In recent weeks the National Credit Union Administration (NCUA), Federal Deposit Insurance Corporation (FDIC), the Federal Housing Finance Agency (FHFA), the Office of the Comptroller of the Currency (OCC), the Federal Reserve Board of Governors (FRB), and the Securities and Exchange Commission (SEC) issued a notice of a proposed interagency rule1 on incentive compensation within covered financial services firms.2 The proposed rule is consistent across agencies and represents an update from a rule previously proposed in 2011 which was modified to address public comments and additional research.

A public comment period on the proposed rule will remain open until July 22, 2016. It will likely go into effect 18 months after the final rule is published.

Section 956 of the Dodd-Frank Act requires that these six federal agencies put forth a rule prohibiting incentive compensation plans that incentivize inappropriate conduct by a covered financial institution, either by providing excessive compensation or by allowing conduct that could lead to material financial losses. The intention of the proposed rule is to reinforce the ability of institutions to establish and maintain effective risk management and controls.3

Key Highlights of the 2016 Proposed Rule on Incentive Compensation4

Applicable Institutions

The proposed rule would be applicable to a wide range of financial institutions including depository institutions, brokerage firms, credit unions, investment advisers and, Fannie Mae and Freddie Mac. The requirements of the proposed rule have been tailored to the size of the covered institutions (see below).

Type Average Total Consolidated Assets (or subsidiaries of such institutions)
Level 1 Institutions $250 billion or greater
Level 2 Institutions $50 billion  up to $250 billion
Level 3 Institutions $1 billion up to $50 billion

The proposed rule would apply additional and/or more stringent requirements for Level 1 and Level 2 institutions. At these organizations, the proposed rule would require that incentive compensation plans for certain covered persons include deferral of payments and be subject to potential downward adjustments, forfeiture, and clawback.

In general, the most stringent requirements of the proposed rule apply to two types of employees at Level 1 and Level 2 institutions: “senior executive officers” and “significant risk-takers.” “Senior executive officers” are employees who perform one or more of the following functions:

· President · Chief lending officer
· Chief executive officer · Chief risk officer
· Executive chairman · Chief compliance officer
· Chief operating officer · Chief audit executive
· Chief financial officer · Chief credit officer
· Chief investment officer · Chief accounting officer
· Chief legal officer · Head of a major business line or control function

“Significant risk-takers” are individuals who receive incentive compensation that is equal to at least one-third of the total of base salary plus incentive compensation and meet either one of the following tests:

  • Has the authority to commit or expose .5% or more of the institution’s capital
  • Granted annual base salary plus incentive compensation among the top 5% (Level 1 institutions) or top 2% (Level 2 institutions) of all employees, excluding senior executive officers

In our view, by limiting the amount, vehicles and timing of the incentive compensation paid to employees in positions where their individual conduct may be linked to the institution’s overall financial health, the rule seeks to strengthen risk management and reduce the potential for an individual employee’s bad actions to materially harm the company.

New Policies and Procedures          

Level 1 and Level 2 institutions would be required to implement new policies and procedures consistent with and supporting the proposed rule. These policies specify the incentive compensation plan designs, specifically the substantive and procedural criteria for scenarios including forfeiture, clawback and vesting acceleration and the governance structure in place to manage and monitor incentive compensation.

Risk Management Framework

The proposed rule would require that Level 1 and Level 2 institutions implement a risk management framework for their incentive compensation programs that meets the following guidelines:

  1. Independent of any lines of business
  1. Includes an independent compliance program that provides for internal controls, testing, monitoring, and training with written policies and procedures
  1. Is commensurate with the size and complexity of the institution’s operations

The proposed rule would add a number of additional requirements for Level 1 and Level 2 institutions to confirm adherence to the spirit of the regulation. For example, these institutions would be required to ensure that jobs in control functions have sufficient authority to monitor and manage compensation-related risk. In addition, these firms must provide for independent monitoring of the compensation plans, documenting handling of downward adjustments, forfeiture and clawbacks to confirm alignment with the proposed rule and the institution’s own policies and procedures.

Governance

Unlike the 2011 proposed rule, the updated proposed rule would require Level 1 and Level 2 institutions to establish a compensation committee of independent, non-employee directors. The committee would be required to obtain input from the risk and audit committees and risk management function on the effectiveness of incentive-compensation risk management. This committee, or the board of directors, must oversee the institution’s incentive compensation plans for all employees, approve plan designs and award amounts for senior executive officers, and determine whether adjustments, forfeiture or clawbacks are required. Management would also be required to submit an annual assessment of the effectiveness of the institution’s incentive compensation program and related compliance and control processes.

Reporting Requirement

Under the proposed rule all covered institutions would be required to:

  1. Create records explaining the structure of all incentive compensation plans
  1. Demonstrate compliance with the proposed rule
  1. Maintain all such records for at least 7 years

Each institution’s appropriate Federal regulator could request the records for internal review, but otherwise records would not be disclosed. Level 1 and Level 2 institutions would have additional record keeping requirements to document any downward adjustments, forfeitures or clawbacks and track awards for senior executive officers and significant risk-takers.

Mandatory Deferrals of Incentive Compensation

Deferral of a percentage of incentive compensation would be required for select individuals at Level 1 and Level 2 institutions for a period of time following the end of the performance period. The proposed rule includes modifications for long-term incentive plans which already have multi-year waiting periods embedded in the performance period.5 Deferral is not required at Level 3 institutions.

Deferral Details (from end of performance period) Senior Executive Officers

 

Significant Risk-Takers
% of incentive compensation Deferral period % of incentive compensation Deferral period
Level 1 Institutions 60% 4 years 50% 4 years
Level 2 Institutions 50% 3 years 40% 3 years
Level 3 Institutions n/a n/a n/a n/a

Downward Adjustment and Forfeiture of Incentive Compensation Awards

The proposed rule requires that all unvested incentive-based compensation of any senior executive officer or significant risk-taker at a Level 1 or Level 2 institution be subject to forfeiture or downward adjustment.

Consideration of forfeiture or downward adjustment of incentive-based compensation would be required in the following situations:

  • Poor financial performance due to lack of adherence to established policies and procedures
  • Inappropriate conduct or risk-taking, regardless of the impact on financial performance
  • Material risk management or control failures
  • Non-compliance with regulatory standards resulting in enforcement or legal action brought by a regulator, or a requirement that the covered institution restate a financial statement
  • Other aspects of conduct or poor performance as defined by the covered institution

Clawbacks

Not included in the 2011 proposed rule, the revised rule would require that Level 1 and Level 2 covered institutions include clawback provisions in the incentive compensation arrangements for senior executive officers and significant risk-takers. These provisions would allow the institution to recoup incentive compensation from a current or former employee for seven years after the award vests, if the institution determines that the individual committed one or more of the following activities:

  • Misconduct that resulted in significant financial or reputational harm to the covered institution
  • Fraud
  • Intentional misrepresentation of the information used to determine his or her incentive compensation

The downward adjustment, forfeiture and clawback requirements of the proposed rule are designed to disincentivize inappropriate risky behavior, reducing conduct risk overall.

Implications

The proposed rule has broad implications for financial services firms and they are encouraged to act swiftly to perform the following actions:

  1. Assess the extent of the compliance gap between current compensation plans, policies and procedures and the proposed rule.
  1. As per requirements, redesign compensation plans to align with the proposed rule and offer appropriate balance of risk and reward required to meet business needs, attract, motivate and retain employees and promote a risk-based culture.
  1. As per the proposed rule, evaluate and modify select jobs within Compliance, Risk, and/or HR, including duties, reporting relationships, and independence, as needed, for  proper governance and controls, and to oversee incentive compensation plans in accordance with the proposed rule.
  1. Implement new/updated policies and procedures for ongoing record keeping, Management and Board reporting, and payout evaluation, outlining expected conduct at multiple employee levels and ensuring alignment with desired culture as per the requirements.
  1. Update Risk, Compliance, and Audit programs to carry out new policies and procedures, providing support for the board of directors/compensation committee to perform new required duties as per the requirements.
  1. As per the proposed rule, educate employees, leadership and the board of directors on the rule’s impact to both their compensation and their roles in ongoing risk management.
  1. Review/assess regulatory compliance and ability of related policies and procedures to limit conduct risk and promote an appropriate risk-based culture.

How Accenture Can Help

Human Resources (HR) functions are expected to be the drivers of compensation strategy within impacted Financial Services firms, with Risk and Compliance functions supporting alignment and soundness of new procedures and governance protocols.

Organizations are encouraged to complete a specific impact analysis of the new compensation rules inclusive of scenario modeling for compliance while improving performance management to maintain executive commitment, link new processes to desired culture, and put in place the proper governance processes.  It will be critical in our view for Financial Services firms to proactively define a comprehensive approach focused on maintaining key executive talent and aligning the performance management process to retain and engage impacted individuals.

Accenture has significant experience partnering with HR, Compliance and Risk functions to help define and shape strategies to reduce conduct risk and comply with the proposed rule.  Accenture is well equipped to assist clients in a number of key areas including assessment of current compliance gap, governance planning, policy development and communication, independent incentive plan monitoring, performance management, job design and enhancement, culture transformation, and organization design strategy.

References

  1. “Incentive-Based Compensation Arrangements,” Office of the Comptroller of the Currency, Federal Reserve System, Federal Deposit Insurance Corporation, Federal Housing Finance Agency, National Credit Union Administration, Securities and Exchange Commission, Notice of Proposed Rulemaking and Request for Comments, 17 CFR Part 303. Access at: https://www.ncua.gov/About/Documents/Agenda%20Items/AG20160421Item2b.pdf
  1. Section 956 defines the term “covered financial institution” to mean a depository institution; a depository institution holding company; a registered broker-dealer; a credit union; an investment adviser; Fannie Mae and Freddie Mac; and any other financial institution that the Agencies determine should be treated as a covered financial institution for purposes of section 956. This includes the U.S. operations of foreign banking organizations that are treated as bank holding companies pursuant to section 8(a) of the International Banking Act of 1978 (12 U.S.C. 3106). “Incentive-Based Compensation Arrangements,” Office of the Comptroller of the Currency, Federal Reserve System, Federal Deposit Insurance Corporation, Federal Housing Finance Agency, National Credit Union Administration, Securities and Exchange Commission, Notice of Proposed Rulemaking and Request for Comments, 17 CFR Part 303. Access at: https://www.ncua.gov/About/Documents/Agenda%20Items/AG20160421Item2b.pdf
  1. “Incentive-Based Compensation Arrangements,” Office of the Comptroller of the Currency, Federal Reserve System, Federal Deposit Insurance Corporation, Federal Housing Finance Agency, National Credit Union Administration, Securities and Exchange Commission, Notice of Proposed Rulemaking and Request for Comments, 17 CFR Part 303. Access at: https://www.ncua.gov/About/Documents/Agenda%20Items/AG20160421Item2b.pdf
  1. Ibid
  1. For Long-term incentive plans (incentive plans with performance periods of 3 or more years) the deferral period is reduced to two years from four years following the end of the performance period for Level 1 institutions and to one year from 3 years for Level 2 institutions. “Incentive-Based Compensation Arrangements,” Office of the Comptroller of the Currency, Federal Reserve System, Federal Deposit Insurance Corporation, Federal Housing Finance Agency, National Credit Union Administration, Securities and Exchange Commission, Notice of Proposed Rulemaking and Request for Comments, 17 CFR Part 303. Access at: https://www.ncua.gov/About/Documents/Agenda%20Items/AG20160421Item2b.pdf

Newsletter Author: Samantha Regan  Emily Berger

Newsletter Contact Person: Samantha Regan

Visit www.accenture.com/RegulatoryCompliance for latest insights on regulatory remediation and compliance transformation.

Disclaimer

This blog is intended for general informational purposes only, does not take into account the reader’s specific circumstances, may not reflect the most current developments, and is not intended to provide advice on specific circumstances. Accenture disclaims, to the fullest extent permitted by applicable law, all liability for the accuracy and completeness of the information in this blog and for any acts or omissions made based on such information. Accenture does not provide legal, regulatory, audit or tax advice. Readers are responsible for obtaining such advice from their own legal counsel or other licensed professional.

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