May 21, 2024

Irregular Time—A Quasi-Proposed Rule on Incentive-Based Compensation

6 min

For the third time, federal agencies have issued a proposed rule to regulate incentive-based compensation paid by certain financial institutions and other entities (the 2024 Proposal). The 2024 Proposal has been released by the FDIC, OCC, NCUA, and the Federal Housing Finance Agency. Section 956 of the Dodd-Frank Act, however, requires that six specific federal agencies issue a joint rule or guidance on incentive-based compensation. In the absence of the Federal Reserve and the SEC, the 2024 Proposal will not be published in the Federal Register for formal comment. The issuing agencies will accept comments on the draft version in the meantime. While the 2024 Proposal is not an actual proposal, entities that would be covered should note how the agencies' thinking on these issues may be evolving.

While the 2024 Proposal uses the text of the proposed rule that all six required agencies issued in 2016 (the 2016 Proposal), it includes a new preamble with important questions that could lead to a different final rule. The 2016 Proposal was released after a proposal in 2011 (the 2011 Proposal). Both the 2016 Proposal and the 2011 Proposal received thousands of comment letters—many critical. Rather than a principles-based approach, the 2024 Proposal (like the 2016 Proposal) would take a relatively prescriptive approach.

This alert summarizes highlights of the 2024/2016 Proposal and how the 2024 Proposal's new questions for comment could lead to a different rulemaking.

1. What the agencies would do in the 2024 Proposal

The 2024 Proposal would re-propose the 2016 Proposal in its entirety and without change. But the questions that the agencies pose could signal future changes for any future final rule.

2. Why the agencies issued the 2024 Proposal

It would appear that some agencies are in a race against the clock to implement the remaining key policies of the Biden administration, because of either idiosyncratic intra-agency pressures or the upcoming 2024 election.

That being said, Congress called for such action in 2010 and expected it "not later than 9 months" after the Dodd-Frank Act's enactment. That was approximately 14 years ago.

3. What Section 956 of the Dodd-Frank Act requires

Section 956 requires six federal agencies to jointly issue regulations or guidelines that (1) prohibit incentive-based compensation at covered institutions that encourage inappropriate risks by providing excessive compensation or that could lead to material financial loss and (2) require covered institutions to disclose certain information concerning incentive-based compensation to the relevant agency/agencies.

4. The Federal Reserve's absence and what it means

While the SEC is expected to take action on this proposal, the Federal Reserve has declined to do so. Absent the Federal Reserve's participation, the 2024 Proposal is not the interagency action required by statute.

5. How the federal banking agencies currently regulate incentive-based compensation

Although the agencies have not issued a joint regulation or guidance under Section 956, they still regulate and supervise these issues. Notably, the federal banking agencies did issue interagency Guidance on Sound Incentive Compensation Policies in 2010. In addition, the federal banking agencies can use their general safety and soundness guidelines to scrutinize such arrangements. The OCC also has heightened guidelines for larger banks and thrifts that it supervises.

6. What the 2024/2016 Proposal would do

The description below provides a high-level overview of the 2016 Proposal, which would generally be applicable to banks, investment advisors, broker-dealers, and credit unions ("covered institutions") with more than $1 billion in average total consolidated assets.

Covered institutions would be divided into three categories, based on average total consolidated assets over a specified period:

  • Level 1: $250 billion or more
  • Level 2: $50 billion to $250 billion
  • Level 3: $1 billion to $50 billion.

The 2024/2016 Proposal would not apply to institutions with less than $1 billion in average total consolidated assets.

For all covered institutions the 2024/2016 Proposal would:

  • Prohibit types and features of incentive-based compensation arrangements that encourage inappropriate risks
  • Require adherence to certain principles for incentive-based compensation arrangements to balance between risk and reward and establish effective risk management governance
  • Require appropriate board (or board committee) oversight, recordkeeping, and disclosures to the appropriate agency

Level 1 and Level 2 covered institutions would be subject to the following requirements and prohibitions or limits:

  • Requirements
    • Deferral of awards for senior executive officers and significant risk-takers
    • Consideration of forfeiture or downward adjustment of awards
    • Clawback of paid awards if certain triggers were to occur
    • Establishment of a board compensation committee
    • Appropriate risk management and control framework
    • Additional recordkeeping requirements for senior executive officers and significant risk-takers
    • Policies and procedures to ensure compliance
  • Prohibitions/limits
    • Excessive award leveraging
    • Using only relative (peer) performance measures
    • Use of options
    • Volume-driven incentive-based compensation without regard to transaction quality or compliance with sound risk management
    • Purchase of hedging instruments by an institution on behalf of a covered person to offset any decrease in the value of incentive-based compensation

7. Key questions from 2024 Proposal's preamble that could signal future changes

The 2024 Proposal seeks feedback on so-called potential alternatives to the 2024/2016 Proposal's provisions. These questions are essentially the new part of the 2024 Proposal, and the agencies explain that they reflect their "additional supervisory experience, changes in industry practice, and other developments" since the 2016 Proposal. These potential alternatives, on balance, could make the 2024 Proposal more prescriptive than the 2016 Proposal.

These changes could include, among others:

  • Shorter time to comply. Shortening the compliance date from approximately 1.5 years to 1 year from the first quarter, that being a year after the final rule's publication in the Federal Register
  • More requirements for smaller covered institutions. Establishing a two-level structure for covered institutions, rather than the proposed three-level structure. This could essentially push more, but not all, heightened requirements on to Level 3 covered institutions (leverage limits, volume-driven incentive compensation prohibitions, hedging prohibitions)
  • Less discretion for Level 1 and Level 2. Level 1 and Level 2 covered institutions could be required to recover incentive-based compensation by forfeiture and downward adjustment for certain adverse outcomes (e.g., poor financial performance). These covered institutions would have to have formal governance, review, and documentation procedures for these decisions. Similarly, covered institutions could be required to claw back from current or former senior executive officers or significant risk-takers their vested incentive-based compensation. Under the 2016 Proposal, covered institutions would have to consider such forfeiture, downward adjustment, and clawbacks
  • No transaction/volume-based incentive-based compensation. Incentive-based compensation determined by transaction revenue or volume could be prohibited. The 2016 Proposal would prohibit such incentive-based compensation that is based solely on these characteristics
  • Performance measures. The changes could force banks to establish performance measures and targets before the performance period begins. Essentially, this would front-load targets and prevent covered institutions from making changes without approval and documentation from certain appropriate personnel. It would also broaden the proposed subset of measures to include all performance measures for deferral, downward adjustment, and forfeiture actions
  • Reduce limits on options. Options-based compensation could be lowered from the proposed 15% limit to 10% of the total incentive-based compensation for a senior executive officer or significant risk-taker during a given performance period
  • Risk assessment. Level 1 and Level 2 covered institutions' risk management framework could be required to consider a risk management and controls assessment from the independent risk and control functions when setting incentive-based compensation for their senior executive officers and significant risk-takers
  • Changing the "significant risk-taker" test. The agencies may consider modifying this test to take a more "flexible risk-based approach"

While the 2024 Proposal explains that the agencies will consider comments submitted to the 2016 Proposal, covered institutions and other affected or interested entities may be interested in commenting on the material changes that could follow based on these proposed potential alternatives.