Proposed Rule on Incentive-Based Compensation at Financial Institutions

Joseph Bachelder is founder and senior partner of the Bachelder Law Firm. This post is based on an article by Mr. Bachelder that first appeared in the New York Law Journal.

On Feb. 7, 2011, the Federal Deposit Insurance Corporation (FDIC) approved a proposed rule regarding incentive-based compensation at covered financial institutions pursuant to Section 956 of the Dodd-Frank Wall Street and Consumer Protection Act, 12 U.S.C. §5641 (2010). Subsequently, the National Credit Union Administration (NCUA) (Feb. 17) and the Securities and Exchange Commission (SEC) (March 2) approved their own versions of the proposed rule (each version being very much the same as the FDIC’s). Four other agencies are expected to approve their own similar versions of the proposed rule shortly. [1]

Pursuant to Dodd-Frank Section 956, these regulators are coordinating in a joint interagency rulemaking process. All seven agencies must approve the proposed rule before it is published as a proposed rule in the Federal Register, after which there will be a 45-day comment period. It is expected that the seven versions of the rule will essentially mirror one another, subject to certain inevitable differences such as those reflecting the jurisdictions of the different agencies. [2] The final version of the rule will go into effect six months after its publication (expected to be jointly issued) in the Federal Register.

The following discussion will be based on the first published version of the proposed rule—that of the FDIC on Feb. 7. As noted, all versions of the proposed rule are (or, in the case of the four still to be issued, are expected to be) essentially the same.

Discussion of Proposed Rule

Covered Financial Institutions. The proposed rule, [3] as approved by the FDIC for institutions under its jurisdiction, would apply to a state non-member bank and an insured U.S. branch of a foreign bank (covered financial institution) that has total consolidated assets of $1 billion or more. [4] For those “covered financial institutions” under its jurisdiction that have $50 billion or more in assets, the FDIC proposes additional special rules for executive officers [5] and certain other employees (see next section). [6]

Like the FDIC, it is expected that some (not necessarily all) of the agencies will have at least two size categories of “covered financial institutions,” for purposes of applying the standards. For example, the SEC’s proposed rule has the same two size categories as the FDIC’s with special, additional standards applicable to certain covered persons at the institutions in the larger category. The NCUA’s proposed rule also has two size categories, but the larger institution category is for those with $10 billion or more in total consolidated assets.

Covered Persons. Section 372.3(d) of the proposed rule provides that a “[c]overed person means any executive officer, employee, director, or principal shareholder of a covered financial institution.” [7]

Incentive-Based Compensation. Section 372.3(g) of the proposed rule provides that “[i]ncentive-based compensation means any variable compensation that serves as an incentive for performance.” [8]

Prohibited Types of Incentive-Based Compensation. Section 372.5 of the proposed rule prohibits incentive-based compensation that “encourages” inappropriate risks by the covered financial institution due to such compensation

  • (i) being “excessive,” meaning “unreasonable or disproportionate” relative to the services being performed by a covered person, or
  • (ii) being of a type that could lead to material financial loss to the covered financial institution as a result of its being provided to a covered person, individually or as a part of a group.

As to compensation covered by point (i), Section 372.5(a) provides as follows:

  • (a) Excessive compensation prohibition.
    • (1) In general. A covered financial institution must not establish or maintain any types of incentive-based compensation arrangements, or any feature of any such arrangements, that encourage inappropriate risks by the covered financial institution by providing a covered person with excessive compensation.
    • (2) Standards. An incentive-based compensation arrangement provides excessive compensation when amounts paid are unreasonable or disproportionate to the services performed by a covered person… [9]

As to compensation covered by point (ii), Proposed Rule Section 372.5(b)(1) provides as follows:

  • (b) Material financial loss prohibition.
    • (i) Generally. A covered financial institution must not establish or maintain any types of incentive-based compensation arrangements, or any feature of any such arrangements, that encourage inappropriate risks by the covered financial institution, by providing incentive-based compensation to covered persons, either individually or as part of a group of persons who are subject to the same or similar incentive-based compensation arrangements, that could lead to material financial loss to the covered financial institution.

Proposed Rule Section 372.5(b) further provides, in subparagraph (2), that an incentive-based compensation arrangement will fail to satisfy the “material financial loss prohibition,” unless it

  • (i) Balances risk and financial rewards, for example, by using deferral of payments, risk adjustment of awards, reduced sensitivity to short-term performance, or extended performance periods;
  • (ii) Is compatible with effective controls and risk management; and
  • (iii) Is supported by strong corporate governance, including active and effective oversight by the covered financial institution’s board of directors or a committee thereof. [10]

Additional Rules for (i) Executive Officers and (ii) Certain Other Employees Whose Actions Can Have Significant Risk Consequences for the Covered Financial Institution. Under the FDIC proposed rule, for those covered financial institutions in the $50 billion or more asset category, additional rules will apply to executive officers and to covered persons (other than executive officers) who are determined by the Board of Directors, or a committee thereof, of a covered financial institution, in accordance with the new rules, to be in a position to have significant impact on risk.

For executive officers, at least 50 percent of incentive-based compensation must be deferred for at least a three-year period and the amount deferred must be subject to adjustment for losses or other performance results during the deferral period. The deferred amount may be vested on a pro rata basis over the three-year period. [11]

The board of directors, or a committee thereof, of a covered financial institution with total consolidated assets of $50 billion or more also is required to identify those individuals (other than executive officers) who “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 the authority to place at risk a substantial part of the capital of the covered financial institution.” Proposed Rule §372.5(f)(2).

As to these individuals with significant “risk potential,” the proposed rule provides that the incentive-based compensation arrangement(s) for such an individual must be approved, and such approval documented, by the board of directors (or a committee thereof).

Under Proposed Rule Section 372.5(f)(2), such approval cannot be given “unless the board or committee determines that the arrangement, including the method of paying compensation under the arrangement, effectively balances the financial rewards to the employee and the range and time horizon of risks associated with the employee’s activities, employing appropriate methods for ensuring risk sensitivity such as deferral of payments, risk adjustment of awards, reduced sensitivity to short-term performance, or extended performance periods.”

Proposed Rule Section 372.5(b) is an example of a rule that may be very difficult to administer. It involves determining different degrees of “risk potential” associated with different executives at different covered financial institutions. Adding to the difficulty will be administration of the rule by seven different agencies, each with its own views and interpretations of risk.

Reports (Proposed Rule Section 372.4). The proposed rule requires annual reports that disclose the structure, design and amounts of the covered compensation arrangements and provide adequate basis for evaluating whether the incentive-based compensation involved is “excessive compensation” or causes inappropriate risks of material losses to the covered financial institution.

Information as to individual executives is not required as part of the report. Proposed Rule Section 372.4(c) provides in greater detail the information to be included in the report. Presumably in response to anticipated concerns regarding the Freedom of Information Act, the Federal Deposit Insurance Act (FDIA) states, in its introductory comments to the proposed rule, that:

[I]n light of the nature of the information that will be provided to the Agencies…, and the purposes for which the Agencies are requiring the information, the Agencies generally will maintain the confidentiality of the information submitted to the Agencies, and the information will be nonpublic to the extent permitted by law.

Policies and Procedures (Proposed Rule Section 372.6). The proposed rule provides that incentive-based compensation will not be in compliance with the proposed rule unless “adopted pursuant to policies and procedures developed and maintained by each covered financial institution and approved by its board of directors, or a committee thereof, reasonably designed to ensure and monitor compliance with the requirements set forth in 12 U.S.C. 5641 and this part and commensurate with the size and complexity of the organization, as well as the scope and nature of its use of incentive-based compensation.”

Section 372.6(b) of the proposed rule provides in greater detail what the policies and procedures must provide in order to be in compliance with the proposed rule.

Comments on Proposed Rules

  • Attempts by the federal government in the past to regulate the highly complex subject of executive compensation have produced mixed results. During the approximately three years of pay controls in the early 1970s, U.S. employers often made exceptions to basic rules for controlling year-to-year increase in the value of executive compensation arrangements—either by obtaining rulings from the Pay Control board or based on advice of their own counsel. A great deal of uncertainty and controversy accompanied the restrictions—now generally lifted—that accompanied TARP (Troubled Asset Relief Program).Will seven different agencies administering the proposed rule under Dodd-Frank Section 956 provide consistent interpretations as to how the rule applies to the hundreds of financial institutions involved? The general standards of Proposed Rule Section 372.5 are so broad that it is almost inevitable that conflicting interpretations will occur in applying them to specific situations.
  • Illustrating the prior comment are the distinctions that will be drawn in evaluating the impact of different compensation arrangements on risk at different types of financial institutions. The standards that may be needed for the business of a commercial bank or a thrift association are not the same as those needed for a broker-dealer. Distinctions as to risk also will be made based on size of the financial institution and, in turn, as to risks associated with individual executives depending upon the size, nature and scope of their duties.
  • How forcefully is the proposed rule going to be administered? Will one agency’s enforcement process be consistent with that of the others? As discussed in footnote 3, the FDIC and several other agencies issued somewhat similar regulations in 1995 under FDIA Section 39(c). These regulations appear to have had relatively little impact on executive compensation in the banking industry. Will the enforcement of the proposed rule “fade away” if there is a softening in political hostility toward banks and other financial institutions generally?On the other hand, if the proposed rule is forcefully implemented over the next two or three years, what will be the impact on covered financial institutions trying to reestablish themselves as competitors in the global financial community? As Milton Friedman said, “[t]he system doesn’t work unless business is willing to take risks….” Sylvia Nasar, “Private Sector; An Economic Reality Check From Someone Who’s Seen It All,” The New York Times, Sept. 29, 2002, §3 at 2.
  • The proposed rule raises significant long-term questions. How will the proposed/final rule affect say on pay voting at covered financial institutions? Will it give shareholder activists additional bases for criticizing executive pay at those institutions? Will the rule impact on state rules, as applied to financial institutions, on the subject of what is reasonable compensation? What will be its impact on court interpretations of fiduciary duties of directors and officers at covered financial institutions?


The issuance of proposed rulemaking by the FDIC, the NCUA and the SEC (and shortly by four additional regulators) pursuant to Dodd-Frank 956 represents just “the beginning of the beginning.” Following the rulemaking process, the Final Rule is scheduled to take effect six months after its publication in the Federal Register. As in the case of precedents such as Pay Controls and TARP, it is likely that the impact of these standards will diminish as the crisis giving rise to it fades. That is not much consolation for the financial institutions who must wrestle with the problems of complying with these standards for the foreseeable future.


[1] The other four regulators are the Federal Reserve System (the “Federal Reserve”), the Office of the Comptroller of the Currency (OCC), the Office of Thrift Supervision (OTS) and the Federal Housing Finance Agency (FHFA).
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[2] In its introductory comments to the proposed rule the FDIC states, “Although this is a joint interagency rulemaking, each Agency will codify its version of the rule in its specified portion of the Code of Federal Regulations in order to accommodate differences between regulated entities as well as other applicable statutory and regulatory requirements.” (The NCUA and the SEC use the same language.)
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[3] The incentive-based compensation standards of the proposed rule, and of Dodd-Frank Section 956 itself, include standards set out in Federal Deposit Insurance Act Section 39(c), enacted in 1991 regarding compensation practices at banking institutions. Seven basic criteria for determining “excessive compensation” are contained in Proposed Rule Section 372.5(a)(2)(i) to (vii) which virtually duplicate FDIA Section 39(c)(2)(A)-(G). See also Interagency Guidelines Establishing Standards for Safety and Soundness, 2 C.F.R. pt. 364 app. A, adopted in 1995 by the FDIC pursuant to Section 39(c). The OCC, the OTS and the Federal Reserve adopted their respective versions of those guidelines. Whereas Dodd-Frank Section 956 and the proposed rule are limited to incentive-based compensation, FDIA Section 39(c) is directed at bank compensation practices generally.

Another precedent to Dodd-Frank Section 956 and the proposed rule is the Interagency Guidance on Sound Incentive Compensation Policies (the “Interagency Guidance”) published as a final guidance in the Federal Register June 25, 2010. 75 Fed. Reg. 36395. The FDIC, the OCC, the Federal Reserve and the OTS joined in the issuance of the Interagency Guidance.
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[4] As noted in the text, the proposed rule will apply to different “covered financial institutions” reflecting the list of institutions in Dodd-Frank Section 956(e)(2). This includes depository institutions, broker-dealers, credit unions, investment advisers (as defined in section 202(a)(11) of the Investment Advisers Act of 1940), the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation and “any other financial institution that the appropriate Federal regulators, jointly, by rule, determine should be treated as a covered financial institution for purposes of this section.” Financial institutions with assets of less than $1 billion, as noted in the text, are exempted by Dodd-Frank Section 956.
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[5] “Executive Officer” is defined in Proposed Rule Section 372.3(f) as a person with one of more of the following positions: “president, chief executive officer, executive chairman, chief operating officer, chief financial officer, chief investment officer, chief legal officer, chief lending officer, chief risk officer, or head of a major business line.”
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[6] According to the FDIC’s introductory discussion to the proposed rule, the number of companies under the FDIC’s jurisdiction are: 289 between $1 billion and $50 billion total consolidated assets and 12 at $50 billion or more. The SEC, in its comments on the proposed rule, provides estimates of the number of financial institutions subject to the jurisdiction of a number of the regulatory agencies (See Part V, B of the SEC release).
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[7] In its introduction to the proposed rule, the FDIC states,

No specific categories of employees are excluded from the scope of the Proposed Rule, although it is the underlying purpose of this rulemaking to address those incentive-based compensation arrangements for covered persons or groups of covered persons that encourage inappropriate risk because they provide excessive compensation or pose a risk of material financial loss to a covered financial institution.

It is expected that the regulators may have different definitions of “covered person,” reflecting the differences in the institutions they regulate. For example, while the FDIC version of the proposed rule is the same as the SEC’s, the NCUA excludes a “principal shareholder” since it regulates credit unions.
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[8] In Part III of its discussion, entitled “Section by Section Description of the Proposed Rule,” the FDIC states:

The definition is broad and principles-based to address the objectives of section 956 in a manner that provides for flexibility as forms of compensation evolve. The form of payment, whether it is cash, an equity award, or other property, does not affect whether compensation meets the definition of incentive-based compensation.

The introductory comments to the proposed rule note that not all types of compensation fall within the definition of “incentive-based compensation.” It cites exceptions such as salary and rewards for such non-risk-taking activities as achieving or maintaining a professional certification. Also, compensation arrangements based solely on an individual’s level of fixed compensation, such as employer contributions to a 401(k) plan based on a percentage of salary, would not be considered incentive-based compensation. Nor would dividends paid and appreciation realized on stock or other equity that the individual owns outright (i.e., stock not subject to vesting or deferral arrangements).
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[9] Proposed Rule Section 372.5(a)(2) directs that several factors be taken into account in determining whether an individual’s compensation is excessive, including (i) the combined value of all benefits provided (cash and non-cash), (ii) the individual’s compensation history and that of comparable employees, (iii) the financial condition of the institution in question, (iv) comparable compensation practices at other institutions comparable in size, location and complexity, (v) the projected cost and benefit of post-employment benefits, (vi) any connection between the individual and a fraudulent act, breach of trust or duty or insider abuse, and (vii) any other relevant factors. Precedent for this will be found in FDIA §39(c).
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[10] These three conditions to compliance were stated as the three basic principles of the Interagency Guidance published June 25, 2010.
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[11] The language in the introductory discussion of the proposed rule suggests that pro-rata vesting can occur on an annual basis (but not more frequently than that). It is not clear whether vesting may be accelerated upon the occurrence of terminations such as death, disability, termination without cause or by the executive for good reason.
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