On February 7, 2011, the Federal Deposit Insurance Corporation (FDIC) Board approved and, with six other federal agencies1, issued joint proposed rulemaking implementing Section 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Section 956 of the Dodd-Frank Act seeks to prohibit incentive-based compensation plans that expose “covered financial institutions” to inappropriate risks. The comment period is 45 days after publication of the proposed rules in the Federal Register. Such publication may be delayed as the other agencies conduct the necessary approval procedures.

The proposed rules would:

  • Apply to “covered financial institutions” that have over $1 billion in assets and offer incentive-based compensation programs. Such institutions would need to file an annual report with their primary federal regulator detailing the structure of incentive-based plans.
  • Prohibit incentive-based compensation that would encourage inappropriate risks by providing excessive compensation, or that could lead to a material loss for the institution.
  • Require each covered financial institution to establish and maintain policies and procedures regarding incentive compensation that are commensurate with the size and complexity of the institution.
  • Require covered financial institutions with over $50 billion in assets, in addition to the above, to defer at least 50 percent of incentive-based payments to executive officers for a minimum of three years.

What institutions would be subject to the proposed rules?

The proposed rules apply to “covered financial institutions” that have assets of $1 billion or more and offer incentive-based compensation programs. Covered financial institutions include:

  • a depository institution or a depository institution holding company as defined in the Federal Deposit Insurance Act;
  • a broker-dealer registered under Section 15 of the Securities Exchange Act of 1934;
  • a credit union described in the Federal Reserve Act;
  • an investment adviser as defined by Section 202(a)(11) of the Investment Advisers Act of 1940;
  • Fannie Mae and Freddie Mac; and
  • other financial institutions that federal regulators determine jointly, by rule, to treat as a covered financial institution.

What incentive-based compensation is covered and which persons are covered?

The definition under the proposed rules is very broad. “Incentive-based compensation” includes any variable compensation that serves as an incentive for performance. The covered persons would be executive officers, employees, directors, or principal shareholders (owning 10 percent or more of outstanding equity) of the covered financial institution.

Incentive compensation is considered “excessive” under the proposed rules if the amount paid is unreasonable or disproportionate to the amount, nature, quality, and scope of services performed by the person. The proposed rules provide that an incentive-based compensation plan does not comport with the rules unless it balances risk and financial rewards, is compatible with effective controls and risk management, and is supported by strong corporate governance.

What would the proposed annual report cover?

The proposed rules would require each covered financial institution to file an annual report detailing the structure of its incentive-based compensation plans. The report must:

  • clearly describe the components of the institution’s incentive-based compensation arrangements;
  • describe the institution’s policies and procedures governing its incentive-based compensation arrangements and any changes made to those policies and procedures since submission of the last annual report; and
  • set forth specific reasons why the institution believes that its compensation plans do not provide incentives to engage in behavior that is likely to cause a material financial loss to the institution, and do not provide excessive compensation.

A covered financial institution is not required to report the actual compensation received by covered persons. The applicable federal agency that receives the annual report would then make an assessment of whether the incentive compensation violates Section 956 of the Dodd-Frank Act. Each agency will adopt standards for determining whether an incentive-based compensation arrangement may encourage inappropriate risk-taking that are consistent with the key principles established for incentive compensation in the Interagency Guidance on Sound Incentive Compensation Policies2 adopted by federal banking agencies.

The required reports would be kept confidential by the applicable federal agencies to the maximum extent permitted by the Freedom of Information Act (FOIA).

What additional requirements would be imposed on large covered financial institutions?

Covered financial institutions with assets in excess of $50 billion must:

  • Provide a description of any specific incentive-based compensation plans applicable to the institution’s executive officers or other individuals who may expose the institution to possible losses;
  • Defer at least 50 percent of incentive-based payments to an executive officer for a minimum of three years. Deferred amounts paid must be adjusted for actual losses or other aspects of performance that come to light during the deferral period; and
  • Identify individuals other than executive officers who possess the ability to expose the institution to losses that are substantial in relation to the institution’s size, capital, and overall risk tolerance. An incentive-based compensation arrangement applicable to an identified individual must be approved by the institution’s board of directors. The institution’s board of directors must further determine that the arrangement balances the reward to the individual and the risks associated with the individual’s activities.

The FDIC indicated that these proposed rules, including the deferral obligation, aligns the restrictions on U.S.-based covered financial institutions with the standards and limitations adopted by international regulatory authorities.

Ballard Spahr’s Financial Institutions Reform Task Force continues to monitor the Dodd-Frank Act, and its members are available to assist clients as they prepare to address these new requirements. Please contact Mary J. Mullany, 215.864.8631 or mullany@ballardspahr.com; Justin P. Klein, 215.864.8606 or kleinj@ballardspahr.com; or any member of the Securities Group with any questions.

[1] The other agencies are the Office of the Comptroller of the Currency (OCC), Board of Governors of the Federal Reserve System (Board), Office of Thrift Supervision (OTS), National Credit Union Administration (NCUA), U.S. Securities and Exchange Commission (SEC), and Federal Housing Finance Agency (FHFA).

[2] 75 FR 36395 (Jun. 25, 2010), adopted by the OCC, Board, FDIC and OTS.

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