Proposed Rules on Incentive-Based Compensation Arrangements

Corporate / Financial Institutions Alert

February 15, 2011
Corporate / Financial Institutions Alert


Under Section 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), various federal agencies must issue rules which will require the reporting of incentive-based compensation arrangements by covered financial institutions (specified institutions with consolidated assets of more than $1 billion) and prohibit incentive-based compensation arrangements at covered financial institutions that (1) provide excessive compensation; or (2) that could expose the institution to inappropriate risks that could lead to a material financial loss. These agencies (collectively, “the Agencies”) include: the Office of the Comptroller of the Currency, Treasury (OCC); Board of Governors of the Federal Reserve System (Board); Federal Deposit Insurance Corporation (FDIC); Office of Thrift Supervision, Treasury (OTS); National Credit Union Administration; U.S. Securities and Exchange Commission (SEC); and the Federal Housing Finance Agency.

On February 7, 2011, the FDIC issued a proposed rule (Proposed Rule). Comments are due within 45 days of the publication of the rules in the Federal Register. The other of the Agencies must approve the Proposed Rule before it is published in the Federal Register.

The Proposed Rule would be effective six months after publication of the final rule in the Federal Register, with annual reports due within 90 days of the end of each covered financial institution’s fiscal year. 

This alert contains a brief description of the Proposed Rule. Download to read the detailed analysis here: Proposed Rules on Incentive-Based Compensation Arrangements.

Summary of the Proposed Rule
The Proposed Rule would supplement the Agencies’ existing rules, guidance and ongoing supervisory efforts. It prohibits:

The Proposed Rule also requires:

The Proposed Rule

Prohibition of Certain Incentive-based Compensation Arrangements

The Proposed Rule would prohibit a covered financial institution from having incentive-based compensation arrangements that may encourage inappropriate risks by providing excessive compensation, or that could lead to a material financial loss. 

Excessive Compensation. Standards for determining whether an incentive-based compensation arrangement provides excessive compensation are set out below. These are based on the standards established under Section 39 of the Federal Deposit Insurance Act (FDIA). Compensation for a covered person would be considered excessive when amounts paid are unreasonable or disproportionate to, among other things, the amount, nature, quality and scope of services performed by the covered person. 

Calculating Compensation. In making such a determination, the Agencies will consider:

Inappropriate Risks That May Lead to a Material Financial Loss. The Proposed Rule prohibits a covered financial institution from establishing or maintaining any incentive-based compensation arrangement, or any feature of one, that encourages a covered person to expose the institution to inappropriate risks that could lead to a material financial loss at the covered financial institution.

This prohibition will apply only to those incentive-based compensation arrangements for individual covered persons, or groups of covered persons, whose activities may expose the covered financial institution to a material financial loss. Such covered persons include:

Larger Covered Financial Institutions

Deferral Arrangements Required for Executive Officers

The Proposed Rule would establish a deferral requirement for larger covered financial institutions (i.e., generally those with $50 billion or more in total consolidated assets). At least 50 percent of the incentive-based compensation of an "executive officer" would have to be deferred over a period of at least three years. In addition, the deferred amounts must be adjusted for actual losses or other measures or aspects or performance that are realized or become better known during the deferral period.

A larger covered financial institution may decide to: (1) release (or allow vesting of) the full deferred amount in a lump sum only at the conclusion of the deferral period; or (2) release the deferred amounts (or allow vesting) in equal increments, pro rata, for each year of the deferral period. Any such deferral arrangement must be accompanied by the loss adjustment provision mentioned above. In no event, however, may the release or vesting of amounts required to be deferred be faster than a pro rata equal-annual-increments distribution. 

Special Review and Approval Requirement for Other Designated Individuals

At a larger covered financial institution, the board of directors, or a committee thereof, must identify those covered persons (other than executive officers) who individually have the ability to expose the institution to possible losses that are substantial in relation to the institution’s size, capital or overall risk tolerance. These covered persons may include, for example, traders with large position limits relative to the institution’s overall risk tolerance and other individuals who have authority to place at risk a substantial part of the covered financial institution’s capital. The board of directors, or a committee thereof, must approve the incentive-based compensation arrangement for such individuals, and maintain documentation of such approval.

While these employees will be subject to additional scrutiny, they will not be subject to the mandatory deferral provisions applicable to executive officers of larger covered financial institutions.

Policies and Procedures Governing Awards

Covered financial institutions would have to adopt policies and procedures governing the award of incentive-based compensation designed, at a minimum, to address the prohibitions contained in the Proposed Rule. The prohibition on incentive-based compensation arrangements that could lead to a material financial loss is likely to affect only those arrangements for covered persons that, either individually or as a group, may expose the institution to a material financial loss. The policies and procedures, therefore, must be designed to address these issues. 

Certain jobs and classes of jobs may not expose the organization to a material financial loss. Incentive-based compensation arrangements for employees within these job classes may be outside the scope of these restrictions. Examples of jobs and classes of jobs that may be unlikely to expose the institution to material risk include tellers, bookkeepers, couriers or data processing personnel.

Internal Review

Risk management, risk oversight and internal control personnel should be involved in all phases of the process for designing incentive-based compensation arrangements. An ongoing assessment of the policies should be made by risk management and risk oversight personnel to help to ensure that the processes remain up-to-date and effective relative to the incentive compensation practices. The personnel should be properly trained and compensated.

Such monitoring should be conducted, where practicable, by a group or person independent of the covered person so they can determine whether incentive-based compensation payments are reduced to reflect adverse risk outcomes or high levels of risk taken. To be independent, the group or person monitoring or assessing incentive-based compensation awards must have a separate reporting line to senior management from the covered person who is creating the risks.

Board Involvement

In order to provide appropriate information to the board or committee, a covered financial institution will need to develop and maintain policies and procedures designed to ensure that the board, or a committee thereof, receives data and analysis from management and other sources sufficient to allow it to assess the overall design and performance of the entity’s incentive-based compensation arrangements. The policies and procedures relating to an incentive-based compensation arrangement must provide for ongoing oversight by the board of directors or the committee. 

Supporting Documentation

A covered institution must maintain sufficient documentation of its processes for establishing, implementing, modifying and monitoring incentive-based compensation arrangements. These must be sufficient to allow the institution’s appropriate federal regulator to determine the covered financial institution’s compliance with Section 956 of the Dodd-Frank Act and the Proposed Rule. The documentation should include, but not be limited to:

Annual Report
A covered financial institution must submit an annual report to its appropriate federal regulator disclosing the structure of its incentive-based compensation arrangements. The format for the annual report will be specified by the appropriate federal agency. The report must contain:

Covered financial institutions will be encouraged to avoid submitting voluminous materials that could obfuscate the actual structure and likely effects of an institution’s incentive-based compensation arrangements. 


The Agencies generally will maintain the confidentiality of the information submitted to them. The information will be nonpublic to the extent permitted by law.

For more information, please contact Timothy SullivanMichael D. Morehead or your regular Hinshaw attorney.

Tax Advice Disclosure: To ensure compliance with the Internal Revenue Service regulations governing the issuance of advice on Federal tax issues, we advise you that any tax advice in this communication (and any attachments) is not written with the intent that it be used, and cannot be used, to avoid penalties that may be imposed under the Internal Revenue Code.

This alert has been prepared by Hinshaw & Culbertson LLP to provide information on recent legal developments of interest to our readers. It is not intended to provide legal advice for a specific situation or to create an attorney-client relationship.