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by Alison Stemler *
One of the main purposes of the Dodd-Frank Act is to promote financial stability in the US economy, including through a significant number of provisions relating to financial institutions. [Incentive-Based Compensation Arrangements, 81 Fed. Reg. 37669 (proposed June 10, 2016) (to be codified at 12 C.F.R. pt. 1232, 12 C.F.R. pt. 236, 12 C.F.R. pt. 372, 12 C.F.R. pt. 42, 12 C.F.R. pt. 741, 17 C.F.R. pt. 240, 17 C.F.R. pt. 275, 17 C.F.R. pt. 303).] Among these, the Dodd-Frank Act imposes restrictions and controls on incentive-based compensation for senior executive officers, certain other individuals, and directors of financial institutions, intended to address the concern that officers and directors may be incentivized to make excessively risky investments to increase their own compensation. Rules proposed in 2016 will, once they are finalized, require covered institutions' incentive compensation arrangements with covered persons to be structured to avoid excessive risk and to contain terms for deferral of a portion of the compensation and required executive repayment to the employer (a "clawback") in the event of certain excessive risk or misconduct by the executive.
Section 956 of the Dodd-Frank Act requires several federal agencies to promulgate regulations to address incentive-based compensation structures in financial institutions. In May 2016, six federal regulatory agencies issued a proposed rule (the "2016 Proposed Rule") relating to incentive-based compensation arrangements in financial institutions. The agencies are the Office of the Comptroller of the Currency ("OCC"), Federal Reserve System ("Federal Reserve"), Federal Deposit Insurance Corporation ("FDIC"), Federal Housing Finance Agency ("FHFA"), National Credit Union Administration ("NCUA"), and U.S. Securities and Exchange Commission ("SEC"). The 2016 Proposed Rule replaces a similar proposed rule issued in 2011, and would become effective no later than the beginning of the first calendar quarter beginning at least 540 days after the publication of the final rule in the Federal Register.
Covered Institutions for Purposes of Incentive Compensation Rules
The 2016 Proposed Rule has several major components, including a prohibition on certain incentive-based compensation arrangements, requirement of oversight of incentive-based compensation arrangements by boards of directors, and recordkeeping requirements. The 2016 Proposed Rule applies to "covered institutions," which definition is specific to the applicable agency.
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Covered Persons for Purposes of Incentive Compensation Rules
The 2016 Proposed Rule applies to a covered institution's arrangements with "covered persons," which include directors, executive officers, principal shareholders, significant risk-takers… , and employees who receive incentive-based compensation from a covered institution…
Prohibition on Excessive Compensation
The 2016 Proposed Rule prohibits incentive-based compensation arrangements that encourage inappropriate risk through payment of excessive compensation, fees, or benefits. "Incentive-based compensation" is defined as any variable compensation, fees or benefits that serve as an incentive or reward for performance (regardless of the form of payment)…
Mandatory Deferral of Incentive Compensation
Level One and Two covered institutions must defer the vesting of certain portions of senior executive officer or significant risk-taker incentive-based compensation. The minimum amount that must be deferred for Level One covered institutions is 60% of incentive-based compensation for senior executive officers, and 50% for significant risk-takers. In both cases, the amount is deferred for four years or two years, depending on the nature of the incentive plan…
Forfeiture or Downward Adjustment Following Adverse Outcomes
Level One and Two covered institutions must consider forfeiture or downward adjustment for deferred, unvested incentive-based compensation to senior executive officers or significant risk-takers. Forfeiture and downward adjustment considerations are required in the event of an adverse outcome or event...
Required Clawback Terms
Level One and Two covered institutions must also include clawback provisions in their incentive-based compensation arrangements with senior executive officers and significant risk-takers…
Prohibition on Policies that Could Lead to a Material Financial Loss
Incentive-based compensation arrangements must appropriately balance risk and reward, be compatible with effective risk management and controls, and be supported by effective governance…
Prohibitions on Incentive-Based Compensation Practices
Prohibitions on certain practices and compensation structures will require significant changes to compensation programs for many employees…
Required Director Oversight
The 2016 Proposed Rule requires a covered institution's board of directors or committee of the board to oversee all incentive-based compensation programs, and to approve incentive-based compensation arrangements for senior executive officers (including amounts, time of vesting, and payouts), and material exceptions or adjustments to incentive-based arrangements for senior executive officers…
Required Risk Management Practices and Controls
Level One and Two covered institutions must have a risk management framework for incentive-based compensation programs that is independent of the business. This risk management framework must include an independent compliance program that provides for internal controls, testing, monitoring and training…
Recordkeeping Requirements
Covered institutions must keep records of the structure of all incentive-based compensation arrangements, and compliance with the 2016 Proposed Rule. These records must be kept for at least seven years, and the covered institution must produce them upon the request of an agency…
Alison M. Stemler, J.D. is a member of the Kentucky Bar.
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