Six U.S. federal financial regulatory agencies in May 2016 revised and re-proposed rules that were originally proposed in 2011, to govern the incentive compensation practices at financial institutions with consolidated assets of at least $1 billion (covered institutions). The proposed rules include new – and more stringent – requirements, especially for the largest institutions. The rules will impact the compensation practices at a wide variety of financial institutions, including banks, broker-dealers and investment advisers, as well as the U.S. operations of foreign banking organizations.
The timeliness of the proposed rules is underscored by the recent enforcement action by the Consumer Financial Protection Bureau and the Comptroller of the Currency against Wells Fargo involving the creation of unauthorized deposit and credit card accounts of customers. The incentive compensation practices of Wells Fargo have been spotlighted as a key factor in encouraging employees to engage in these practices and are at the heart of additional government inquiries into the matter. In testimony before the Senate Banking Committee on September 20, Comptroller of the Currency Thomas Curry urged adoption of the proposed incentive compensation rules as a step that can be taken to address unacceptable sales practices of the type that occurred at Wells Fargo.
The proposed rules would govern the incentive-based compensation practices of covered institutions with respect to executive officers, employees, directors and principal shareholders (covered persons) – with progressively more rigorous and prescriptive requirements applying to “senior executive officers” and “significant risk-takers” at the largest institutions. As a general matter, the Agencies have found that incentive-based compensation programs may encourage inappropriate risk-taking at covered institutions if such entities do not sufficiently expose covered persons to the consequences of their risk decisions over time.
What compensation would be “incentive-based?” Under the proposed rules, “incentive-based compensation” would include any variable compensation, fees, or benefits that serve as an incentive or reward for performance, whether in the form of cash or non-cash payments. This definition does not include compensation that is paid “for reasons other than to induce performance,” such as signing bonuses, compensation for continued employment, compensation related to the achievement of professional certifications, and dividends paid or appreciation realized on stock owned outright by an employee.
Which institutions would be “covered institutions?” As a general matter, covered institutions would include following entities but only if they have greater than $1 billion in average total consolidated assets on their balance sheet: (i) all FDIC-insured banks and bank holding companies, (ii) the U.S. operations of foreign banks, including U.S. branches and agencies, (iii) credit unions, (iv) Fannie Mae, Freddie Mac and the Federal Home Loan Banks and (v) investment advisers and registered broker-dealers.
How would the proposed rules distinguish between different sizes of covered institutions? The proposed rules would distinguish between smaller and larger institutions based on their asset size. Specifically, the proposed rules would divide institutions into three asset levels as follows:
|Average total consolidated asset amounts|
|Level 1||$250 billion or more|
|Level 2||At least $50 billion and less than $250 billion|
|Level 3||At least $1 billion and less than $50 billion|
Many of the more detailed and rigorous requirements under the proposed rules would be reserved for larger institutions that fit within Level 1 or Level 2, including mandatory deferral, forfeiture and clawback requirements, as described in further detail below.
While the proposed rules would not apply to institutions with assets of less than $1 billion, over time the rules are likely to become viewed by the Agencies as “best practices” and, as often happens with size-based regulation, eventually may be applied on a de facto basis to smaller, community institutions.
Basic Prohibitions Applicable to All Covered Institutions
The proposed rules would prohibit any covered institution from establishing or maintaining incentive-based compensation arrangements (arrangements) that encourage inappropriate risks at the covered institution (i) by providing a covered person with “excessive” compensation or (ii) that could lead to “material financial loss” at the institution.
When is compensation “excessive?” An arrangement would be considered excessive when amounts paid are unreasonable or disproportionate to the value of the covered person’s services, taking into consideration all relevant factors, including, but not limited to:
- The combined value of all compensation, fees or benefits provided to the covered person;
- The compensation history of the covered person and other individuals with comparable expertise at the covered institution;
- The financial condition of the covered institution;
- The compensation practices at comparable institutions;
- For post-employment benefits, the projected total cost and benefits to the covered institution; and
- 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 covered institution.
What arrangements could lead to “material financial loss?” An arrangement would be deemed to encourage inappropriate risks that could lead to material financial loss at the covered institution unless the arrangement: (i) appropriately balances risk and reward; (ii) is compatible with effective risk management and internal controls; and (iii) is supported by effective corporate governance by the institution’s board of directors (board).
Balancing risk and reward in the arrangement. An arrangement achieves balance between risk and financial reward when the amount of incentive-based compensation ultimately received by a covered person depends not only on his or her performance, but also on the risks taken in achieving that performance. For example, an arrangement that determined compensation amounts based upon performance measures that are closely tied to short-term revenue or profit generated by a covered person, without any adjustment for the longer-term risks associated with obtaining such revenue or profit, would impermissibly encourage inappropriate risks that could lead to material financial loss. The proposed rules would require a properly structured arrangement to: (i) include financial and non-financial measures of performance, including considerations of risk-taking; (ii) allow non-financial measures of performance to override financial measures when appropriate; and (iii) allow downward-adjustment of any amounts awarded to reflect actual losses, inappropriate risks taken, compliance deficiencies or other measures or aspects of performance.
Additional Requirements Applicable to Level 1 and Level 2 Covered Institutions
The proposed rules would require arrangements for senior executive officers and significant risk-takers at Level 1 and Level 2 covered institutions to include: (i) deferral; (ii) downward adjustment and forfeiture; and (ii) clawback features with respect to any incentive-based compensation amounts.
Deferral features. Under the proposed rules, a portion of the incentive-based compensation to senior executive officers and significant risk-takers must be deferred for a period of time after the relevant performance period. Level 1 covered institutions would be required to defer a greater amount of incentive-based compensation for a longer period than Level 2 covered institutions, reflecting the view of the Agencies that arrangements of the largest organizations generally present the greatest risks to the financial system.
Downward adjustment and forfeiture features. The proposed rules would require that all deferred incentive-based compensation to senior executive officers and significant risk-takers at Level 1 or Level 2 covered institutions be susceptible to reviews for (i) downward adjustment during an arrangement’s performance period prior to an award being made and (ii) forfeiture of an unvested amount during its deferral period. An institution would be required to consider reducing some or all of a senior executive officer’s or significant risk-taker’s un-awarded and unvested deferred incentive-based compensation upon the occurrence of certain adverse events affecting the institution.
Clawback features. The proposed rules would require that all vested incentive-based compensation to senior executive officers and significant risk-takers at Level 1 or Level 2 covered institutions be susceptible to clawback for a period of no less than seven years following the date on which such compensation vests, regardless of whether the senior executive officer or significant risk-taker remains an employee at the institution. In order to exercise clawback of vested compensation, the institution would need to determine that the senior executive officer or significant risk-taker engaged in: (i) misconduct resulting in significant financial or reputational harm to the institution (whether in the eyes of customers, shareholders, creditors or even the general public); (ii) fraud; or (iii) intentional misrepresentation of information involved in determining the senior executive officer’s or significant risk-taker’s incentive-based compensation.
Proposed Compliance Date
If adopted, the proposed rules would have a compliance date of the first calendar quarter that begins at least 540 days after the final rules are published in the Federal Register. Thus, if the final rules were published on December 1, 2016, covered institutions would be required to begin complying with them on July 1, 2018.
The proposed rules are designed to ensure that the interests of employees who receive incentive-based compensation at a financial institution are aligned with the longer-term health of the institution. Poorly designed incentive compensation plans that rewarded employees solely for meeting certain performance or sales targets without taking into consideration the risks to the institution have been cited as one of the principal factors contributing to the financial crisis. The CFPB’s recent enforcement action against Wells Fargo will only intensify regulators’ scrutiny of compensation practices at financial institutions and likely will lead to vigorous enforcement of the new rule.
Mr. Ansell is a partner in Dechert LLP’s Financial Services Group. He specializes in bank regulation and is based in Washington, DC. This article was based on a legal update originally published by Dechert’s Financial Services Group.
 The agencies are: the Federal Deposit Insurance Corporation (FDIC); Federal Housing Finance Agency; Board of Governors of the Federal Reserve System (FRB); National Credit Union Administration; Office of the Comptroller of the Currency (OCC); and the Securities and Exchange Commission (SEC) (collectively, Agencies).