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4/22/16 - Agencies’ Proposal Would Require Changes to Incentive Compensation for Senior Executives and High Earners at Financial Firms

On April 21, 2016, six U.S. financial regulators — the Office of the Comptroller of the Currency, Federal Reserve Board, Federal Deposit Insurance Corporation, Securities and Exchange Commission, National Credit Union Administration, and Federal Housing Finance Agency — began releasing their respective versions of the joint interagency proposed rule on incentive-based compensation. Comments on the proposal are due July 22, 2016. The agencies’ proposal comes five years after their first attempt to implement Section 956 of the Dodd-Frank Act, which prohibits covered firms from providing incentive-based compensation deemed excessive or that could lead to material financial loss. The new proposal indicates that the agencies expect major changes in the way financial institutions compensate their senior-most officials and high earners. Understanding those expectations will be key to compliance. Significant aspects of the proposal include:

  • Expansive definition of “significant risk-takers” (SRTs), whose incentive-based compensation is subject to restrictions
  • Mandatory deferral of incentive-based compensation for senior executive officers (SEOs) and SRTs
  • Risk management and governance requirements around incentive-based compensation
  • Limits on the proportion by which SEOs’ or SRTs’ incentive-compensation awards can exceed targets

What and Who is Covered?

Covered Institutions

The proposal applies to a broad range of institutions, including any bank, savings association, branch or agency of a foreign bank, bank holding company, savings and loan holding company, credit union, broker-dealer, or investment adviser that has greater than or equal to $1 billion in assets and offers incentive-based compensation. It also applies to U.S. operations of a foreign banking organization that meet this threshold. The proposal identifies three levels of covered institutions:

  • Level 1: greater than or equal to $250 billion in assets
  • Level 2: greater than or equal to $50 billion and less than $250 billion in assets
  • Level 3: greater than or equal to $1 billion and less than $50 billion in assets

The most stringent requirements of the proposal apply to the largest covered institutions. The thresholds at which various requirements apply are based on average total consolidated assets. For that reason, an institution that, when viewed alone, would be a Level 3 institution, but that is part of a Level 1 bank holding company, would be subject to the more stringent Level 1 requirements. In addition, the proposal includes a reservation of authority that would allow an agency to require certain Level 3 institutions to comply with some or all of the more rigorous requirements applicable to Level 1 and Level 2 covered institutions. Significantly, total consolidated assets do not include assets under management for a covered institution that is an investment adviser.

Covered Persons

The proposal applies to an executive officer, employee, director, or principal shareholder who receives incentive compensation at a covered institution. For Level 1 and Level 2 institutions, the proposal imposes substantive restrictions on incentive compensation of SEOs and SRTs. SEOs include individuals spanning the first, second, and third lines of defense, who hold the title or perform the functions of a:

  • 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
  • Head of a major business line or control function
 

SRTs include individuals at Level 1 or 2 institutions — other than SEOs — who receive at least one-third of total compensation in incentive-based compensation and are either among the top earners (top 5% in base pay and incentive compensation at Level 1 institutions and top 2% at Level 2 institutions) or have the ability to commit or expose at least 0.5% of the institution’s capital (called the “exposure test” in the proposal). A Level 1 or 2 institution may not evade the exposure test by authorizing an employee at an affiliate that is not a covered institution to commit or expose this amount of the Level 1 or 2 institution’s capital.

What Requirements Apply to All Covered Institutions?

Compensation Prohibitions

All covered institutions are subject to the proposal’s umbrella prohibitions on compensation arrangements that could encourage inappropriate risks by providing excessive compensation or that could lead to material financial loss to the covered institution.

Board of Directors Requirements

In addition, a covered institution’s board of directors (or committee thereof) must:

  • Oversee the institution’s incentive-based compensation program
  • Approve incentive-based compensation arrangements for SEOs
  • Approve any material exceptions or adjustments to incentive-based compensation policies or arrangements for SEOs

Recordkeeping

A covered institution must create annually and maintain for at least seven years records that document the structure of incentive-based compensation arrangements and that demonstrate compliance with the proposed rule.

What Additional Requirements Apply to Mid-Size and Larger Institutions?

Disclosure and Recordkeeping

Level 1 and Level 2 covered institutions are required to create annually and maintain for at least seven years records that document SEOs and SRTs and their incentive-based compensation, SRT and SEO forfeiture and downward adjustment or clawback reviews and decisions, and any material changes to the covered institution’s incentive-based compensation arrangements and policies.

Risk Management and Governance

Level 1 and Level 2 institutions must have a risk management framework covering their incentive-based compensation programs that: is independent of any lines of business; includes 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.

These institutions must also: provide individuals engaged in control functions the authority to influence the risk-taking of the business areas they monitor; compensate such individuals based on their control function performance and independently of the performance of the business areas they monitor; and conduct independent monitoring of plans, triggering events, forfeiture and downward adjustment decisions, and compliance with policies and procedures.

The proposal also requires that Level 1 and Level 2 institutions have compensation committees composed solely of directors who are not SEOs. The compensation committee must obtain input from the board’s risk and audit committees and the risk management function and, at least annually, obtain written assessments of the effectiveness of the institution’s incentive-based compensation program and related compliance and control processes.

Mandatory Deferral

SEOs and SRTs at Level 1 and Level 2 institutions are subject to the proposal’s requirements for mandatory deferral of portions of their incentive compensation. The proposal requires a 40%, 50%, or 60% deferral depending on whether the institution is Level 1 or Level 2 and whether the individual is an SEO or SRT (see chart below). The proposal also requires a shorter deferral period for incentive-based compensation awarded under a long-term incentive plan, which means a plan with a performance period of three or more years. In addition, deferred incentive-based compensation for SEOs and SRTs must include “substantial” portions of both deferred cash and equity-like instruments throughout the deferral period.

Forfeiture, Downward Adjustment, and Clawback

A Level 1 or Level 2 covered institution must make subject to forfeiture all of an SEO or SRT’s unvested deferred incentive-based compensation, and must make subject to downward adjustment all of an SEO or SRT’s incentive-based compensation not yet awarded for the current performance period. A Level 1 or Level 2 covered institution would be required to consider forfeiture or downward adjustment of incentive-based compensation in the event of certain triggering events, including poor financial performance due to deviation from risk parameters, material risk management or control failures, and non-compliance with statutory, regulatory, or supervisory standards that leads to an enforcement action or material financial restatement. The proposal also requires a Level 1 or Level 2 institution to include clawback provisions in incentive-based compensation arrangements for SEOs and SRTs that would allow the institution to recover such compensation for at least seven years after it vests in the event of misconduct, fraud, or intentional misrepresentation.

Additional Prohibitions

Level 1 and Level 2 institutions are subject to prohibitions on hedging compensation obligations, maximum incentive-based compensation opportunity (which the proposal refers to as “leverage”), relative performance measures, and volume-driven incentive-based compensation. The “leverage” prohibition means that SEOs may not earn more than 125% of target incentive-based compensation, and SRTs may not earn more than 150% of such target amount.

When Are the Requirements Effective?

The agencies recognized the substantial changes that may be required in incentive-based compensation programs and provided that covered institutions will have 540 days after the proposal is finalized to implement the necessary changes. An incentive-based compensation plan with a performance period for measuring incentive compensation that begins before the compliance date is not subject to the proposal’s requirements. This presents the interesting prospect that portions of incentive compensation packages based on past performance could be “grandfathered,” but portions of the same compensation package tied to prospective, longer term performance would not be.

Requirements at a Glance

Requirement Level 1 Level 2 Level 3
Prohibition on compensation that is excessive
Prohibition on compensation that could lead to material financial loss to the institution
  • Requires that compensation arrangements (1) appropriately balance risk and reward; (2) be compatible with effective risk management and controls; and (3) be supported by effective governance.
 
Basic disclosure and recordkeeping requirements
Enhanced disclosure and recordkeeping requirements N/A*
Prohibition against hedging N/A*
Maximum “leverage”
  • SEO: 125% of target amount of incentive-based compensation
  • SRT: 150% of target amount of incentive-based compensation
 
N/A*
Prohibition against relative performance measures N/A*
Prohibition against volume-driven compensation N/A*
Deferral
  • SEO: 60% of short-term incentive-based compensation for at least four years and of long-term incentive-based compensation for at least two years
  • SRT: 50% of short-term incentive-based compensation for at least four years and of long-term incentive-based compensation for at least two years
  • Includes limits on vesting, acceleration, and adjustments and restrictions on composition
 
  • SEO: 50% of short-term incentive-based compensation for at least three years and of long-term incentive-based compensation for at least one year
  • SRT: 40% of short-term incentive-based compensation for at least three years and of long-term incentive-based compensation for at least one year
  • Includes limits on vesting, acceleration, and adjustments and restrictions on composition
 
N/A*
Forfeiture
  • Must place unvested deferred incentive-based compensation of SEOs and SRTs at risk and review and consider forfeiture on triggering events for which the SEO or SRT is responsible
 
N/A*
Clawback
  • Must have provisions that allow the institution to claw back compensation from a current or former SEO or SRT for seven years
 
N/A*
Enhanced risk management and controls requirements
  • Must have risk management framework; provide persons in control functions with sufficient authority and appropriately structured compensation; and conduct independent monitoring of plans, triggering events, forfeiture and downward adjustment decisions, and compliance with policies and procedures.
 
N/A*
Board responsibilities
Enhanced governance requirements
  • Must establish a compensation committee composed solely of directors who are not SEOs that obtains: (1) input from the board’s risk and audit committees and the risk management function on the effectiveness of the incentive-based compensation program; and (2) at least annually, a written effectiveness assessment from both management and the internal audit or risk management function
 
N/A*
Policies and procedures requirement N/A*

* A covered institution with $10 billion or greater in average total consolidated assets may be required to comply with one or more of these requirements if the agency determines that the institution’s complexity of operations or compensation practices are consistent with those of a Level 1 or Level 2 institution.

How Promontory Can Help

Covered firms need to react to this proposal as a fundamental change in incentives and governance as they apply to incentive compensation, not just a legal exercise in conveying the particulars of another proposed rule. Promontory has deep regulatory experience and can help firms understand and adjust to these new expectations for incentive-based compensation. We can:

  • Conduct a gap assessment to identify all aspects of your firm’s current incentive-based compensation programs, risk management and governance framework, and corporate policies that do not align with the proposal’s requirements and agencies’ expectations
  • Develop and apply methodologies to identify SRTs based on earnings and the ability to commit or expose capital
  • For foreign banking entities, map the proposal’s requirements with home-country requirements and identify overlap and inconsistencies
  • Assist with creating a monitoring and validation framework to assess the effectiveness of incentive-based compensation
  • Design and implement appropriate testing to analyze incentive-based compensation against supervisory expectations
  • Help develop necessary reports for boards, compensation committees, and regulators
  • Design a road map of issues that will need to be addressed in order to comply with a final rule within the implementation period
  • Refine policies and procedures to align with a final rule

Contact Us

Please contact Promontory to discuss how we can help your firm prepare for compliance with the proposed rules on compensation.

Julie Williams
Managing Director and Director of the Domestic Advisory Practice
juwilliams@promontory.com
+1 212 365 6990

Michele Meyer
Director
mmeyer@promontory.com
+1 202 603 3709

Conway Dodge
Managing Director
cdodge@promontory.com
+1 202 370 0461