Bank Regulators Revive Proposed Rules on Incentive Pay

Three federal regulators have reproposed rules that implement the requirements for bank incentive compensation programs that were included in the Dodd-Frank legislation 14 years ago.  Section 956 of Dodd-Frank required the financial regulatory agencies to issue rules for financial institutions with $1 billion or more or more in assets that prohibit incentive compensation arrangements that provide excessive compensation or that could lead to material loss to the covered entity.  The re-proposed regulations, which reflect the text first proposed in June 2016, were issued jointly by the Federal Deposit Insurance Corporation (“FDIC”), the Office of the Comptroller of the Currency (“OCC”), and the Federal Housing Finance Agency (“FHFA”) with the National Credit Union Administration (“NCUA”) expected to follow suit in the coming weeks.  The Federal Reserve Board (“FRB”) and the Securities and Exchange Commission (“SEC”) have not joined the proposal, although the latter has included Section 956 rulemaking on the agency’s regulatory agenda.  The re-proposal is accompanied by suggested alternatives to the 2016 approach and questions on which the regulators are seeking public input.  Interested parties will have 60 days from the date of Federal Register publication to comment on the proposed rule although, given the significance of the rules and the apparent lack of consensus among the regulators, it is likely that the comment period will be extended.

The major bank failures in 2023 returned the focus of federal regulators to incentive pay programs as a contributing factor and no doubt inspired the decision to reissue the 2016 proposed rule.  Reports issued by the FDIC and FRB in the aftermath of the Silicon Valley Bank, Signature Bank and First Republic Bank failures all highlighted the fact that incentive compensation arrangements at these institutions were often structured in a manner that was inconsistent with sound risk management and suffered from poor oversight at the board level. 

Federal regulators have struggled to release final guidance under Section 956.  In 2010, just prior to the enactment of Dodd-Frank, the FDIC, OCC and FRB issued guidelines on the design and implementation of incentive pay arrangements.  The guidelines provided that incentive compensation arrangements should (i) appropriately balance risk and reward; (ii) be compatible with effective risk management and controls; and (iii) be supported by strong corporate governance.  Over the intervening years, in the absence of final regulations, the 2010 guidelines have been the principal source of guidance for bank examiners when they review incentive pay arrangements.  In 2011, the FDIC, OCC, FRB,  NCUA and SEC issued a proposed rule that largely tracked the principles outlined in the 2010 guidance but added two additional requirements: (i) executive officers at covered institutions would be required to defer 50 percent of their incentive pay for at least three years and (ii) the board of directors would be required to identify and approve incentive pay for employees who individually have the capacity to expose the institution to risks that are substantial in relation to the institution’s size, capital or overall risk tolerance.  More than 10,000 comments were submitted on the 2011 proposed rule.

The 2016 Re-Proposed Proposed Rule

The 2016 proposed rule, which has now been reproposed, includes the following:

  • “Covered institutions” are classified into three tiers: Level I (greater than or equal to $250 billion); Level II (greater than or equal to $50 billion but less than $250 billion) and Level III (greater than or equal to $1 billion but less than $50 billion).Covered institutions that are subsidiaries of other covered institutions would be subject to the requirements applicable to the parent institution. As a general matter, the level of regulation under the rule is dependent on the institution’s placement under the classification scheme.
  • “Covered persons” under the rule include any executive officer, employee, director or principal shareholder who receives incentive-based compensation at a covered institution.
  • All covered institutions are subject to a general prohibition on incentive pay arrangements that encourage inappropriate risk by providing excessive compensation or that could lead to a material financial loss.
  • For purposes of the rule, incentive compensation is considered “excessive” when the amounts paid are unreasonable or excessive relative to the services provided by the covered person. The rule outlines six factors to be considered when assessing whether compensation is excessive including (i) the covered person’s total compensation; (ii) the compensation history of the covered person as compared to other individuals with comparable expertise at the institution; (iii) the institution’s financial condition; (iv) compensation practices at comparable institutions (based on peer group factors such as assets size, geographic location and business operations); (v) the projected total cost of any post-employment benefits; (vi) any connection between the covered person and any fraud, fiduciary breach or insider abuse at the institution.
  • The rule requires covered institutions to create and maintain for at least seven years records that document the structure of their incentive compensation programs and demonstrate compliance with the rule. Such records must be available for inspection by examiners upon request.
  • Level I and Level II institutions are subject to additional requirements, particularly with respect to “senior executive officers” and “significant risk takers” who receive incentive pay.
  • “Senior executive officers” include a covered institution’s president, chief executive officer, executive chair, chief operating officer, chief financial officer, chief compliance officer, chief audit executive, chief credit officer, or the head of a major business line or control function.
  • “Significant risk takers” include an employee who satisfies either of the following tests: (i) a covered person (other than senior executive officers) who are among the institution’s top 5 percent (for Level I institutions) or top 2 percent (for Level II institutions) highest compensated persons in the consolidated organization or (ii) a covered person who has the authority to commit or expose 0.5 percent of the capital of the covered institution or the an affiliate that is a covered institution.
  • Senior executive officers and significant risk takers would be required to defer up to 60 percent of their incentive compensation depending on the size of the institution and the identity of the recipient. The size of the deferral is generally dependent on whether the compensation is short- or long-term.
  • Level I and II institutions would be required to consider forfeiture or downward adjustment of incentive pay in the event of (i) poor financial performance due to a deviation from risk guidelines; (ii) inappropriate risk taking; (iii) material risk management or control failures; (iv) statutory, regulatory or supervisory noncompliance that results in enforcement or legal action; and (v) other poor performance of misconduct.
  • Incentive pay programs at Level I and II institutions would be required to include claw back provisions for senior executive officers or significant risk takers that provide for a minimum seven-year period in which incentive compensation can be recovered if the individual engaged in misconduct that results in significant financial or reputational harm to the covered institution, fraud, or intentional misrepresentation of information used to determine the individual’s incentive pay.
  • The rules include a series of separate prohibitions applicable to Level I and Level II institutions, including the following:
  • For individuals subject to the mandatory deferral requirement, stock options counted towards the deferral requirement cannot exceed 15 percent of the total incentive compensation awarded for the performance period.
  • Level I and II institutions cannot purchase hedging instruments for covered persons to mitigate their risk of loss if the value of their incentive pay declines over the deferral period.
  • A senior executive officer at a Level I or II institution cannot be awarded incentive pay in excess of 125% of the target amount under the applicable incentive plan. The limit increases to 150% of target for a significant risk taker.
  • Level I and II institutions would be barred from using “relative” performance measures that are based on industry peer performance.
  • Level I and II institutions cannot provide incentive compensation to a covered person based solely on transaction revenue or volume without taking into account transaction quality or compliance with sound risk management.

Suggested Alternatives to the 2016 Proposed Rule

Perhaps in recognition of the significant passage of time since the proposed regulations were first issued, the regulators are seeking comment on possible alternatives to specific sections of the rule:

  • Should the compliance timeline be reduced to 365 days rather than 540 days after issuance of a final rule?
  • Should the asset classification thresholds be reduced from three to two? This change would subject all institutions with $50 billion in assets or more on a consolidated basis to all of the requirements applicable under the proposed rule to an institution with $250 billion or more in assets.
  • Should the definition of “significant risk taker” be modified to provide for identification by the institution? This alternative would require a minimum classification as significant risk takers at a Level I and II of the top two percent of covered employees (other than senior executive officers) by compensation (base salary plus incentive pay). Covered institutions would be required to submit their identification methodology to the regulators. Covered institutions would also be allowed to exclude certain roles or functions, but the regulators would be permitted to include certain roles or functions
  • Should performance measures and targets be set prior to the performance period?
  • Should the limit on stock options as a percentage of total incentive pay be reduced from 15 to 10 percent?
  • Should Level I and II institutions be limited in their discretion to seek or recover incentive compensation through forfeiture or downward adjust of awards? The proposed rule currently provides that these actions should be considered but are not required. A similar alternative is offered for claw backs of vested incentive pay from former or current senior executive officers or significant risk takers.
  • Should Level I and II institutions be required to obtain a risk management and controls assessment from the institution’s independent risk and control functions when setting incentive compensation for senior executive officers and significant risk takers.

What’s Next?

            The fact that only three regulatory bodies signed on to the decision to re-propose the2016 incentive pay rules suggests a lack of consensus among all interested regulators.  It is unclear whether the FRB and the SEC will ultimately align with a rule that imposes detailed requirements on bank incentive pay in the absence of a compelling case that additional regulation is necessary to avoid a repetition of the 2023 bank failures.  In recent congressional testimony, Federal Reserve Chairman Jerome Powell referred to incentive compensation practices as a “tertiary factor” among the reasons why these banks failed.  At the same hearing, Powell stated “I would like to understand the problem we’re solving, and then I would like to see a proposal that addresses that problem.”  SEC Chairman Gary Gensler has previously hinted at his desire to see the bank regulators take the first step on the incentive pay rules.  Efforts to finalize the incentive compensation regulations are likely to move slowly as the regulators, including those that did not join in the re-proposal of the 2016 rules, digest what are likely to be extensive public comments.  A final rule is unlikely to appear this year and further debate among the regulators could result in additional delay.  For now, banks should maintain an incentive pay program that aligns with the 2010 joint agency guidance which, for now, is likely to continue as a roadmap for examiner review of the structure and governance of such programs.


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