Federal banking and securities regulators published a notice of proposed rulemaking revisiting incentive compensation standards that were originally proposed in 2011. The 2016 proposal provides a more prescriptive approach for larger financial institutions than the previous proposal, and it applies to institutions with $1 billion or more in assets. As with prior guidance applicable to incentive compensation, the overarching principles should be considered by financial institutions of all sizes when designing their compensation programs consistent with the Interagency Guidance on Sound Incentive Compensation Policies issued in June 2010, which applies to all banking organizations regardless of asset size.
The 2016 proposal is similar to the previous proposal in that it prohibits excessive compensation to “covered” persons. However, unlike the 2011 proposal, the 2016 proposal more clearly defines requirements of institutions by creating three levels based on average total consolidated assets, with the lowest scrutiny applying to Level 3 institutions, those that have assets of $1 billion or more but less than $50 billion.
The proposal has implications for any incentive compensation provided to officers, directors, employees and principal shareholders associated with an institution with assets of $1 billion or more. As required under the Dodd-Frank Act, the proposal tries to discourage excessive compensation and compensation that could lead to a material financial loss.
There are two distinct elements for consideration. First is excessive compensation, which involves amounts paid that are unreasonable or disproportionate to the amount, nature, quality and scope of services performed by the covered person. Types of information the regulatory agencies will consider in making this assessment include, among others:
- The combined value of all compensation, fees or benefits provided to the covered person;
- The compensation history of the covered person and similarly-situated individuals;
- The financial condition of the covered institution;
- Peer group practices; and
- Any connection between the individual and any fraudulent act or omission, breach of fiduciary duty or insider abuse.
Material Financial Loss
In determining whether incentive-based compensation could lead to a material financial loss, regulators have previously stated that they will balance potential risks with the financial reward and assess whether the institution has effective controls and strong corporate governance. The 2016 proposal specifically provides that an incentive-based compensation arrangement would 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.
Additional Elements of the 2016 Proposal
The 2016 proposal re-emphasizes that internal controls and corporate governance are essential in monitoring risks related to incentive compensation. The 2016 proposal also contains a requirement that certain records must be disclosed upon request of the covered institution’s federal banking regulator.
The 2016 proposal will be effective 540 days after publication of the final rule and does not apply to any incentive plans with a performance period that begins before the effective date. Similarly, an institution that increases assets to become a Level 1, 2 or 3 institution must comply with rules applicable to that level within 540 days of the triggering size (determined based on asset size over the four most recent consecutive quarters).
We recommend that boards begin taking steps in order to comply with the 2016 proposal and the Guidance.
- Consider whether any of the institution’s incentive-based compensation is excessive or encourages risks that could result in a material financial loss by: applying the excessive compensation factors as set forth above; making compensation sensitive to risk through deferrals, longer performance periods and claw-backs; and considering a peer group study.
- Document relevant considerations as evidence of compliance with the Guidance at the committee and board levels.
- Implement controls and governance to oversee and monitor compensation and determine whether to risk–adjust awards.
- Review compensation policies annually.