. These policies and procedures must be commensurate with the size and complexity of the covered financial institution, as well as the scope and nature of its use of incentive-based compensation. The policies and procedures must ensure that (i) risk-management, risk-oversight and internal control personnel, (ii) independent monitors (who have a separate reporting line to senior management than the covered person) and (iii) the institution’s board of directors or a committee of the board all play a significant ongoing role in reviewing the incentive-based compensation arrangements and analyzing their effect on risk-taking by the institution. The board of directors or a committee of the board must approve any arrangements for executive officers. In addition, the processes for establishing, implementing, modifying and monitoring incentive-based compensation arrangements must be sufficiently documented to enable the applicable Agency to determine the institution’s compliance with Section 956 and the Proposed Rule.
The Agencies are considering whether a covered financial institution’s policies and procedures should also be required to specifically include limits on personal hedging strategies. The Proposed Rule does not address personal hedging strategies, but the Preamble notes that the Agencies are concerned that allowing covered persons whose equity compensation is subject to deferral to undertake personal hedging strategies during deferral periods could diminish the alignment between risk and financial rewards that may be achieved through the deferral arrangements.
Annual Reporting Requirement
Under the Proposed Rule, a covered financial institution must submit an annual report on its incentive-based compensation arrangements for covered persons to the applicable Agency within 90 days of the end of each fiscal year. The report must include a clear narrative description of the components of any incentive-based compensation arrangements applicable to covered persons and specify the types of covered persons to which they apply. The report must also include a succinct description of the financial institution’s policies and procedures governing its incentive-based compensation arrangements, including any material changes to the institution’s incentive-based compensation arrangements and policies and procedures since the last annual report. It must also state specific reasons why the institution believes its incentive-based compensation arrangements do not encourage inappropriate risks by providing covered persons with excessive compensation or incentive-based compensation that could lead to material financial loss to the institution. Larger covered financial institutions must also describe their policies that are designed to comply with the special rules for such institutions, as explained below.
Each Agency will specify the format of its required annual reports. The Preamble emphasizes that the reports should be streamlined and specifically directed to help the Agencies effectively identify and address any areas of concern, with the level of volume and detail commensurate with the size and complexity of the institution and the scope and nature of the incentive-based compensation arrangements. A covered financial institution is not required to report the actual amount of compensation paid to particular covered persons.
The Preamble states that the annual reports will generally be afforded confidential treatment to the full extent allowed by law, and refers to certain exemptions under the Freedom of Information Act (FOIA) under which the Agencies may have the authority to withhold information: FOIA Exemption 4 for "trade secrets and commercial or financial information obtained from a person and privileged or confidential" and FOIA Exemption 8 for matters that are "contained in or related to examination, operating or condition reports prepared by, on behalf of, or for the use of an agency responsible for the regulation or supervision of financial institutions." In addition, the Agencies have asked for comments on any ways to minimize concerns of covered institutions regarding confidentiality.
The Agencies’ intent to treat the annual reports as confidential does not, however, guarantee that the annual reports will remain confidential. Even allowing for a presumption of confidential treatment from the Agencies, private parties can challenge the denial of access to the records. If a private party makes such a challenge with respect to a covered financial institution’s annual report, the applicable Agency, by Executive Order, will give the covered financial institution notice of the request for its annual report to be made public, and the financial institution can then initiate a court proceeding to prevent public disclosure. Whether either of the two exemptions mentioned in the Preamble is determined to apply would turn on the relevant facts and circumstances. As many companies have learned in the context of preparing the "compensation discussion and analysis" sections of their annual proxy statements, the standards of FOIA Exemption 4, which are required to be met if a company claims that it cannot disclose in its proxy statement the performance targets applicable to the compensation of its "named executive officers" for confidentiality-related reasons, may be very difficult to meet. FOIA Exemption 8 has been broadly construed, but it has generally been interpreted to cover only documents that relate to the financial security of banks. In a proceeding relating to either FOIA exemption, the fact that the reports are mandatory, not voluntary, filings would be a factor in favor of public disclosure. In addition, the annual reports may be discoverable in private litigation to the extent that the underlying facts related to the incentive-based compensation are considered relevant to the particular issue being litigated. If the facts are considered relevant, the annual reports may be viewed by plaintiffs as responsive, relevant summary documents. During the discovery phase, parties routinely protect confidential business information from becoming public, or if very sensitive, from even being viewed by anyone other than counsel to the parties, or the court in camera. However, if a matter proceeds to trial, it generally becomes more difficult to prevent evidence from becoming public. Thus, covered financial institutions should understand that the annual reports may be maintained in confidence by the Agency as an initial matter, but could become public should legal proceedings calling for the document ensue.
Enhanced Requirements for Larger Covered Financial Institutions
In addition to the requirements stated above, larger covered financial institutions must comply with additional obligations under the Proposed Rule. These requirements must be met in order for the incentive-based compensation arrangements of these institutions to be considered to balance risk and financial rewards appropriately.
Mandatory Deferral of Executive Officers’ Compensation
The Proposed Rule requires that at least 50 percent of the annual incentive-based compensation of executive officers be deferred over a period of no less than three years, with the release of the deferred amount to occur no faster than on a pro-rata basis. For example, an institution required to apply a three-year deferral to a $150,000 deferral amount could release $50,000 each year or could withhold the entire sum for the entire period and distribute it as a lump-sum at the conclusion of the three-year period. The institution could also release no amount after the first year, $100,000 after the second year, and $50,000 after the third year. However, the institution could not release $100,000 after the first year and $50,000 after the third year (or otherwise provide for the deferral to be released at a faster than pro-rata basis over three years).
In addition, the deferred amount must be adjusted in order to "reflect actual losses or other measures or aspects of performance that are realized or become better known during the deferral period." The Proposed Rule does not contain any specific requirements for how such clawback should be implemented, but presumably clawback provisions will be drafted into applicable plans and award agreements. For many covered companies, this clawback of vested payments may be the most significant deviation from current practice. Many larger financial institutions already provide a significant amount of senior executive compensation through the use of performance shares, restricted stock, stock options and other equity awards that vest over a period of years. One consequence of the Proposed Rule may be that larger financial institutions that provide for longer vesting periods will face pressure from executives to move to three year pro-rata vesting.
Additional Requirements for Other Covered Persons
The board of directors of a larger covered financial institution, or a committee of the board, must identify covered persons (other than executive officers) who individually have the ability to expose the financial institution to possible losses that are substantial in relation to the institution’s size, capital or overall risk tolerance. The Proposed Rule cites as an example of these types of individuals traders with large position limits. For any such individuals, the board of directors or a committee of the board must approve any incentive-based compensation arrangement and must document such approval. The Proposed Rule provides that the board of directors or the applicable committee may not approve an incentive-based compensation arrangement for any such covered person unless it determines that the arrangement effectively balances the financial rewards to the covered person and the range and time horizon of risks associated with the covered person’s activities, including risks that may be difficult to predict, measure or model.
Timing of the Rules
A 45-day comment period on the Proposed Rule began on the date the Proposed Rule was published in the Federal Register. This 45-day period will end on May 31, 2011. Following such comment period, the final rule will be adopted. The requirements of the final rule will become effective six months after it is adopted and published in the Federal Register. It is not clear from the Proposed Rule whether the final rule will apply only to incentive-based compensation granted after the effective date. It is likely that transitional guidance will be released on this point.
Further Actions in Light of the Proposed Rule
In light of the Proposed Rule, financial institutions should first determine whether they are covered under the Proposed Rule (including whether more than one member of the institution’s affiliated group is covered), and if so, identify which compensation arrangements will be subject to the Proposed Rule. Covered institutions should then determine whether any of their incentive-based compensation arrangements either provide "excessive compensation" or could expose the institution to a material financial loss.
All covered financial institutions should establish written policies and procedures to maintain and ensure compliance with the Proposed Rule. Larger covered financial institutions should consider whether changes to their equity and other incentive-based compensation plans and arrangements will be necessary in order to comply with the required deferral and clawback policies for executive officers and should determine which individuals will be subject to the additional board oversight. Although the Agencies have not yet specified the format of their required annual reports, covered financial institutions may also wish to begin to consider implementing appropriate procedures to prepare the required reports.
Finally, covered institutions should review the responsibilities of their compensation committees and of their risk-management, risk-oversight and internal control personnel to ensure that the design, approval, monitoring and review of incentive-based compensation arrangements will comply with all Section 956 requirements. It may be appropriate to amend the compensation committee charter to ensure that the committee has the requisite authority to satisfy its obligations under Section 956. To ensure complete compliance under the rule, consultation with counsel is advised.