At its April 26, 2016, meeting, the board of directors for the Federal Deposit Insurance Corporation approved a notice of proposed rulemaking (NPR) that would implement section 956 of the Dodd-Frank Act that the FDIC, along with the Office of the Comptroller of the Currency and the Federal Reserve Board, to prohibit certain types of incentive-based payment arrangements.
The proposed rule, which replaces a never acted upon 2011 proposal, will be jointly published by the three banking agencies, as well as the Securities and Exchange Commission, Federal Housing Finance Agency, and National Credit Union Administration. The NCUA had already approved the proposed rule at its April 21, 2016, meeting.
Comments on the proposed rule are due by July 22, 2016.
“Covered institutions.” The proposed rule would apply to all covered institutions, which include insured depository institutions, holding companies, as well as other institutions added by the agencies acting jointly by rule, with total assets of $1 billion or more. These covered institutions would also be divided into three categories based on assets: $250 billion and above (Level 1); $50 billion to $250 billion (Level 2); and $1 billion to $50 billion (Level 3).
The OCC, Fed, and FDIC estimated that approximately 1,411 banking organizations supervised by the agencies would be subject to the proposed rule’s requirements.
Under the proposed rule, 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 that is “excessive” or “could lead to material financial loss” to the covered institution.
Excessive compensation. Compensation would be considered “excessive” when amounts paid are “unreasonable or disproportionate” to the services performed by the “covered person.” Factors for determining whether amounts paid are unreasonable or disproportionate are set forth in the NPR and would be consistent with the compensation standards in section 39(c) of the Federal Deposit Insurance Act.
Encouraging inappropriate risks. The proposed rule also provides that a covered institution’s incentive-based compensation arrangement would not “encourage inappropriate risks that could lead to material financial loss” if the arrangement appropriately balances risk and reward; is compatible with effective risk management and controls; and is supported by effective governance.
Balanced risks and rewards. An incentive-based compensation arrangement would “appropriately balance risk and reward” only if 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.
Other provisions that would be applicable to covered institutions include active board of director’s involvement in the oversight and approval of their institution’s incentive-based compensation programs and arrangements. Similarly, all covered institutions would have to create a recordkeeping and disclosure system that document the structure of incentive-based compensation arrangements and that demonstrate compliance with the proposed rule’s requirements.
Level 1 and 2 requirements. Covered institutions that fall within the Level 1 or Level 2 asset range would also be subject to additional requirements under the proposed rule.
These additional requirements would affect the senior executive officers and significant risk takers of these covered institutions. These enhanced requirements for Level 1 and Level 2 covered institutions would also establish the deferral requirements that would be applied to the senior executive officers and “significant risk takers” incentive-based compensation arrangements, including the risk of downward adjustment and forfeiture.
Significant risk takers. The proposed rule provides a threshold to determine whether an executive officer is a significant risk taker (SRT) based on the level of compensation and the ability of the executive officer to could commit or expose 0.5 percent or more of the covered institution’s equity capital. In addition, the banking agencies could designate a person as an SRT if has the ability to expose the covered institution to risks that could lead to material financial loss in relation to the covered institution’s size, capital, or overall risk tolerance, subject to notice of the proposed action and opportunity for response.
Deferral. Under the deferral provisions of the proposed rule, a Level 1 covered institution would have to defer at least 60 percent of a senior executive officer’s qualifying incentive-based compensation and 50 percent of a SRT’s qualifying incentive-based compensation for at least four years. The term “qualifying incentive-based compensation” is defined as all incentive-based compensation awarded in a performance period other than compensation awarded under a long-term incentive plan. 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 SRT’s qualifying incentive-based compensation for at least three years.
The proposed rule also provides for deferral requirements senior executive officers that are not deemed to be SRTs. The percentage of qualifying incentive-based compensation and the length of time are shortened for these senior executive officers.
Forfeiture, downward adjustment, and clawback. The forfeiture, downward adjustment, and clawback provisions of the proposed rule would require a covered institution to reduce incentive-based compensation for senior executive officers and significant risk-takers in the event of certain adverse outcomes resulting from, among other things, inappropriate risk taking or material risk management or control failure.
A “downward adjustment” of a senior executive officers or SRT’s incentive-based compensation would be reduction of the amount of the incentive-based compensation not yet awarded for any performance period that has already begun. “Forfeiture” would be a reduction in the amount of deferred incentive-based compensation awarded to a person that has not vested.
Under the clawback provisions of the proposed rule, a covered institution would be able to recover vested incentive-based compensation if certain events occur. At a minimum, a covered institution would be able to recover incentive-based compensation for seven years following vesting, if it is determined that 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 senior executive officer or significant risk-taker’s incentive-based compensation.
It should be noted that the 2011 proposal did not have a clawback provision.
Contributing factor. In a statement following approval of the proposed rule, FDIC Chairman Martin J. Gruenberg indicated, “This is perhaps the most important Dodd-Frank rulemaking remaining to be implemented.” He added, “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.”
Complicated rules. During the meeting, FDIC Vice Chairmen Thomas M. Hoenig noted, “I will acknowledge this is one of the more complicated rules and that is saying something among all the rules we have had.”
Powerful motivator. Richard Cordray, the Director of the Consumer Financial Protection Bureau, added, during the meeting, that “incentive compensation at all levels is a power—powerful motivator for behavior.” He continued, “You don’t want to micromanage businesses but it seems that this [proposed rule] could have good effects.”
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