Many continue to blame Wall Street incentive pay structures for fueling the 2007 financial crisis through such creations as sub-prime mortgages, Alt-A mortgages, CDOs, Credit Default Swaps and the like. After the collapse of iconic institutions such as Bear Stearns, Lehman Brothers, et al., Congress responded in part by enacting the Dodd-Frank Act in 2010. Section 956 of the Act required that various government federal regulators (the “Regulators”
) jointly issue rules prohibiting excessive compensation that could lead to material loss for certain regulated financial institutions, and requiring those same institutions to disclose information sufficient to allow their federal regulator to determine whether their incentive compensation structures “encourage inappropriate risks” by providing excessive compensation or creating a risk of material loss to the financial institution.
Oddly, the Act does not require reports about the actual compensation, fees, or benefits paid.
In 2011, the Regulators issued a proposed rule (the “2011 Proposed Regulations”) that languished for five years. Now, in the waning months of the Obama administration, the National Credit Union Administration has released a revised proposal (the “2016 Proposed Regulations”), with the other Regulators being expected to soon propose the same regulations. Meanwhile, comments on the 200+ page 2016 Proposed Regulations are due by July 22, 2016.
Dodd-Frank gave the Regulators sweeping power to reduce perceived systemic risk, including the mandate of Section 956 to prohibit certain enumerated individuals from receiving excessive “compensation, fees, or benefits” that could lead to material financial loss to covered institutions. Covered financial institutions include those that have at least $1 billion in assets and are (i) a depository institution or its holding company, (ii) a registered broker-dealer under Section 15 of the 1934 Act, (iii) a credit union, (iv) an investment adviser under section 202(a)(11) of the Investment Advisers Act of 1940, (v) Fannie Mae, (vi) Freddie Mac and, amazingly, (vii) any other financial institutions that the appropriate regulators by rule determine should be treated as a covered financial institution.
The preambles to the 2016 Proposed Regulations recognize that incentive-based compensation arrangements can be good for covered financial institutions, by, for example, allowing them to attract and retain employees and encouraging better performance. But the preambles also engage in a certain amount of hyperbole, by asserting that poorly-structured incentive-based compensation arrangements can lead to inappropriate risk-taking that endangers the entire U.S. economy if those incentives undermine the long-term health of the covered financial institution (echoing the oft-chanted phrase of the late 2000s, “too big to fail”). Examples of such “inappropriate” risks include mortgage officers and others who sold long-term financial obligations, such as mortgages, that were subject to default over decades, but received bonuses in real time, based on the present sales.
Interestingly, the preambles to the 2016 Proposed Regulations note that only 18 of the 518 banks that failed between 2007 and 2015 would have raised issues or concerns related to their compensation arrangements, in some cases for incentive-based compensation and in others for poor governance (such as dominant management). In other words, the preambles fail to articulate demonstrable proof that the proposed regulations would have had a material impact on all but perhaps a small percentage of the identified bank failures.
The preambles recognize that post-crisis, the largest banking institutions have refined their incentive-based compensation arrangements to reflect risk adjustments, to penalize adverse outcomes, to require more pay to be deferred, and to subject a larger percentage of deferred pay to reduction based on failure to meet performance targets or on account of adverse outcomes triggering forfeiture and clawback reviews. Despite these recognized improvements, the Regulators assert more oversight is necessary. Perhaps a harbinger of things to come, the preambles suggest that even under the 2016 Proposed Regulations, “some flexibility in the design and operation of incentive-based compensation arrangements” will be possible.
The 2011 Proposed Regulations generated over 10,000 comments, which resulted in various changes to the 2016 Proposed Regulations. Because the 2011 Proposed Regulations are akin to dinosaurs in today’s rapidly-changing marketplace, we see no benefit in comparing the 2011 Proposed Regulations to the 2016 Proposed Regulations.
In the lengthy time between the 2011 Proposed Regulations and the 2016 Proposed Regulations, the preambles recognize that non-U.S. banking regulators have acted on incentive-based compensation, including the EU, which adopted the Capital Requirements Directive IV, which requires up to 100% of variable compensation be subject to “malus” or clawback, and the PRA and the FCE require covered entities to defer 40-60% of a covered person’s variable compensation, recently updated to extend deferral periods to 7 years for senior executives and 5 years for certain others. The Regulators have eschewed principles of nationalism, indicating that they will “work with their domestic and international counterparts to foster sound compensation practices across the financial services industry.”
The 2016 Proposed Regulations impose different and increasingly onerous standards on financial institutions, depending on their size: Level 3 institutions are those with at least $1 billion but less than $50 billion in assets; Level 2 institutions are those with at least $50 billion but less than $250 billion in assets; and Level 1 institutions are those with at least $250 billion in assets.
The 2016 Proposed Regulations will not be effective until at least 2018, as they are slated to take effect in the first calendar quarter that begins at least 540 days after publication of the final rule in the Federal Register. Any incentive-based compensation plan having a performance period that begins before the effective date will be grandfathered. In other words, covered financial institutions have a long time to implement new compensatory schemes that will remain unaffected by the final rule. And, all of this assumes that a final rule can be published in the current volatile political climate, complicated by a presidential election year. Further, the tougher standards will not apply to a financial institution that matures into a higher level institution until the first day of the first calendar quarter that begins at least 540 days after the date on which the financial institution becomes a higher-level institution and grandfathers any incentive-based compensation plan with a performance period that begins before the coverage date. Although not likely to lead to intentional manipulation, those entities that become lower-level institutions will be subject to the more stringent standards until they remain at the lower level for four consecutive regulatory reports.
Prohibitions Applicable to All Covered Financial Institutions
Covered financial institutions would be prohibited from having incentive-based compensation arrangements that either provide excessive compensation to covered persons or that encourage them to take inappropriate risk, if doing so could lead to a material financial loss.
Under the 2016 Proposed Regulations, compensation, fees, and benefits are excessive when amounts paid are unreasonable or disproportionate to the value of the services performed by a covered person, taking into consideration all relevant factors, including:
- The combined value of all compensation, fees, or benefits provided to a covered person;
- The compensation history of the covered person and other individuals with comparable expertise at the covered financial institution;
- The financial condition of the covered financial institution;
- Compensation practices at comparable institutions, based upon such factors as asset size, geographic location, and the complexity of the covered financial institution’s operations and assets;
- For post-employment benefits, the projected total cost and benefit to the covered financial institution; and
- 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 covered financial institution.
An incentive-based compensation arrangement would be considered to encourage inappropriate risks that could lead to material financial loss to the covered financial institution, unless the arrangement:
- Appropriately balances risk and reward;
- Is compatible with effective risk management and controls; and
- Is supported by effective governance.
Incentive-based compensation arrangements would not be considered to appropriately balance risk and reward unless they:
- Include financial and non-financial measures of performance;
- Are designed to allow non-financial measures of performance to override financial measures of performance, when appropriate; and
- Are subject to adjustment to reflect actual losses, inappropriate risks taken, compliance deficiencies, or other measures or aspects of financial and non-financial performance.
Board of Director Requirements Applicable to All Covered Financial Institutions
The board of directors of each covered financial institution (or a committee thereof) would be required to:
- Conduct oversight of the covered financial institution’s incentive-based compensation program;
- Approve incentive-based compensation arrangements for senior executive officers, including amounts of awards and, at the time of vesting, payouts under such arrangements; and
- Approve material exceptions or adjustments to incentive-based compensation policies or arrangements for senior executive officers.
These mandates reflect current banking principles that hold boards accountable for overseeing safe and sound compensation structures. Boards should nevertheless expect greater scrutiny for their decisions, and it consequently makes sense to shape future compensation structures in a manner that reflects the standards promulgated by the Regulators.
The 7-Year Itch (Recordkeeping and Disclosure Requirements)
Covered financial institutions would be required to create annually, and to maintain for at least seven years, records that document the structure of their incentive-based compensation arrangements and that demonstrate compliance with the 2016 Proposed Regulations. The records would have to be disclosed to the covered financial institution’s appropriate federal regulator upon request.
Level 1 and Level 2 Financial Institutions
Level 1 and Level 2 financial institutions would be subject to the most stringent requirements, being required to create annually and maintain for at least seven years records that document:
- The covered financial institution’s senior executive officers and significant risk-takers, listed by legal entity, job function, organizational hierarchy, and line of business;
- The incentive-based compensation arrangements for senior executive officers and significant risk-takers, including information on the percentage of incentive-based compensation deferred and forms of award;
- Any forfeiture and downward adjustment or clawback reviews and decisions for senior executive officers and significant risk-takers; and
- Any material changes to the covered financial institution’s incentive-based compensation arrangements and policies.
Such records would need to be created and maintained in a manner that would allow for an independent audit of incentive-based compensation arrangements, policies, and procedures, and the institutions would be required to provide the records described above in such form and frequency as the appropriate federal regulator requests.
Level 3 Financial Institutions
Level 3 covered institutions would generally be subject to only the basic set of prohibitions and disclosure requirements described above, and are even relieved from being required to develop and follow policies and procedures related to incentive-based compensation. However, if a Level 3 institution has over $10 billion of assets, its Federal Regulator could determine that the institution’s activities, complexity of operations, risk profile, or compensation practices require treatment consistent with those of a Level 1 or Level 2 covered institution.
Deferral, Forfeiture, Cutback, and Clawback Requirements
Incentive-based compensation arrangements for certain covered persons would be required to include deferral of payments, forfeiture, cutback, and clawback risk to appropriately balance risk and reward.
The mandatory deferral requirements for incentive-based compensation awarded during a performance period at Level 1 and Level 2 covered financial institutions would be as follows:
Level 1 Financial Institutions
A Level 1 covered financial institution would be required to defer at least 60% of a senior executive officer’s “qualifying incentive-based compensation” and 50% of a significant risk-taker’s qualifying incentive-based compensation for at least four years. In addition, for senior executive officers, at least 60% (50% for significant risk takers) of incentive-based compensation under a “long-term incentive plan” would need to be deferred for at least two years after the end of the related performance period. This deferred compensation could vest no faster than on a pro rata annual basis, and, for covered financial institutions that issue equity or are subsidiaries of covered financial institutions that issue equity, the deferred amount would be required to consist of substantial amounts of both deferred cash and equity-like instruments throughout the deferral period. Additionally, if a senior executive officer or significant risk-taker receives incentive-based compensation in the form of options for a performance period, the amount of such options used to meet the minimum required deferred compensation could not exceed 15% of the amount of total incentive-based compensation awarded for that performance period. Payment acceleration would be prohibited, except for death or disability.
Level 2 Financial Institutions
A Level 2 covered financial institution would be required to defer at least 50% of a senior executive officer’s qualifying incentive-based compensation (40% of a significant risk-taker) for at least three years. In addition, for senior executive officers, at least 50% (40% for a significant risk taker) of incentive-based compensation under a long-term incentive plan would need to be deferred for at least one year after the end of the related performance period. Additionally, if a senior executive officer or significant risk-taker receives incentive-based compensation in the form of options for a performance period, the amount of such options used to meet the minimum required deferred compensation could not exceed 15% of the amount of total incentive-based compensation awarded for that performance period. Payment acceleration would be prohibited, except for death or disability.
Forfeiture and Cutback
Level 1 and Level 2 covered financial institutions would be required, in certain circumstances, to reduce (a) incentive-based compensation that has not yet been awarded to a senior executive officer or significant risk-taker and (b) deferred incentive-based compensation of a senior executive officer or significant risk-taker. A “forfeiture” is a reduction in unvested deferred incentive-based compensation. “Cutback” (or as the 2016 Proposed Regulations call it, “downward adjustment”) is a reduction in yet-to-be-awarded incentive-based compensation for any performance period already in effect.
Level 1 and Level 2 covered financial institutions would be required to subject to forfeiture all unvested, deferred incentive-based compensation of any senior executive officer or significant risk-taker, including unvested deferred amounts awarded under long-term incentive plans. This forfeiture requirement would apply to all unvested, deferred incentive-based compensation for those individuals, even if the deferral was not required by the 2016 Proposed Regulations. These financial institutions also would be required to make subject to cutback all incentive-based compensation amounts not yet awarded to any senior executive officer or significant risk-taker for the current performance period, including amounts payable under long-term incentive plans.
Level 1 and Level 2 covered financial institutions would be required to consider forfeiture or downward adjustment of incentive-based compensation under the following circumstances:
- Poor financial performance attributable to a significant deviation from the covered financial institution’s risk parameters set forth in the covered financial institution’s policies and procedures;
- Inappropriate risk-taking, regardless of the impact on financial performance;
- Material risk management or control failures;
- Non-compliance with statutory, regulatory, or supervisory standards resulting in enforcement or legal action brought by a federal or state regulator or agency, or a requirement that the covered financial institution report a financial statement restatement to correct a material error; and
- Other aspects of conduct or poor performance as defined by the covered financial institution.
In addition to deferral, downward adjustment, and forfeiture, the 2016 Proposed Regulations would require a Level 1 or Level 2 covered financial institution to include clawback provisions in the incentive-based compensation arrangements for senior executive officers and significant risk-takers. The term “clawback” refers to a mechanism by which a covered financial institution can recover vested incentive-based compensation from a senior executive officer or significant risk-taker if certain events occur. The 2016 Proposed Regulations would require clawback provisions that, at a minimum, allow the covered financial institution to recover incentive-based compensation from a current or former senior executive officer or significant risk-taker for seven years following the date on which such compensation vests, if the covered financial institution determines that the senior executive officer or significant risk-taker engaged in misconduct that resulted in significant financial or reputational harm to the covered financial institution, fraud, or intentional misrepresentation of information used to determine the senior executive officer or significant risk-taker’s incentive-based compensation.
Additional prohibitions would apply to:
- Maximum incentive-based compensation opportunity (also referred to as leverage);
- Relative performance measures; and
- Volume-driven incentive-based compensation.
Risk Management and Controls
All Level 1 and Level 2 covered financial institutions would be required to have a risk management framework for their incentive-based compensation programs that is independent of any lines of business; includes an independent compliance program that provides for internal controls, testing, monitoring, and training with written policies and procedures; and is commensurate with the size and complexity of the covered financial institution’s operations. In addition, Level 1 and Level 2 covered financial institutions would be required to:
- Provide individuals in control functions with appropriate authority to influence the risk-taking of the business areas they monitor and ensure covered persons engaged in control functions are compensated independently of the performance of the business areas they monitor; and
- Provide for independent monitoring of: (a) incentive-based compensation plans to identify whether the plans appropriately balance risk and reward; (b) events related to forfeiture and downward adjustment and reviews of forfeiture and downward adjustment decisions to determine consistency with the 2016 Proposed Regulations; and (c) compliance of the incentive-based compensation program with the covered financial institution’s policies and procedures.
Each Level 1 or Level 2 covered financial institution would be required to establish a compensation committee composed solely of directors who are not senior executive officers to assist the board of directors in carrying out its responsibilities under the 2016 Proposed Regulations. The compensation committee would be required to obtain input from the covered financial institution’s risk and audit committees (or groups performing similar functions) and risk management function on the effectiveness of risk measures and adjustments used to balance incentive-based compensation arrangements. Additionally, management would be required to submit to the compensation committee on no less than an annual basis a written assessment of the effectiveness of the covered financial institution’s incentive-based compensation program and related compliance and control processes in providing risk-taking incentives that are consistent with the risk profile of the covered financial institution. The compensation committee would also be required to obtain an independent written assessment from the internal audit or risk management function of the effectiveness of the covered financial institution’s incentive-based compensation program and related compliance and control processes in providing risk-taking incentives that are consistent with the risk profile of the covered financial institution.
Policies and Procedures
The 2016 Proposed Regulations would require all Level 1 and Level 2 covered financial institutions to have policies and procedures that, among other requirements:
- Are consistent with the requirements and prohibitions of the 2016 Proposed Regulations;
- Specify the substantive and procedural criteria for forfeiture and clawback;
- Document final forfeiture, cutback, and clawback decisions;
- Specify the substantive and procedural criteria for the acceleration of payments of deferred incentive-based compensation to a covered person;
- Identify and describe the role of any employees, committees, or groups authorized to make incentive-based compensation decisions, including when discretion is authorized;
- Describe how discretion is exercised to achieve balance;
- Require that the covered financial institution maintain documentation of its processes for the establishment, implementation, modification, and monitoring of incentive-based compensation arrangements;
- Describe how incentive-based compensation arrangements will be monitored;
- Specify the substantive and procedural requirements of the independent compliance program; and
- Ensure appropriate roles for risk management, risk oversight, and other control personnel in the covered financial institution’s processes for designing incentive-based compensation arrangements and determining awards, deferral amounts, deferral periods, forfeiture, cutback, clawback, and vesting and assessing the effectiveness of incentive-based compensation arrangements in restraining inappropriate risk-taking.
The 2016 Proposed Regulations would prohibit covered financial institutions from indirectly (including through other persons or entities) doing anything that would be unlawful for the covered financial institution to do directly.
 Office of the Comptroller of the Currency, Treasury (OCC), Board of Governors of the Federal Reserve System, the FDIC, the Federal Housing Finance Agency, the National Credit Union Administration, and the SEC.
 In order to maintain context, this Client Alert borrows heavily certain language from the 2016 Proposed Regulation text and its preamble.
 Executive Officers, employees, directors, or principal shareholders (generally those natural persons who own, control, or have the power to vote at least 10% of any class of voting securities (but not for credit unions)).
 Generally defined as all direct and indirect payments, whether in cash or not, in exchange for services, including pension, perquisites, equity, post-employment benefits, etc., but excluding reasonable business expense reimbursements.
 A covered person holding the title (or who performs the function of one of the following): president, chief executive officer, executive chairman, chief operating officer, chief financial officer, chief investment officer, chief legal officer, chief lending officer, chief risk officer, chief compliance officer, chief audit executive, chief credit officer, chief accounting officer, or head of a major business line or control function.
 Generally, any variable compensation, fees, or benefits that serve as an incentive or reward for performance.
 Individuals at Level 1 or Level 2 covered financial institutions who are not senior executive officers but are in the position to put a Level 1 or Level 2 covered financial institution at risk of material financial loss. There would be two alternative tests for determining whether a covered person is a significant risk-taker. The first test is based on the amounts of annual base salary and incentive-based compensation of a covered person relative to other covered persons working for the covered institution and its affiliate covered institutions (the “relative compensation test”) and covers those individuals who are among the top 5 percent (for Level 1 covered financial institutions) or top 2 percent (for Level 2 covered financial institutions) of highest compensated covered persons in the entire consolidated organization, including affiliated covered institutions. The second test is based on whether the covered person has authority to commit or expose 0.5 percent or more of the capital of the covered financial institution or an affiliate that is itself a covered institution (the “exposure test”). Individuals are not significant risk-takers if they received annual base salary and incentive-based compensation of which less than one-third is incentive-based compensation (one-third threshold), based on the covered person’s annual base salary paid and incentive-based compensation awarded during the last calendar year that ended at least 180 days before the beginning of the performance period for which significant risk-takers are being identified. In addition, the 2016 Proposed Regulations permit covered financial institutions or the Regulators (if the covered person 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) to designate additional persons as significant risk-takers.
 This might be particularly challenging and costly, as the rule fails to specify the format of the required documents, but requires the entities to produce them in the form requested by the appropriate regulator, which could be seven years after the initial records were created.
 Generally, all incentive-based compensation awarded to a covered person for a particular performance period, excluding amounts awarded for that particular performance period under a long-term incentive plan. With the exception of long-term incentive plans, all forms of compensation, fees, and benefits that qualify as “incentive-based compensation,” including annual bonuses, would be included in “qualifying incentive-based compensation.”
 Generally, any plan that provides incentive-based compensation with a performance period of at least three years.
 If the 2016 Proposed Regulations are implemented in their current form, it will be of particular interest whether this last requirement will cause courts and regulatory institutions, such as FINRA, to be more lenient on employers who forfeit or cutback deferred compensation because of bad behavior as defined by the institution.
 Generally those in a compliance, risk management, internal audit, legal, human resources, accounting, financial reporting, or finance role responsible for identifying, measuring, monitoring, or controlling risk-taking activities.