Recently, four of six regulators issued an inter-agency proposal for new rules on incentive compensation under §956 of the Dodd-Frank Act. The new rules replace the joint rules proposed in 2011, which never went into effect. Banks boards must approve incentive compensation plans for senior executives and “risk takers” under the framework of the law.
Four Key Differences
While some of the re-proposal is the same, there are important differences between the new rules and the 2011 rules. Here we touch on four key differences, and one important similarity.
1. The regulators have been “getting smart” on incentive compensation. While the 2011 rules seemed to have been proposed in a vacuum, the regulators have indicated that the new rules are based on their collective supervisory experiences gained over the last several years. The new rules incorporate practices that institutions and foreign regulators have adopted to address compensation practices that may have contributed to the financial crisis.
2. The new rules try to lessen the burden on smaller institutions by further dividing banks into categories based on assets and by scaling the requirements. The new rules recognize three categories each of which will be subject to varying levels of oversight:
- Level 1 (greater than or equal to $250 billion);
- Level 2 (greater than or equal to $50 billion and less than $250 billion); and
- Level 3 (greater than or equal to $1 billion and less than $50 billion).
Institutions with average total consolidated assets of less than $1 billion will be subject only to the “safety and soundness” aspects described below. In most cases, the new rules apply the most stringent aspects only to Levels 1 and 2, while Level 3 just has primarily governance and recordkeeping obligations. However, regulators do have the discretion to subject Level 3 institutions to the rules applicable to Level 1 and 2 institutions.
3. The new rules get more specific about troublesome compensation designs. An incentive compensation arrangement will not be considered to appropriately balance risk and reward unless 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.
4. The new rules extend mandatory deferral and clawback periods for Level 1 and 2 institutions. At their most restrictive, the new rules will require deferral for at least four years of at least 60 percent of senior executive officers’ incentive compensation and at least 50 percent of significant risk-takers’ incentive compensation. In addition, the new rules will require clawback provisions that, at a minimum, allow the institution to recover incentive compensation from the same individuals for seven years following the date on which the compensation vests, if the institution determines that the individual engaged in misconduct, fraud or intentional misrepresentation of information.
In addition to the foregoing key differences from the 2011 proposal, one important aspect remains the same. Similar to the 2011 rules, the new rules will prohibit all institutions from establishing or maintaining incentive compensation plans that encourage inappropriate risk by providing excessive compensation, fees, or benefits or that could lead to material financial loss to the covered institution. In this regard, the new rules continue to rely on the bank regulators’ “safety and soundness” guidelines respecting all compensation arrangements. In particular, in assessing the balance of risk and reward with respect to any compensation arrangement, institutions should consider 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 institution;
- The financial condition of the covered institution;
- Compensation practices at comparable institutions, based upon such factors as 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.
Effective Date and Transition
It is expected that the last two regulators will publish their version of the new rules in the coming weeks. Variation between versions is not expected. A comment period will follow publication by each of the regulators. The new rules will become effective approximately 18 months after being published in final form. The new rules will not apply to any incentive compensation plan with a performance period that begins before the final rules are effective.