Federal Banking Agencies Offer Proposal to Reform Financial Institution Incentive Pay

Acting on a Dodd-Frank mandate, federal bank regulators have released proposed guidance establishing general requirements for the incentive compensation arrangements of a variety of covered financial institutions. The proposal implements Section 956 of Dodd-Frank, which requires the agencies to prohibit incentive pay arrangements that encourage inappropriate risks by providing excessive compensation or that could lead to a material loss. The application of Section 956 is limited to financial institutions with a $1 billion or more in assets, defining “financial institution” broadly to include all depository institutions, credit unions, broker-dealers, investment advisors, GSEs like Fannie Mae and Freddie Mac and the Federal Home Loan Banks. The rules cover all programs that offer “variable compensation that serves as an incentive for performance” and extends to all officers, employees, directors or 10 percent shareholders that participate in such programs. The proposal will be open for a 45-day comment period after publication in the Federal Register with a final rule expected to be in place by 2012.

Enhanced Reporting of Incentive Pay

The proposed regulation mandates enhanced reporting of incentive compensation arrangements to provide the agencies with a basis for determining whether an institution’s pay practices violate the prohibitions on excessive compensation or encourage inappropriate risk that could lead to a material loss. All covered financial institutions would be required to submit an annual report describing the structure of their incentive pay arrangements in a clear narrative format along with a discussion of the institution’s policies and procedures relating to the governance of incentive pay programs. However, for institutions with less than $50 billion in assets, the regulation does not require reporting of an individual executive’s actual compensation. Institutions with assets of $50 billion or more (large covered institutions) would be required to provide additional specific information on policies and procedures applicable to the determination of incentive compensation for executive officers (see below) and certain other employees identified by the board of directors as having the ability to expose the institution to losses that are substantial in relation to the institution’s size, capital or overall risk tolerance. Large covered institutions would also be required to report on material changes in their incentive pay program since the prior year’s report and to detail the specific reasons why the institution’s incentive pay practices do not provide excessive compensation or encourage inappropriate risk that could lead to a material loss.  

Prohibited Practices

The proposed rules identify two classes of prohibited incentive pay practices: (i) programs that encourage unnecessary risk by providing excessive compensation and (ii) programs that encourage inappropriate risks leading to material financial loss.

Excessive Compensation . The agencies define “excessive compensation” as amounts paid to a covered individual that are unreasonable or disproportionate to the services performed, taking into account a variety of factors, including (i) the individual’s total compensation (both cash and non-cash), (ii) the individual’s compensation history, (iii) the institution’s financial condition, (iv) peer group practices, and (iv) the individual’s connection to any fraudulent act or omission.

Material Financial Loss . The proposed rules ban incentive pay arrangements that encourage either covered individuals or groups of covered individuals to take inappropriate risks that could lead to a material financial loss. The guidance does not identify specific arrangements that fit within this category but makes reference to the three principles identified in the agencies’ prior Guidance on Sound Incentive Compensation Policies released in June 2010: (i) balance of risk and financial reward through the use of deferrals, risk adjusted awards and reduced sensitivity to short-term performance, (ii) compatibility with effective controls and risk management and (iii) support by strong corporate governance, particularly at the board or board committee level.

Deferral Requirements for Large Covered Institutions

For large covered institutions, the proposal requires that at least 50 percent of annual incentive compensation for “executive officers” be deferred for at least three years. The proposal defines “executive officer” fairly narrowly to include only persons holding the title (or function) of the president, chief executive officer, executive chairman, chief operation officer, chief financial officer, chief risk officer or the head of a major business unit. Deferred amounts are also subject to adjustment for actual losses or by reference to other aspects of performance that are realized or become known over the deferral period. The rules allow the deferred amounts to cliff vest, i.e., no vesting or payment prior to three years, or on a graded schedule, i.e., one-third vesting and paid each year of the deferral period.

High Risk Employees

The agencies are also requiring the board or a board committee at large covered institutions to identify persons other than executive officers who have the ability to expose the institution to losses that are substantial in relation to the institution’s size. For such persons, any incentive arrangement is subject to documented approval by the board or a board committee and the board or committee must make a specific determination that the arrangement (i) effectively balances the financial rewards to the employee and the range and time horizon of the risks associated with the employee’s activities, (ii) includes appropriate methods for ensuring risk sensitivity such as deferral, (iii) provides for risk adjustment of awards and (iv) is structured to reduce sensitivity to short-term performance.

New Governance Requirements for Incentive Pay

The proposal also mandates specific governance requirements for the implementation and operation of incentive pay arrangements. All covered institutions are required to adopt board-approved policies and procedures that are designed to ensure continuing oversight of compliance efforts. Specifically, the rules require (i) the inclusion of the institution’s risk management personnel in the incentive pay design process, (ii) ongoing monitoring of incentive pay awards and required risk-based adjustments, and (iii) the regular flow to the Board of critical data and analysis from management and other sources to allow the Board to assess the consistency of incentive pay programs with regulatory requirements.

For covered institutions, regardless of size, we recommend an immediate assessment of how the proposed rules will impact your existing incentive arrangements and a review of related corporate governance practices. The early identification of covered officers and an analysis of the viability of current incentive pay programs under the new rules will help ease the transition to a compliant structure.