Incentive Based Compensation Arrangements Dodd-Frank Section 956
The Dodd-Frank Wall Street Reform and Consumer Protection Act, which was signed into law on July 21, 2010, requires federal agencies to jointly prescribe regulations or guidelines with respect to incentive-based compensation practices at “Covered Financial Institutions” (financial institutions with over $1B in total assets). Specifically, section 956 of the Dodd-Frank Act requires that the agencies prohibit incentive-based payment arrangements at a covered financial institution that they determine encourage inappropriate risks that could lead to a material financial loss.
Under the act, a covered financial institution must disclose the structure of its incentive-based compensation arrangements to its appropriate federal regulator sufficient to determine whether the structure provides “excessive compensation, fees or benefits” or “could lead to material financial loss” to the institution. The Dodd-Frank Act does not demand that a covered financial institution report the actual compensation of particular individuals as part of this requirement.
On Feb. 4, 2011 the FDIC adopted proposed rules implementing Section 956 of the Dodd-Frank Act. Until this time, the agencies had only presented the “Interagency Guidance on Sound Compensation Policies” in June of 2010, which was actually intended as “principles based guidelines,” without having the force and effect of law. While the new proposal is rule-based, those rules are really not any more specific than the general guidelines. While prohibiting incentive-based pay plans that could lead to a material financial loss, the proposed rules provide no guidance as to what constitutes the materiality of loss. The proposal’s stated goal is to achieve a better “balance” between the incentive to take risks in order to drive bank performance and whatever incentive exists to avoid too much risk.
Establishing the appropriate levels of risk on both sides of this equation is a relative concept. The proposed rules provide no criteria or structure which would enable regulators to identify the “right” or “wrong” level of variable compensation and its calibration to risk factors. Bankers will need to find a way to quantify the risk inherent in their business models and compare it to the dollar value of the incentive awards in their compensation plans.
The new proposal pertains to financial institutions with $1 billion or more in consolidated assets (Covered Financial Institutions), while for those under $1 billion, the new proposal would require no changes. The new rules prohibit any incentive-based compensation arrangement that encourages executive officers, employees, directors or principal shareholders (Covered Persons) to expose the institution to inappropriate risks by providing the Covered Persons with excessive compensation. Any incentive-based compensation arrangements for Covered Persons that encourage inappropriate risk-taking by the Covered Financial Institution that could lead to a material financial loss are also prohibited.
The rules require that the board or a committee approve all incentive plans for Covered Persons, and that policies and procedures are in place to help ensure compliance with these rules. Banks also will be required to provide an annual report to their regulators explaining the strategy and design of all variable compensation plans for Covered Persons and why they don’t incent inappropriate risk-taking. Banks over $50 billion in assets (Larger Covered Financial Institutions) must also submit a description of incentive arrangements in place for those who, by virtue of their role, can expose the organization to potential substantial losses. Additionally, half or more of their compensation must be delivered in a form that is delivered at least three years after it is earned. The proposal also defines credit unions with assets over $1 billion as Larger Covered Institutions.
The proposed rulemaking will not be published in the Federal Register until all of the federal agencies have reviewed and approved it. A 45-day comment period will then commence. All comments will be considered by the federal agencies, and then they will publish the final rule. The proposal anticipates that the final rule (whatever it may contain) will become effective six months after publication in the Federal Register. Banks will be expected to submit their informational reports within 90 days of the end of their fiscal year, following each Covered Financial Institution’s fiscal year, after that six month effective date.