Law-Practices-Finance-pen-and-graph-670x447

The proposal seeks to make executive compensation arrangements more sensitive to risk and would require complex risk management programs to ensure compliance.

By Arthur S. Long, Pia Naib, and Deric Behar

On May 6, 2024, the Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency (OCC), the Federal Housing Finance Agency (FHFA), and the National Credit Union Administration (NCUA) (collectively, the agencies) issued a joint Notice of Proposed Rulemaking (the Proposed Rule) to curb “excessive risk-taking” resulting from incentive-based compensation arrangements. The Board of Governors of the Federal Reserve System (FRB) and the Securities and Exchange Commission (SEC) did not join in the Proposed Rule.[1],[2] Critically, without the FRB’s participation, the Proposed Rule may not be finalized.

The Proposed Rule seeks to curtail incentives for certain financial services sector officers, employees, and directors to take inappropriate risks as a result of seeking excessive compensation, fees, or benefits. It uses a tiered approach based on asset size categories, where covered institutions (defined below) within the two largest asset size categories would be subject to prescriptive requirements related to the structure of their incentive-based compensation arrangements, including incentive award limits, deferral requirements, downward adjustments, forfeitures, and clawbacks.

The Proposed Rule re-proposes the regulatory text previously proposed in June 2016 (with a new preamble that acknowledges developments and supervisory learnings) and seeks additional feedback from commenters on potential alternatives to various provisions.

Dodd-Frank Section 956

Section 956 of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (Section 956) requires that six federal financial regulators (FRB, FDIC, OCC, NCUA, FHFA, and SEC) jointly prescribe regulations or guidelines with respect to incentive-based compensation practices at “covered financial institutions” that have $1 billion or more in assets.

The term “covered financial institution” under Section 956 includes:

  1. a depository institution or depository institution holding company, as such terms are defined in section 3 of the Federal Deposit Insurance Act;
  2. a broker-dealer registered under section 15 of the Securities Exchange Act of 1934;
  3. a credit union, as described in section 19(b)(1)(A)(iv) of the Federal Reserve Act;
  4. an investment advisor, as such term is defined in section 202(a)(11) of the Investment Advisers Act of 1940;
  5. the Federal National Mortgage Association (Fannie Mae);
  6. the Federal Home Loan Mortgage Corporation (Freddie Mac); and
  7. any other financial institution that the appropriate federal regulators, jointly, by rule, determine should be treated as a covered financial institution for purposes of Section 956.

Key Definitions

Under the Proposed Rule, “covered institutions” are defined more broadly than the covered financial institutions specifically identified in Section 956. The Proposed Rule would cover the following types of institutions, with respect to the agency indicated, that have $1 billion or more in consolidated assets:

  • OCC: a national bank, federal savings association, or federal branch or agency of a foreign bank (both insured and uninsured), with average total consolidated assets greater than or equal to $1 billion; and a subsidiary of any such national bank, federal savings association, or federal branch or agency of a foreign bank that (i) is not a broker, dealer, person providing insurance, investment company, or investment adviser and (ii) has average total consolidated assets greater than or equal to $1 billion.
  • FDIC: a state non-member bank, state savings association, or state insured branch of a foreign bank, with average total consolidated assets greater than or equal to $1 billion; and a subsidiary of a state non-member bank, state savings association, or state insured branch of a foreign bank that (i) is not a broker, dealer, person providing insurance, investment company, or investment adviser and (ii) has average total consolidated assets greater than or equal to $1 billion.
  • FHFA: Fannie Mae and any of its affiliates and Freddie Mac and any of its affiliates, with total consolidated assets greater than or equal to $1 billion, and a Federal Home Loan Bank.
  • NCUA: an insured credit union or a credit unit eligible to apply to become an insured credit union.

The expansion of the list of financial institutions under the Proposed Rule is intended to achieve equal treatment across similar entities that are under the same regulatory regime or that have different charters, and to ensure parity of treatment between US banking organizations and foreign banking organizations operating in the US.

“Covered persons” as defined under the Proposed Rule generally comprise executive officers, employees, directors, principal shareholders (generally, individuals who control 10% or more of any class of voting securities of the institution), and significant risk-takers.[3] An “executive officer” would include individuals who are senior executive officers,[4] as well as other individuals whom the covered institution designates as executive officers. Notably, certain parts of the Proposed Rule would apply to only senior executive officers and significant risk-takers.

The Proposed Rule defines “incentive-based compensation” as any variable compensation, fees, or benefits that serve as an incentive or reward for performance. The form of payment, whether cash, an equity-like instrument, or any other thing of value, does not affect whether compensation, fees, or benefits meet this definition.

The Proposed Rule: Key Components

The Proposed Rule employs a tiered approach based on a covered institution’s average total consolidated assets:

  1. Level 1 ($250 billion or more);
  2. Level 2 ($50 billion to less than $250 billion); and
  3. Level 3 ($1 billion to less than $50 billion).

The Proposed Rule has three main components that would apply to all covered institutions:

  1. Prohibitions:
    • Incentive-based compensation arrangements that encourage inappropriate risks by the covered 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 institution are prohibited.
  2. Board of Directors:
    • The board of directors of a covered institution (or a committee thereof) is required to (i) conduct oversight of the covered institution’s incentive-based compensation program; (ii) approve incentive-based compensation arrangements for senior executive officers, including amounts of awards and, at the time of vesting, payouts under such arrangements; and (iii) approve material exceptions or adjustments to incentive-based compensation policies or arrangements for senior executive officers.
  3. Disclosure and Recordkeeping Requirements:
    • Covered institutions are required to create and retain annual records (for seven years) that document the structure of all the institution’s incentive-based compensation arrangements and demonstrate compliance with the Proposed Rule, and to disclose these records to the appropriate agency upon request.

Level 1 and Level 2 covered institutions would be subject to more extensive requirements, including:

  • Requirements to disclose the identity of senior executive officers and significant risk-takers and provide details of the incentive-based compensation arrangements for such individuals.
  • Requirements to defer the vesting of specified portions of the incentive-based compensation awarded to senior executive officers and significant risk-takers. Specifically:
    • A Level 1 covered institution would be required to defer (for at least four years) at least 60% of a senior executive officer’s qualifying incentive-based compensation awarded for each performance period (and at least 50% for a significant risk-taker).
    • A Level 2 covered institution would be required to defer (for at least three years) at least 50% of a senior executive officer’s qualifying incentive-based compensation awarded for each performance period (and at least 40% for a significant risk-taker).
  • Requirements to subject all incentive-based compensation of senior executive officers and significant risk-takers that is not yet awarded to downward adjustment, and to subject all such individuals’ incentive-based compensation that is awarded and deferred to forfeiture until vesting, and to subject all vested incentive-based compensation to potential clawback for seven years following vesting.
  • Enhanced risk management controls and for incentive-based compensation programs including 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 institution’s operations.

Potential Alternatives to Regulatory Provisions

The Proposed Rule contains newly added potential alternatives to the provisions as proposed, with the intention to obtain feedback on such alternatives. These alternatives include:

  • shortening the compliance date from 540 days to 365 days after a final rule is published;
  • establishing a two-level structure for covered institutions, rather than three;
  • simplifying the significant risk-taker definition;
  • requiring performance measures and targets to be established before the performance period;
  • modifying the proposed limit on options from 15% to no more than 10% of the amount of total incentive-based compensation awarded for that performance period;
  • requiring Level 1 or Level 2 covered institutions to pursue forfeiture and downward adjustments (instead of requiring consideration of forfeiture and downward adjustments);
  • requiring Level 1 or Level 2 covered institutions to claw back any vested incentive-based compensation (instead of requiring consideration of clawbacks);
  • prohibiting Level 1 and Level 2 covered institutions from allowing hedging;
  • modifying the approach to volume-driven incentive-based compensation; and
  • imposing enhanced risk management and control requirements for Level 1 and Level 2 covered institutions.

Regulators Weigh In

  • FDIC Chairman Martin J. Gruenberg issued a statement in support of the Proposed Rule, noting “the passage of time, additional supervisory experience, changes in industry practices, and other developments.” He called it “perhaps the most important Dodd-Frank rulemaking remaining to be implemented,” and indicated that “all six agencies will continue to coordinate on implementing [S]ection 956.”
  • FDIC Vice Chairman Travis Hill issued a statement against the Proposed Rule, saying it is overly prescriptive rather than principles-based as well as “too broad and too blunt.” He also pointed out that “[i]t is extremely odd to issue this proposal without all the relevant agencies participating” and questioned whether commenters should respond to the feedback request without full agency participation.
  • Acting Comptroller of the Currency Michael J. Hsu issued a statement in support of the Proposed Rule. Despite not being issued by all six required agencies, he encouraged “robust engagement” by financial market participants and regulators alike on how to “most effectively curtail problematic incentive compensation practices.”
  • Consumer Financial Protection Bureau Director Rohit Chopra issued a statement in support of the Proposed Rule. He asserted that bonuses and executive compensation incentives played a role in the spring 2023 bank failures, saying they demonstrated a “a premium on short-term profits over long-term sustainability.” He encouraged the remaining agencies to issue the proposal “so that it can be quickly finalized.”
  • FHFA Director Sandra L. Thompson issued a statement in support of the Proposed Rule, stating that “robust risk management with respect to compensation practices is critical to promoting the safety and soundness of FHFA’s regulated entities.”

Conclusion

The revival of the Proposed Rule was driven in part by lawmakers and regulators seeking to mitigate potential causal factors in the wake of the spring 2023 banking crisis (for more information, see this Latham report). Others, however, deny that incentive-based compensation was among the triggers of that crisis.

If adopted, the Proposed Rule would represent the first time the agencies have established specific prescriptions on pay other than for institutions receiving financial assistance from the government.

Firms would potentially be required to invest in complex risk management programs to ensure compliance with the Proposed Rule, and they could lose certain executives to less-regulated institutions (such as investment banks and hedge funds).

The Proposed Rule will not be published in the Federal Register until it is proposed by all six federal financial agencies. If it is published in the Federal Register, it will have a comment period of 60 days following the date of publication.

Because many provisions of the Proposed Rule are unprecedented, how it would be enforced and, in particular, whether each of the six required agencies would adopt, interpret, administer, and enforce the rules in a uniform manner remains unclear.

Endnotes

[1] The FRB has not joined in the Proposed Rule due to reluctance by FRB Chairman Jerome Powell (expressed in response to a question on implementing Section 956 of the Dodd-Frank Act at a House Financial Services Committee hearing on March 6, 2024): “I would like to understand the problem we’re solving and then I would like to see a proposal that addresses that problem.”

[2] The SEC has not joined in the Proposed Rule, but the SEC’s fall 2023 rulemaking agenda reflects the intention to implement Section 956.

[3] A covered person is considered a “significant risk-taker” (applicable only to Level 1 and Level 2 covered institutions) if the covered person received an annual base salary and incentive-based compensation of which at least one-third was incentive-based compensation 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, and the covered person either (i) is 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) has authority to commit or expose 0.5% or more of the capital of the covered institution or an affiliate that is itself a covered institution. Even if neither test is met, the agencies may designate additional individuals as significant risk-takers, including because of their ability to expose a covered institution to risks that could lead to material financial loss in relation to the institution’s size, capital, or overall risk tolerance.

[4] “Senior 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; chief compliance officer; chief audit executive; chief credit officer; chief accounting officer; or head of a major business line or control function.