Section 956 requires joint implementation by all of the appropriate Federal regulators. While the National Credit Union Administration (NCUA) has stated that it expects to take action on the Proposed Rule in the near future, and the rulemaking is currently on the Securities and Exchange Commission’s (SEC) rulemaking agenda,[3] the Board of Governors of the Federal Reserve System (FRB) has not, to date, indicated its intention to adopt the Proposed Rule. In the absence of joint action by all six of the appropriate Federal regulators, the proposal will not yet be published in the Federal Register to commence a formal comment period. Instead, the OCC, FDIC, FHFA and NCUA are currently making the Proposed Rule available on their respective websites for informal comment by the public.
Covered financial institutions and tiered applicability
The Proposed Rule would apply to any of the following types of “covered institutions” (CIs) with $1 billion or more in assets:
- Depository institutions and depository institution holding companies (as defined in Section 3 of the Federal Deposit Insurance Act);
- SEC-registered broker-dealers;
- Credit unions (as described in Section 19 of the Federal Reserve Act);
- Investment advisers (as defined in Section 202 of the Investment Advisers Act of 1940);
- Fannie Mae and Freddie Mac; and
- Federal Home Loan Banks.[4]
The Proposed Rule further stratifies CIs into three levels based on average total consolidated assets:
- Level 1: $250 billion or more;
- Level 2: $50 billion to less than $250 billion; and
- Level 3: $1 billion to less than $50 billion.
Under the Proposed Rule, Level 1 and Level 2 CIs would be subject to more rigorous requirements. The appropriate Federal regulators can also exercise discretion on a case-by-case basis to apply to a Level 3 CI some or all of the requirements applicable to Level 1 and Level 2 CIs, provided that the appropriate Federal regulators determine that the Level 3 CI’s complexity of operations or compensation practices are consistent with those of a Level 1 or Level 2 CI.
The Proposed Rule would require the board of directors of each CI to (1) conduct oversight of the CI’s incentive-based compensation program; (2) approve incentive-based compensation arrangements for “senior executive officers,”[5] including the amounts of all awards and, at the time of vesting, payouts under such arrangements; and (3) approve any material exceptions or adjustments to incentive-based compensation policies or arrangements for senior executive officers.
Key prohibitions and requirements
The Proposed Rule would prohibit CIs from establishing or maintaining incentive-based compensation arrangements for “covered persons”[6] that either (1) provide excessive compensation, fees or benefits,[7] or (2) could lead to material financial loss to the CI. The Proposed Rule would also impose certain additional rigorous requirements for Level 1 and Level 2 CIs, including the following:
- Disclosure and Recordkeeping: Requirement to create annually and maintain for at least seven years comprehensive records of the CI’s incentive-based compensation arrangements for certain covered persons and disclose these records to the appropriate Federal regulator from time to time.
- Deferral, Forfeiture, Downward Adjustment, Clawback: Requirement to incorporate risk-mitigating features into incentive-based compensation arrangements for certain covered persons, including: (1) required deferral periods to receive payment; (2) potential forfeiture of unvested deferred compensation; (3) potential downward adjustment of all incentive-based compensation; and (4) clawback provisions for vested compensation if the covered person engaged in misconduct resulting in financial or reputational harm to the CI.
- Additional Prohibitions: Prohibitions on: (1) purchasing hedging instruments on behalf of covered persons to hedge or offset any decrease in the value of the covered person’s incentive-based compensation; (2) awarding incentive-based compensation to certain covered persons in excess of 125% (or 150% in some cases) of the target amount for such compensation; (3) using performance measures based solely on industry peer performance comparisons; and (4) providing incentive-based compensation based solely on transaction revenue or volume.
- Risk Management; Policies and Procedures: Requirement to implement an appropriate risk management framework for incentive-based compensation programs that: (1) is independent of any lines of business; (2) includes an independent compliance program providing for internal controls, testing, monitoring and training with written policies and procedures; and (3) is commensurate with the size and complexity of the financial institution’s operations. CIs would also be required to adopt a number of other risk management controls, policies and procedures consistent with decreasing risk across incentive-based compensation plans and programs.
- Governance: Requirement to establish a compensation committee composed solely of directors who are not senior executive officers that obtains input from risk and audit committees of the CI’s board of directors. Management and the CI’s internal audit or risk management functions would also each be required, on an annual or more frequent basis, to submit an independent written assessment to the compensation committee on the effectiveness of the CI’s incentive-based compensation program and related risk measures and compliance and control processes.
Our take
We note that some commentators have suggested that the agencies have jointly issued the Proposed Rule in an attempt to apply pressure on the FRB to take action.[8] Proponents of the Proposed Rule are not as concerned with spurring action by the SEC, since implementation of Section 956 is on the SEC’s Fall 2023 rulemaking agenda.
The Proposed Rule, if adopted by each of the relevant Federal agencies, will require CIs to conduct a thorough review of how they approach executive and employee incentive compensation. CIs will need to ensure that their incentive-based compensation arrangements are compliant with the Proposed Rule and effectively discourage behaviors that could lead to excessive risk-taking. Program restructuring may be needed, but in light of the additional oversight of regulators and change in compensation design best practices since the adoption of the Dodd-Frank Act in 2010, many CIs may find that their existing programs are compliant or near compliant with the framework of the Proposed Rule. CIs are advised to monitor developments under the Proposed Rule at this time and be prepared to assess their current incentive-based compensation plans, programs and recordkeeping in anticipation of these changes.
An opportunity to harmonize across jurisdictions
One of the regulatory aims of the Proposed Rule in 2016 was to promote consistency of compensation requirements for financial institutions operating internationally.
The Proposed Rule would align the US regime more closely with European rules on bankers’ remuneration. For over a decade, EU- and UK-regulated financial institutions have applied conditions such as deferral, “malus” (the adjustment or forfeiture of unvested awards) and clawback, to restrict the variable compensation of key staff (or “material risk takers”), as well as enhanced governance and disclosure requirements. That said, the European regime would still be stricter than the Proposed Rule in many areas. For example, the Proposed Rule would not require a minimum equity-based component of incentive compensation, whereas for EU and UK “material risk takers,” this must be at least 50% of variable pay. Moreover, the cap on incentive-compensation payouts at 125% of target amounts is not as limiting as the 1:1 (or 2:1 with shareholder approval) variable to fixed pay cap that EU institutions must apply on incentive awards, which the UK lifted on October 31, 2023.
In light of these developments, many banks may find it desirable to review and harmonize their pay practices for staff internationally.
[1] Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation, Federal Housing Finance Agency and National Credit Union Administration, Notice of Proposed Rulemaking, Incentive-Based Compensation Arrangements (May 6, 2024).
[2] For purposes of Section 956 and its implementation, and as used in this client alert, the term “appropriate Federal regulator” means the Board of Governors of the Federal Reserve System, the OCC, the FDIC, the FHFA, the Securities and Exchange Commission and the National Credit Union Administration.
[3] U.S. Office of Information and Regulatory Affairs, Securities and Exchange Commission – Agency Rule List – Fall 2023, located at https://www.reginfo.gov/public/do/eAgendaMain?operation=OPERATION_GET_AGENCY_RULE_LIST¤tPub=true&agencyCode&showStage=active&agencyCd=3235.
[4] Section 956 also applies to “any other financial institution that the appropriate Federal regulators, jointly, by rule,
determine should be treated as a covered financial institution for purposes of this section.” See Section 956(e)(2)(G).
[5] The Proposed Rule defines a “senior executive officer” to mean “a covered person who holds the title or, without regard to title, salary, or compensation, performs the function of one or more of the following positions at a covered institution for any period of time in the relevant performance period: 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, or head of a major business line or control function.”
[6] The Proposed Rule defines a “covered person” to mean “any executive officer, employee, director, or principal shareholder who receives incentive-based compensation at a covered institution.”
[7] Compensation, fees, and benefits are considered “excessive” for purposes of Section 956 when amounts paid are unreasonable or disproportionate to the value of the services performed by a covered person, taking into consideration all relevant factors, including, but not limited to: (1) the combined value of all compensation, fees, or benefits provided to the covered person; (2) the compensation history of the covered person and other individuals with comparable expertise at the CI; (3) the financial condition of the CI; compensation practices at comparable institutions; (4) the projected total cost and benefit to the CI for post-employment benefits; and (6) any connection between the covered person and any fraudulent act or omission, breach of trust or fiduciary duty, or insider abuse with regard to the CI.
[8] See E. Weinberger, Fed Faces Heat From Fellow Regulators on Banker Bonus Proposal, BLOOMBERG LAW (May 8, 2024), located at https://news.bloomberglaw.com/banking-law/fed-faces-heat-from-fellow-regulators-on-banker-bonus-proposal.
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