Bank Regulators Revive Restrictions on Incentive-Based Compensation

The Dodd-Frank Act of 2010 prohibits incentive compensation that encourages inappropriate risks or provides excessive compensation, and the National Credit Union Administration, the Federal Deposit Insurance Corporation, the Federal Housing Finance Agency, the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency and the Securities and Exchange Commission have proposed new restrictions on how financial institutions pay their employees and other service providers.

The Rules

The new rules seek to establish general requirements applicable to the incentive-based compensation arrangements of covered persons working in covered institutions. Covered persons are any executive officers, employees, directors or principal shareholders who receive incentive-based compensation¹ at a covered institution. Additional restrictions apply to senior executive officers² and significant risk-takers³.

“Covered institutions” include any of the following institutions that have $1 billion or more in assets:

• A depository institution or depository institution holding company; 
• A broker-dealer registered under section 15 of the Securities Exchange Act of 1934;
• A credit union, as described in section 19(b)(1)(A)(iv) of the Federal Reserve Act; and
• An investment adviser, as such term is defined in section 202(a)(11) of the Investment Advisers Act of 1940.

The proposed rules identify three categories of covered institutions based on average total consolidated assets:

• Level 1 (greater than $250 billion);  
• Level 2 (between $50 and $250 billion); and  
• Level 3 (between $1 and $50 billion).

Requirements for All Covered Institutions

Under the proposed rule, all covered institutions would be prohibited from establishing or maintaining incentive-based compensation arrangements that encourage inappropriate risks by the covered institution (1) by providing covered persons with excessive compensation, fees or benefits, or (2) that could lead to material financial loss to the covered institution. Each covered institution is responsible for its incentive-based compensation arrangements appropriately balancing risk and reward.

A) No Excessive Compensation

The proposed rules prohibit compensation, fees and benefits that are unreasonable or disproportionate to the value of the services performed. Relevant factors include:

• The combined value of all compensation, fees or benefits provided to the covered person;  
• The compensation history of the covered person and the other individuals with comparable expertise at the covered institution;
• The financial condition of the covered institution;
• Compensation practices at comparable covered institutions, based upon asset size, geographic location and the complexity of the covered institution’s operations and assets;  
• For post-employment benefits, the projected total cost and benefit to the covered 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 institution.

B) Appropriate Performance Measures

The performance measures used in an incentive-based compensation arrangement have an important effect on the incentives provided to covered persons. Such an arrangement would not appropriately balance risk and reward unless:

• It includes relevant financial and non-financial measures of performance of a covered person’s role and to the type of business in which the covered person is engaged;
• It is designed to allow non-financial measures of performance to override financial measures when appropriate; and
• Any amounts to be awarded under the arrangement are subject to adjustment to reflect actual losses, inappropriate risks taken, compliance deficiencies, or other measures or aspects of financial and non-financial performance.

C) Effective Controls

A covered institution must implement controls over the design, implementation and monitoring of incentive-based compensation appropriate to the institution’s size and complexity.

D) Approval of Board of Directors

Under the proposed rules, a covered institution’s board of directors, or a committee thereof, would be required to:

• Conduct oversight of the incentive-based compensation program;
• Approve incentive-based compensation arrangements for senior executive officers, including the amounts of all awards and, at the time of vesting, payouts under such arrangements; and
• Approve any material exceptions or adjustments to incentive-based compensation policies or arrangements for senior executive officers.

E) Disclosure and Recordkeeping

All covered institutions would be required to create and maintain records that document the structure of all of the institution’s incentive-based compensation arrangements and disclose these records to the appropriate Federal regulator upon request. Such records must be maintained for at least seven year after they are created. At a minimum, a covered institution’s records must include copies of all incentive-based compensation plans, a list of who is subject to each plan, and a description of how the covered institution’s incentive-based compensation program is compatible with effective risk management and controls.

Download: Bank Regulators Revive Restrictions on Incentive-Based Compensation

1. Incentive-based compensation is defined as any variable compensation, fees, or benefits that serve as an incentive or reward for performance.
2. Senior executive officers include the 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.
3. Significant risk takers are covered persons, other than senior executive officers, who receive annual base salary and incentive-based compensation of which at least one-third is incentive-based compensation, and are (i) among the top 5% (for Level 1 covered institutions) or top 2% (for Level 2 covered institutions) of highest compensated covered persons in the entire consolidated organization, or (ii) authorized to commit or expose 0.5% or more of the capital of a Level 1 or Level 2 institution. Federal agencies charged with enforcing the regulations may designate other service providers as significant risk takers.