The Third Attempt at Section 956 Incentive Compensation Rules
Another step in a strange process
Today the Federal Deposit Insurance Corporation, Federal Housing Finance Agency, and Office of the Comptroller of the Currency issued proposed rules to implement the requirements of Section 956 of the Dodd-Frank Act. The National Credit Union Administration expects to vote to take similar action in the near future.
Section 956 requires those four agencies, as well as the Federal Reserve Board and Securities and Exchange Commission, to “jointly prescribe regulations or guidelines” prohibiting types or features of incentive-based compensation arrangements that “encourage[] inappropriate risks” (1) by providing excessive compensation, fees or benefits or (2) that could lead to material financial loss.1
Dodd-Frank required a Section 956 rulemaking “not later than 9 months” after the date of the law’s enactment, but like certain other provisions of Dodd-Frank the agencies have yet to adopt final rules in satisfaction of this statutory requirement.2
The agencies first proposed a rule to implement Section 956 in 2011. After reviewing the “more than 10,000” comments received3 and other executive-compensation related developments in the United States and internationally, the agencies determined that the rule ought to be revised and re-proposed. They did so in 2016, but due to a change in administration and other factors, the 2016 Proposal was never finalized. (There was reportedly an effort in 2019 to get a revised rule done before the 2020 election, but that effort ultimately came to nothing.)
The FDIC, FHFA, and OCC (and soon NCUA) are now seeking to try again.
Differences Since 2016
For Now, No Changes to the Regulatory Text
In the spirit of transparency, the original plan for this post was to do a comparison between the 2016 proposal and this new 2024 proposal. But as it turns out:
The Agencies are re-proposing the regulatory text of the 2016 Proposed Rule without change. . .
“Alternatives” Proposed for Consideration
Though not actually making any changes to the proposed rule from 2016, the agencies have also included in the preamble, “certain alternatives, for consideration by the public.” Those alternatives are discussed in the next section of this post.
It is not totally unusual for a proposed rule to take an approach which proposes specific regulatory text and then includes in the preamble a discussion of alternatives to that regulatory text— indeed, the 2016 proposal itself did so. Here, though, one gets the sense from some of the statements released today by agency principals that they regard these “alternatives” as something more than that, and in many cases likely preferable to what is currently in the rule.
Most notable, I thought, was this statement by Acting Comptroller Hsu,4 who called the 2016 proposal “a natural place to start” but also observed that the financial system has “changed significantly” since 2016 and that interagency discussions and supervisory experience “have highlighted modifications to the 2016 NPR that would help us fulfill our statutory mandate more effectively.”
Acting Comptroller Hsu’s statement went on to say that “some” of these modifications are discussed in the preamble to today’s proposal. The statement did not elaborate on what these other modifications are or why they did not make into the discussion in the preamble.
The Federal Reserve Board and the SEC
Of course, even though the rule text is the same (with alternatives) there is at least one big difference from 2016. The 2016 proposal was eventually joined by all six agencies; today’s will for now be joined only by four, with neither the Federal Reserve Board or SEC participating.
The release includes not-so-subtle differences in how it describes each of the non-participating agencies.
According to the preamble to the proposal, “[r]ulemaking to implement section 956 is on the SEC’s rulemaking agenda.” This is consistent with what the Wall Street Journal reported last month: the SEC intends to get involved, but first must update the economic analysis that is required of the SEC in certain rulemakings, including this one, but that is not required of the other agencies responsible for section 956.
As for the Federal Reserve, the preamble to the proposal notes only that “the Board has not acted to join this proposal.” A spokesperson for the Board was summarized by Reuters today as saying, consistent with past statements from the Board’s Public Affairs office, that the Board is committed to working with regulators on a joint rule, but wants the rule to be considered based on updated information reflecting current industry practices.
Of course, the Board is made up of individuals and, as that Reuters story also notes, in March Chair Powell expressed his own concern a little differently, saying “I would like to understand the problem we're solving, and then I would like to see a proposal that addresses that problem.”
It is not clear how other members of the Board of Governors, particularly Vice Chair for Supervision Barr, feel about this development.
A few months ago this blog wrote about how, despite accusations to the contrary, I thought Chair Powell’s approach to regulatory matters had been pretty consistent with what he previously told Congress and the public his approach would be. Obviously, that post holds up rather poorly now if it is the case, as some are maintaining, that Vice Chair for Supervision Barr wanted the Board to join this rulemaking, but Chair Powell blocked him from bringing the matter to the Board for a vote.
Is that actually what happened? I am not so sure, but maybe we will find out more next week when the prudential regulators make their semi-annual appearances before the House Financial Services and Senate Banking committees.
Summary of Proposed Rules and “Alternatives” for Consideration
This section of the post summarizes the 2016 (and now 2024) proposal, along with, where applicable, notable alternatives discussed by the agencies in the preamble to today’s release.
1. Covered Financial Institutions
Section 956 applies to “covered financial institutions” with assets of at least $1 billion.
Covered financial institutions are defined in the statute as (a) insured depository institutions, (b) depository institution holding companies, (c) broker-dealers, (d) credit unions, (e) investment advisors, (f) Fannie Mae, (g) Freddie Mac and (h) any other financial institution the agencies jointly determine by rule to be a covered financial institution.
In addition to those firms defined as covered financial institutions under Section 956, the agencies in the 2016 Proposal would have also exercised their authority to include additional firms as covered financial institutions. Firms included on this basis would have included, among others, the Federal Home Loan Banks and certain U.S. operations (including branches) of foreign banks doing business in the United States.
Alternatives Suggested in 2024 Preamble: None.
2. Tailored Applicability
Under the 2016 Proposal, covered financial institutions generally would have been divided into three tiers:
Level 3 institutions were those with total assets of at least $1 billion but less than $50 billion;
Level 2 institutions were those with total assets of at least $50 billion but less than $250 billion;
Level 1 institutions were those with $250 billion or more in total assets.
This was different from the 2011 version of the proposal, which divided covered financial institutions into only two tiers, and set the threshold between the two tiers at $50 billion.
In the preamble to the 2016 Proposal the agencies explained their reasoning for this three-tiered approach as follows.
First, the agencies noted that firms with $50 billion in total assets tend to be “significantly more complex” than those firms with less than $50 billion in total assets and that setting the bar at $50 billion would be consistent with Section 165 of Dodd-Frank.
Second, the agencies explained the inclusion of the new third tier by saying that “covered institutions with assets of $250 billion or more tend to be significantly more complex and thus exposed to a higher level of risk than those with assets of less than $250 billion.”
One notable exception to the thresholds set above: under FHFA’s version of the 2016 Proposal, all Federal Home Loan Banks would have been classified as Level 2 institutions, regardless of asset size. FHFA argued that “asset size is not a meaningful indicator of risk” for FHLBs and that because each FHLB generally “operate[s] in a similar enough manner” to other FHLBs, “treating them differently based on asset size is not justifiable.”
Alternatives Suggested in 2024 Preamble: The agencies ask whether a two-tier approach like the one included in the 2011 proposal would be better after all, and whether the dividing line, as in 2011, should be set at $50 billion dollars. The agencies also ask if there are “other asset thresholds that would be appropriate to differentiate between levels in a two-level structure.”
The agencies are kind of in an interesting place here because neither the 2016 proposal nor the 2011 proposal are completely consistent with either the currently disfavored post-EGRRCPA approach to tailoring or the approach reflected in more recent regulatory proposals which would generally apply mostly equivalent requirements to all firms with $100 billion or more in total assets.
3. For Most Banks, Requirements Based on Consolidated Assets of Parent Company
The 2016 Proposal was generally designed to apply to banking organizations such that if a covered financial institution was a subsidiary of a depository institution holding company subject to the rules, the subsidiary would have been required to comply with the same rules applicable to the parent company.
For example, if a bank holding company was subject to Level 1 requirements, its subsidiary bank (or broker-dealer or investment adviser) that is a covered institution would have been subject to the same Level 1 requirements as the parent bank holding company, even if the subsidiary on its own would be below the Level 1 threshold.
For other companies not affiliated with depository institution holding companies, however, the approach varied. Under the SEC’s version of the 2016 Proposal, for example, a broker-dealer that was not owned by a depository institution holding company would determine its Level based only on its total assets, without looking to the consolidated assets of its parent company (if any).
Alternatives Suggested in 2024 Preamble: None, although the agencies acknowledge that the fact that neither the Federal Reserve Board nor the SEC are currently a party to the proposal does make things awkward:
This proposal continues to include the provisions of the regulatory text from the 2016 Proposed Rule that address covered institutions on a consolidated basis. The Agencies recognize that this may implicate Board-supervised entities – namely depository institution holding companies – and SEC-regulated entities, and the Agencies will continue to coordinate with the Board and the SEC on these and other issues, consistent with the requirements of section 956.
4. Rules Applicable to All Firms
Excessive Compensation
Under the 2016 Proposal, compensation, fees or benefits paid to a covered person5 under an incentive-based compensation arrangement6 would have been considered excessive, and thus prohibited, if the amounts paid were “unreasonable or disproportionate to the value of the services performed.”
In determining whether compensation would be unreasonable or disproportionate, covered institutions would have been required to take into consideration “all relevant factors,” including:
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;
for post-employment benefits, the projected total cost and benefit 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.
Alternatives Suggested in 2024 Preamble: None.
Material Financial Loss
The 2016 Proposal would have deemed an incentive-based compensation arrangement to encourage inappropriate risks that could lead to material financial loss, and thus made the compensation arrangement illegal, unless the arrangement (1) appropriately balanced risk and reward, (2) was compatible with effective risk management and controls and (3) was supported by effective governance.
The 2016 Proposal then set out three requirements an incentive-based compensation arrangement must satisfy to be regarded as appropriately balancing risk and reward:
the arrangement includes financial and non-financial measures of performance, including considerations of risk-taking, that are relevant to a covered person’s role within a covered institution and to the type of business in which the covered person is engaged and that are appropriately weighted to reflect risk-taking;
the arrangement is designed to allow non-financial measures of performance to override financial measures of performance when appropriate in determining incentive-based compensation;
any amounts to be awarded under the arrangement are subject to adjustment to reflect actual losses, inappropriate risks taken, compliance deficiencies, or other measures or aspects of financial and non-financial performance.
Alternatives Suggested in 2024 Preamble: None.
Board Oversight
The 2016 Proposal would have required a covered financial institution’s board of directors, or a committee thereof, to conduct oversight of the firm’s incentive-based compensation programs, approve compensation arrangements for senior executive officers (including amounts, of awards and payouts at time of vesting), and approve any material exceptions or adjustments to incentive-based compensation policies or arrangements for senior executive officers.
Alternatives Suggested in 2024 Preamble: None.
Recordkeeping and Disclosure
Covered financial institutions would have been required to maintain records for at least seven years, including copies of all incentive-based compensation plans, records of who participates in each plan, and a description of how the program is compatible with effective risk management and controls. Records would have been required to be disclosed to the institution’s regulator upon request. Consistent with Section 956, disclosures would not have needed to include disclosure of actual compensation amounts for any particular individual person.
Alternatives Suggested in 2024 Preamble: None.
5. Special Rules for Larger Firms
For Level 1 and Level 2 firms, the 2016 Proposal included several more requirements on top of the generally applicable rules discussed above.
While the generally applicable rules described above would apply to all incentive-based compensation arrangements with any covered employee, many of the enhanced Level 1 and Level 2 requirements would apply only to senior executive officers and significant risk takers.
Definition of Senior Executive Officer
Under the 2016 Proposal “senior executive officer” was defined as a person who “holds the title or, without regard to title, salary, or compensation, performs the function of” president, CEO, 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.7
Alternatives Suggested in 2024 Preamble: None, although the agencies do include the same question they included in 2016 as to whether major business line, though undefined in the rule, has a clear enough meaning, or whether instead the proposal should include more details, or perhaps incorporate by reference already existing definitions in other regulations.
Definition of Significant Risk Taker
To determine the persons at a covered financial institution who were “significant risk takers,” the 2016 Proposal would have established two tests.
First, under the “relative compensation test":
For a Level 1 firm, a significant risk taker would have been a covered person whose total annual base salary and incentive-based compensation for the previous calendar year (i) consisted of at least one-third incentive-based compensation and (ii) placed her among the highest 5 percent in annual base salary and incentive-based compensation among all covered persons (other than senior executive officers) at her institution (and its affiliates).
For a Level 2 firm, a significant risk taker would have been a covered person whose total annual base salary and incentive-based compensation for the previous calendar year (i) consisted of at least one-third incentive-based compensation and (ii) placed her among the highest 2 percent in annual base salary and incentive-based compensation among all covered persons (other than senior executive officers) at her institution (and its affiliates).
Second, under the “exposure test”:
For both Level 1 and Level 2 firms, a significant risk taker would also include a person with the power to commit or expose, over a calendar year, “0.5 percent or more of the common equity tier 1 capital, or in the case of a registered securities broker or dealer, 0.5 percent or more of the tentative net capital,” of the covered institution or one of its affiliates.
The preamble to the 2016 Proposal explained that the agencies would apply the exposure test to also reach and include as a significant risk taker each voting member of a committee with the authority to commit or expose the institution to risk in the above amounts.
Individuals who participate in committee meetings but do not have voting, veto or similar rights would not have been included as significant risk takers on this basis.
In addition to the relative compensation and exposure tests described above, the 2016 Proposal would have allowed the agencies (or firms themselves) to designate as a significant risk taker any person at a Level 1 or Level 2 firm (other than a senior executive officer) not covered by the above definitions if the individual in question had the “ability” to expose the institution to risks that could lead to material financial loss for the institution, relative to its size, capital or overall risk tolerance.
Alternatives Suggested in 2024 Preamble: The definition of significant risk taker was a major focus of commenters on the 2016 Proposal, and the preamble to today’s release includes a discussion of several alternatives.
One alternative would have firms themselves identify those covered persons at their institution (i) for which incentive compensation represents at least one-third of total annual base salary plus incentive compensation and (ii) that have the ability to expose the institution to material financial loss in relation to the firm’s size, capital or overall risk tolerance.
Firms would be required to provide regulators with a list of who has been designated along with a description of the methodology used in doing so.
Any determinations would be subject to the agencies’ authority to designate additional individuals as significant risk takers, even if not identified by the institution itself.
Another alternative would follow the approach described above, except that there would be minimum number of significant risk takers that each firm would need to designate.
The agencies suggest this minimum could be based on a relative compensation test like that included in the current proposal.
For example, a firm could be required to include as significant risk takers at least all those covered persons (other than senior executive officers) who are in the top 2 percent of all covered persons. (Or perhaps the top 5 percent for Level 1 firms and the top 2 percent for Level 2 firms, if the Level 1 vs. Level 2 distinction is maintained in the final rule.)
The agencies also say, without explaining further, that firms “would be allowed to exclude covered persons in particular roles or functions.”
Under this alternative, as under the one above, any determinations made by firms would be subject to the agencies’ authority to designate additional individuals as significant risk takers.
The final alternative noted by the agencies is to remove the exposure test, meaning that significant risk taker determinations would be based only on the relative compensation test in the 2016 Proposal.
In the 2016 Proposal, the agencies also spent a few paragraphs examining the pros and cons of a pure dollar threshold for significant risk taker designation. That alternative is not given any additional space in today’s release, other than to note in passing that some commenters supported it.
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With these definitions established, the 2016 Proposal provided that to meet the “appropriately balance risk and reward,” “compatible with effective risk management and controls,” and “effective governance” requirements that apply to all covered institutions under the rule, incentive-based compensation arrangements adopted by Level 1 or Level 2 firm must meet additional, more exacting standards.
A compensation arrangement that does not meet all the standards described below would be regarded as encouraging inappropriate risks that could lead to material financial loss, and thus would be prohibited.
Maximum Incentive-Based Compensation Opportunity
Under the 2016 Proposal:
A senior executive officer of a Level 1 or Level 2 firm could not be awarded incentive-based compensation in excess of 125 percent of the target amount for that incentive-based compensation.
A significant risk taker of a Level 1 or Level 2 firm could not be awarded incentive-based compensation in excess of 150 percent of the target amount for that incentive-based compensation.
In 2016 the agencies stressed that this was not a cap on total incentive-based compensation, noting that the 2016 Proposal does not include an explicit limit on target amounts and imposes “only a constraint on the percentage by which incentive-based compensation could exceed the target amount.”
Alternatives Suggested in 2024 Preamble: No specific alternatives. Like 2016, a question is included as to whether these limits should be set higher or lower, and if so, why.
Deferral of Qualifying Incentive-Based Compensation
Level 1 firms would be required to defer (a) at least 60 percent of a senior executive officer’s qualifying incentive-based compensation and (b) at least 50 percent of a significant risk taker’s qualifying incentive-based compensation. The required minimum length of deferral would be at least 4 years.
Level 2 firms would be required to defer (a) at least 50 percent of a senior executive officer’s qualifying incentive-based compensation and (b) at least 40 percent of a significant risk taker’s qualifying incentive-based compensation. The required minimum length of deferral would be at least 3 years.
For both Level 1 or Level 2 firms, vesting8 of deferred incentive-based compensation could not occur faster than on a pro rata basis beginning no earlier than the first anniversary of the end of the performance period for which the amounts were awarded. Vesting of amounts required to be deferred could not be accelerated except in the case of death or disability.
Alternatives Suggested in 2024 Preamble: The agencies ask, if the three-tier structure is removed and all institutions above $50 billion are subject to the same rules, whether it would be appropriate to take a “simplified” approach here as well by “using a single deferral percentage of 60 percent and deferral period of 4 years for both senior executive officers and significant risk-takers.”
Deferral of Incentive-Based Compensation Under a Long-Term Incentive Plan
Required deferral amounts of incentive-based compensation under a long-term incentive plan would have been subject to the same 60 percent/50 percent (for Level 1 firms) and 50 percent/40 percent (for Level 2 firms) deferral requirements as described above. Required minimum lengths of deferral periods would have been 2 years (for Level 1 firms) and 1 year (for Level 2 firms). The same restrictions on vesting and acceleration would have applied.
Alternatives Suggested in 2024 Preamble: As noted above, the agencies wonder whether an across-the-board 4-year, 60 percent deferral requirement would be better.
Composition of Deferred Compensation
For both Level 1 and Level 2 firms, deferred compensation awarded to senior executives and significant risk takers would have been required to include “substantial portions” of both deferred cash and equity-like instruments.
If a senior executive officer or significant risk taker received incentive-based compensation in the form of options, the total amount of options that would be allowed to be counted toward the minimum 60/50/40 percent (as applicable) deferral amounts described above would be limited to no more than 15 percent of total incentive-based compensation awarded for the performance period.
Alternatives Suggested in 2024 Preamble: The agencies ask whether a 10 percent, rather than 15 percent, limit on options “would more effectively mitigate concerns about the use of options in incentive-based compensation while still allowing sufficient flexibility for covered institutions to use options in an appropriate manner.”
Forfeiture and Downward Adjustment of Incentive-Based Compensation
Senior executive officers and significant risk takers of Level 1 and Level 2 institutions would have been required to (a) have at risk of forfeiture all unvested deferred incentive-based compensation and (b) have at risk of downward adjustment all incentive-based compensation amounts not yet awarded for the current performance period.
Events Triggering Forfeiture or Downward Adjustment
A Level 1 or Level 2 firm would have been required to monitor for the following events and consider forfeiture or downward adjustment when any of them occur:
Poor financial performance attributable to a significant deviation from the risk parameters set forth in the covered institution’s policies and procedures;
Inappropriate risk taking, regardless of the impact on financial performance;
Material risk management or control failures;
Non-compliance with statutory, regulatory, or supervisory standards that results in:
Enforcement or legal action against the covered institution brought by a federal or state regulator or agency; or
A requirement that the covered institution report a restatement of a financial statement to correct a material error; and
Other aspects of conduct or poor performance as defined by the covered institution.
Person(s) Whose Compensation is Subject to Forfeiture or Downward Adjustment
If a Level 1 or Level 2 firm determined that forfeiture or downward adjustment is appropriate, it would then have been required to determine which senior executive officers and significant risk takers would be forced to forfeit compensation or have their compensation adjusted downward.
In determining which persons should be subject to forfeiture or downward adjustment, a firm would have been required to analyze whether a senior executive officer or significant risk taker had “direct responsibility, or responsibility due to the senior executive officer’s or significant risk-taker’s role or position in the covered institution’s organizational structure, for the events” triggering the forfeiture or downward adjustment.
Degree of Forfeiture or Downward Adjustment
If a Level 1 or Level 2 firm determined that forfeiture or downward adjustment was appropriate, and if the firm determined that a given senior executive officer or significant risk taker should be subject to the forfeiture or downward adjustment in question, the firm would have been required to determine the degree of the forfeiture or downward adjustment after taking into consideration, “at a minimum,” the following factors:
The intent of the senior executive officer or significant risk-taker to operate outside the firm’s risk governance framework or to depart from the firm’s policies and procedures;
The senior executive officer or significant risk taker’s level of participation in, awareness of, and responsibility for, the events triggering the forfeiture or downward adjustment review;
Any actions that could have been taken by the senior executive officer or significant risk taker to prevent the event in question;
The financial and reputational impact of the events in question, both for the firm as a whole and for the relevant line or sub-line of business;
The causes of the event in question, including any decisions made by other individuals; and
Any other relevant information, including past behavior and past risk outcomes attributable to the senior executive officer or significant risk taker.
Alternatives Suggested in 2024 Preamble: The agencies are considering making it mandatory for an institution to cause the forfeiture or downward adjustment of incentive-based compensation after the occurrence of a triggering event described above, rather than framing this as something that an institution would merely need to consider, as the 2016 Proposal could be read to suggest.
Clawbacks
Level 1 and Level 2 firms would have been required to include provisions in incentive compensation arrangements for senior executive officers and significant risk takers allowing (but not requiring) institutions to clawback compensation for at least seven years post-vesting.
Compensation arrangements would have been required to allow for clawback in at least the following circumstances: (a) misconduct that resulted in significant financial or reputational harm to the firm; (b) fraud or (c) intentional misrepresentation of information used to determine the senior executive officer or significant risk-taker’s incentive-based compensation.
The agencies in the preamble to the 2016 Proposal described this clawback requirement as one that would “go beyond, but not conflict with” clawback provisions in compensation arrangements that are required by other laws, such as section 954 of the Dodd-Frank Act.
Alternatives Suggested in 2024 Preamble: The agencies ask whether clawbacks should be mandatory in the circumstances described above. The agencies say, if they were to adopt this alternative, they would include exceptions if a firm “can document that clawback is impracticable or an equivalent amount of incentive-based compensation has been impacted through forfeiture or downward adjustment.”
Hedging on Covered Person’s Behalf
A Level 1 or Level 2 firm would not be allowed to purchase on behalf of any covered person an instrument that would hedge or offset any decrease in the value of the covered person’s incentive-based compensation.
Alternatives Suggested in 2024 Preamble: In addition to prohibiting firms from hedging on their employees’ behalf, the agencies are contemplating prohibiting employees themselves from hedging their incentive-based compensation. This prohibition would be implemented by requiring firms to include in their contracts with covered employees a ban on personal hedging.
Relative Performance Measures
A Level 1 or Level 2 firm could not use incentive-based compensation performance measures for any covered person that are “based solely on” industry peer performance comparisons.
Alternatives Suggested in 2024 Preamble: None.
Volume-Based Compensation
A Level 1 or Level 2 firm could not provide incentive-based compensation to any covered person that is “based solely on” transaction revenue or volume, without regard to transaction quality or compliance with sound risk management.
Alternatives Suggested in 2024 Preamble: The agencies say that, since 2016, they have “observed that incentive-based compensation arrangements that are based in part on transaction revenue or volume may lead to inappropriate risk-taking that could lead to material financial loss, absent other factors designed to cause covered persons to be held accountable for the risks of their activities.”
The agencies, therefore, ask whether all incentive-based compensation that is based on transaction revenue or volume should be banned for Level 1 and Level 2 firms, even if the compensation in question is not “solely” based on such measures.
Risk Management Requirements
A Level 1 or Level 2 firm would have been required to…
Have independent risk management and compliance frameworks for its incentive-based compensation programs that are commensurate with the firm’s size and complexity.
Provide covered persons engaged in control functions with the “authority to influence” the risk-taking of the business areas they monitor.
Compensate covered persons in control functions in accordance with the achievement of performance objectives linked to their control function, and independent of the performance of the business area(s) they oversee.
Independently monitor all incentive-based compensation plans, events related to forfeiture and downward adjustment reviews, the results reached by those reviews, and compliance with policies and procedures.
Alternatives Suggested in 2024 Preamble: The agencies suggest adding a requirement that “a risk management and controls assessment from the independent risk and control functions be considered when setting incentive-based compensation for senior executive officers and significant risk-takers.”
Governance Requirements
A Level 1 or Level 2 firm’s incentive-based compensation arrangements would not have been considered to be supported by effective governance, and therefore would have been considered illegal, unless the institution:
Established a compensation committee composed solely of directors who are not senior executive officers;
Provided to the compensation committee at least annually the following reports assessing the effectiveness of the firm’s incentive-based compensation programs and related compliance and control processes:
a report prepared by the firm’s management with input from both the risk and audit committees of the board of directors and the firm’s risk management and audit functions; and
a report prepared by the firm’s risk management or internal audit function, developed independently of the firm’s management.
Alternatives Suggested in 2024 Preamble: None.
Policies and Procedures
Level 1 and Level 2 firms would have been required to maintain policies and procedures to implement the rules described above. For example, the policies and procedures would need to define the roles of employees, committees or groups authorized to make incentive-based compensation decisions, and would need to build out processes and more detailed criteria to be applied in carrying out the forfeiture and downward adjustment reviews required by the rule.
Alternatives Suggested in 2024 Preamble: None.
Disclosure and Recordkeeping Requirements
On top of the generally applicable disclosure and recordkeeping requirements for all firms subject to the rule, the 2016 Proposal would have imposed additional, more detailed recordkeeping requirements on Level 1 and Level 2 firms. These firms would have been required to maintain for at least seven years records of:
Senior executive officers and significant risk takers, listed by legal entity, job function, organizational hierarchy and line of business;
Incentive-based compensation arrangements for senior executive officers and significant risk takers, including information on percentages of incentive-based compensation deferred and forms of awards;
Any forfeiture, downward adjustment or clawback reviews conducted, and decisions resulting from such reviews; and
Any material changes to the firm’s incentive-based compensation arrangements or policies.
A Level 1 or Level 2 firm would have been required to disclose to its regulator the records described above in accordance with the (unspecified) “form and frequency” required by the firm’s regulator.
Alternatives Suggested in 2024 Preamble: None.
6. Grandfathering of Existing Arrangements
Under the 2016 Proposal, the new rules established by the agencies would not have applied to any incentive compensation arrangement with a performance period that begins before the compliance date (as described below).
If a firm were to grow in size such that it became subject to the more restrictive rules applicable to a higher Level, the more restrictive rules would not have applied to any incentive-based compensation arrangement with a performance period that begins before the effective date of the application of those more restrictive rules.
Alternatives Suggested in 2024 Preamble: No suggested alternatives to the general grandfathering principle, although the agencies do ask about the timing for transitions between Levels. (Again though this would only be forward looking; moving up a level would not render illegal previously permissible incentive-based compensation arrangements.)
7. Compliance Date
The new rules would have taken effect on the first day of the first calendar quarter that begins at least 540 days after the rule is finalized.
Alternatives Suggested in 2024 Preamble: The agencies seek feedback on reducing the compliance period to 365 days.
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Three Other Expected Themes in Comments
Those at advisory firms, public interest groups, banking organizations or in academia who work with or study the design of incentive-based compensation arrangements are almost certainly going to have a long list of more technical comments about how the rule would, or would not, work in practice.
But in terms of higher-level general themes, here are three things I think will be interesting to watch in the comments.
General Authority to Issue the Rule
As noted above Section 956 authorizes the agencies to prohibit types and features of compensation arrangements that provide for excessive compensation, fees or benefits or that could lead to material financial loss. Using that statutory language as the hook, the agencies’ proposal defines for Level 1 and Level 2 firms specific features an incentive-compensation arrangement must, or must not, include in order for the agencies to regard the arrangement as not having the potential to lead to material financial loss. Certain of these required or prohibited features are tied to percentage or other numerical benchmarks.
In 2016, several commenters argued that this approach is overly prescriptive and inconsistent with the statute. More recently, but consistent with this theme, a blog post from the Bank Policy Institute argues that Section 956 “only authorizes the agencies to prohibit a narrowly defined set of bad practices; it does not authorize the agencies to design a single, uniform system of compensation that all firms must use in paying their employees.”
Given developments in the Supreme Court’s approach to statutory interpretation since 2016, and given an increased willingness by regulated firms to litigate over these issues, one would not expect these arguments to be any less prominent this time around.
A Good Start
Turning to the polar opposite view of the industry commenters described above, I would expect a different group of commenters to argue that the 2016 Proposal, though a decent first (second?) (third?) effort, does not go far enough, that the agencies should adopt certain of the proposed alternatives included in the 2024 preamble, and that the agencies should then go further still.
In this regard, it is interesting to look back on comments from Americans for Financial Reform and Better Markets in 2016, which recommended:
deferral periods should be longer;
vesting periods should be longer;
deferred compensation should be required to include a specific, significant amount of compensation that needs to be in the form of cash;
institutions’ compensation policies should be required to contemplate clawbacks not only in cases of misconduct, but also in cases of inappropriate risk taking;
forfeiture and downward adjustment should be mandatory, not just something that institutions would need to consider;
clawbacks should be mandatory, and not just tied to misconduct but also to inappropriate risk taking;
use of options or similar instruments as compensation should be even more significantly restricted, or even entirely prohibited;
deferred pay should be required to be continued to be held at risk even if an employee moves between firms9; and
employees should be prohibited from hedging their own compensation.
Many, though not all, of these suggestions may look familiar to those who just finished reading the discussion of alternatives included in the 2024 preamble.
Incentive Compensation’s Role in 2023 Bank Failures
In the preamble to today’s release, the agencies note that “common weaknesses” of Silicon Valley Bank, Signature Bank and First Republic Bank “included an excessive focus on growth and short-term profitability, and a lack of risk metrics in the banks’ compensation policies and practices that may have encouraged excessive risk taking.” The preamble also notes with concern that executives at these firms “continued to receive cash bonuses, in some cases right up until the bank’s failure.”
Tying the 2023 bank failures to incentive compensation practices is consistent with Vice Chair for Supervision Barr’s report on Silicon Valley Bank, which included a section on incentive compensation that concluded:
The incentive compensation arrangements and practices at SVBFG encouraged excessive risk taking to maximize short-term financial metrics. SVBFG’s compensation practices also did not adequately reflect longer-term performance, nonfinancial risks, or unaddressed audit or supervisory issues. Nor did they include sufficient opportunities for SVBFG’s internal control functions to provide feedback or challenge. Stronger or more specific supervisory guidance or rules on incentive compensation for firms of SVBFG’s size, complexity, and risk profile—or more rigorous enforcement of existing guidance and rules—may have mitigated these risks.
It seems reasonable to expect there to be debate among commenters about the extent to which compensation practices at SVB (or its parent company) and the other failed banks were indeed a meaningful contributor to their respective failure. And, if compensation practices were a contributor, whether and if so to what extent the 2024 Proposal would address these issues.
Comments Due … Sometime
Speaking of comments, it is typical to wrap up these sort of posts by noting that comments are due XX days after publication in the Federal Register.
Here, that doesn’t quite work because the proposal is not going to be published in the Federal Register, with the agencies apparently having concluded that, given Section 956’s requirement for a joint rulemaking, they cannot publish a proposed a rule in the Federal Register without everyone on board.
In the meantime, interested persons are free to submit comments via each participating agency’s respective website or via email addresses created by the agencies for this purpose.
Section 956 also includes other requirements for the agencies, though they are framed in a way that leaves at least some room for discretion. Any guidelines or rules the agencies adopt must be “comparable to the standards established under” the Federal Deposit Insurance Act for insured depository institutions and must “take into consideration” the compensation standards described in Section 39(c) of the Federal Deposit Insurance Act.
In a statement today FDIC Chairman Gruenberg called the Section 956 rules “perhaps the most important Dodd-Frank rulemaking remaining to be implemented” so read into that what you will about the likelihood of a source of strength rulemaking happening anytime soon.
This overstates things a little — the agencies noted in the 2016 preamble that the “vast majority of the comments were substantively identical form letters of two types”— but still it is true there were a bunch of comments.
Notable too was this statement from FHFA Director Thompson. Director Thompson’s statement acknowledges the request for comment on alternatives but declares that the agencies’ decision to propose the same rule as in 2016 is “a testament to the continued strength of the provisions in [the] 2016 proposal.”
Under the 2016 Proposal a covered person meant any executive officer, employee, director, or principal shareholder who receives incentive-based compensation at a covered institution.
Under the 2016 Proposal incentive based compensation was defined broadly as any variable compensation, fees, or benefits that serve as an incentive or reward for performance. (The agencies included in the 2016 preamble a list of things that they would not expect to count as incentive-based compensation, such as fixed employer contributions to a 401(k) plan and “most pensions”.)
An incentive based compensation arrangement was defined in turn as an agreement between a covered institution and a covered person, under which the covered institution provides incentive-based compensation to the covered person, including incentive-based compensation delivered through one or more incentive-based compensation plans.
A control function includes “compliance, risk management, internal audit, legal, human resources, accounting, financial reporting, or finance role responsible for identifying, measuring, monitoring, or controlling risk-taking.”
The concern here as described in the AFR comment letter is that “when employees move between firms, their old employer cancels their deferred bonus pay and their new employer compensates them for this loss in a lump sum payment. This buy out from the new employer effectively provides an acceleration of the deferred compensation.”