Some US Regulators Repropose Joint Rule on Incentive-Based Compensation

On May 6, 2024, the Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency (OCC), the Federal Housing Finance Agency (FHFA) and National Credit Union Administration (NCUA; collectively the “Four Agencies”) reproposed a joint rule (the “2024 Proposal”) to regulate incentive-based compensation paid by certain financial services firms (“Covered Institutions”). The 2024 Proposal would implement Section 956 of the Dodd-Frank Act, which requires enhanced disclosure and reporting of compensation arrangements by Covered Institutions and prohibits incentive compensation arrangements that involve inappropriate risks or could lead to material financial loss.

The 2024 Proposal is notable for being issued by only four of the six agencies whose approval is required for a joint rule. The FDIC staff memo states that the Federal Reserve and SEC have not joined in issuing the 2024 Proposal, and indicates that the 2024 Proposal will not be published in the Federal Register or opened for formal public comment until they do so. However, the FDIC, OCC, and FHFA will accept comments on the pre-publication version of the 2024 Proposal until it is published in the Federal Register.

This Legal Update provides critical background on the Section 956 rulemaking process and explains how the 2024 Proposal builds on prior actions. Covered Institutions should be aware of the direction some regulators are moving with respect to the issue, but also should remember that the 2024 Proposal is not yet an actual proposal and does not need to be treated as one.

Background

Section 956 of the Dodd-Frank Act requires the FDIC, OCC, NCUA, FHFA, Federal Reserve, and SEC (the “Six Agencies”) to jointly establish regulations or guidelines with respect to incentive-based compensation practices at Covered Institutions. Specifically, the Six Agencies must prohibit any types of incentive-based compensation arrangements, or any feature of such arrangements, that the regulators determine encourage inappropriate risks by a Covered Institution: (1) by providing an executive officer, employee, director, or principal shareholder of the Covered Institution with excessive compensation, fees, or benefits; or (2) that could lead to material financial loss to the Covered Institution. Further, they must require Covered Institutions to disclose to their regulators the structure of their incentive-based compensation arrangements.

A Covered Institution is any of the following types of institution that has $1 billion or more in assets: (A) a depository institution or depository institution holding company; (B) an SEC-registered broker-dealer; (C) a credit union; (D) an investment adviser; (E) the Federal National Mortgage Association; (F) the Federal Home Loan Mortgage Corporation; and (G) any other financial institution that the Six Agencies, jointly, by rule, determine should be treated as a Covered Institution for purposes of Section 956.

On April 14, 2011, the Six Agencies published in the Federal Register a proposal to implement section 956 (the “2011 Proposal”). On June 10, 2016, the Six Agencies published in the Federal Register a subsequent proposal to implement section 956 (the “2016 Proposal”). The 2011 Proposal and 2016 Proposal were highly controversial and yielded thousands of comment letters. In particular, the 2016 Proposal was criticized for its rigid, prescriptive nature.

2024 Proposal

The 2024 Proposal restates the proposed requirements from 2016 Proposal in their entirety. We discussed the 2016 Proposal in detail in an earlier Legal Update.

The preamble to the 2024 Proposal requests comment on several alternative provisions that could be included in a final rule (i.e., that could change the requirements from the 2016 Proposal). These alternative provisions are:

1. Reducing the compliance timeline from 540 days to 365 days after a final rule is published in the Federal Register.
2. Include credit union service organizations (CUSOs) in the definition of affiliate, which could result in CUSOs being subject to the final rule (i.e., if they are affiliated with credit unions that are Covered Institutions).
3. Collapsing the three-tier definition of Covered Institution to a two-tier definition. Under this approach, Covered Institutions with average consolidated assets of more than $50 billion would be subject to the more stringent prohibitions and requirements that the 2016 Proposal would have applied only to Covered Institutions with more than $250 billion in assets. The minimum required deferral amounts and deferral periods might be simplified by using a single deferral percentage of 60%, and deferral period of four years, for both senior executive officers and significant risk-takers at Level 1 Covered Institutions.
4. Change the definition of “significant risk-taker” to rely on criteria developed by each Covered Institution (subject to minimum standards) or eliminate the separate exposure test (which would include persons who have the authority to commit or expose 0.5% or more of the Covered Institution’s capital as significant risk takers).
5. Require Covered Institutions to establish performance measures and targets before the beginning of the performance period. Under this alternative, Covered Institutions would be unable to make changes to any target after the performance period begins without documentation and approval of such actions from appropriate personnel. Additionally, under this alternative, a Covered Institution’s decisions about deferral, downward adjustment, or forfeiture would have to account for all performance measures (i.e., not a subset of measures).
6. Reduce the proposed limit on options-based compensation from 15% to no more than 10% of the amount of total incentive-based compensation awarded to the senior executive officer or significant risk-taker for that performance period.
7. Limit the discretion of a Level 1 or Level 2 Covered Institution to seek to recover incentive-based compensation by requiring (rather than requiring consideration of) forfeiture and downward adjustment of incentive-based compensation for the adverse outcomes listed in the proposal. Covered Institutions also would be required to formalize the governance and review processes surrounding such decision-making, and to document the decisions made.
8. Require a Level 1 or Level 2 Covered Institution to claw back (rather than consider clawing back) any vested (i.e., paid) incentive-based compensation from a current or former senior executive officer or significant risk-taker under the same circumstances as identified in the proposal.
9. Prohibit a Level 1 and Level 2 Covered Institution from designing or agreeing to incentive-based compensation arrangements that allow a covered person to purchase a hedging instrument or similar instrument to offset any decrease in the value of the covered person’s incentive-based compensation.
10. Prohibit all incentive-based compensation based in any part on transaction revenue or volume, rather than prohibiting only incentive-based compensation that is based solely on transaction revenue or volume.
11. Require Level 1 and Level 2 Covered Institutions to include, as part of their risk management framework, a consideration of a risk management and controls assessment from the independent risk and control functions in setting incentive-based compensation for senior executive officers and significant risk-takers.