Incentive Compensation Considerations

By Styskal, Wiese & Melchione

January 28, 2013

While finalization of the NCUA’s Proposed Incentive Compensation Rule (required by Dodd-Frank) does not appear to be on the horizon yet, and by its terms will likely not apply to the vast majority of credit unions, a number of other regulations regarding incentive and other compensation restrict management’s freedom to design compensation plans for employees. Even in the absence of a final rule under Dodd-Frank, due to existing NCUA rules regulating compensation in specific contexts, a Board-approved Incentive Compensation Policy, including annual review of the Policy and Internal Controls by the Board, is highly advisable for credit unions of all sizes.

Three NCUA rules in particular restrict incentive compensation practices: Sections 701.21(c)(8) (regarding compensation in connection with lending activities, available here), 701.23(g) (regarding compensation in connection with sale or purchase of “eligible obligations,” available here), and 721.7 (regarding compensation related to incidental powers, available here). Each of these regulations allow for the payment of salary, the payment of incentives based on the overall financial performance of the credit union, and incentives to non-senior management employees under a Board-approved policy.

For example, if a credit union will provide its loan department with a pool of money from which to give discretionary bonuses to loan processors for their performance, that payment would be related to lending activity, and so prohibited under Section 701.21(c)(8) absent a Board-approved policy. Innocent, normal, and relatively low risk areas like this are often areas where credit unions inadvertently violate the NCUA’s rules.

We note also that one of the areas in which incentive compensation is regularly used, heavily regulated, and carefully scrutinized by examiners, is with mortgage loan officers. For example, under Regulation Z section 1026.36(d) (available here), mortgage loan originators cannot be compensated based on the terms of mortgage loan transactions (other than a fixed percentage of the amount of the loan or certain payments from overall mortgage lending profits). Additional restrictions apply under RESPA.

Beyond the restrictions noted above, existing NCUA rule 712.8 limits the ability of FCU senior management officials to receive compensation from CUSOs, conversion rules prohibit compensation based on conversion to a mutual savings bank, and merger rules require disclosure of material increases in compensation and benefits connected to a merger transaction. For more information on merger-related financial arrangements, see SW&M’s Emerging Issues on Merger Related Financial Arrangements.

With all of these rules in mind, development of Board policies regarding compensation are a necessary compliance step. A Compensation Policy can delegate to the CEO or senior management establishment of incentive programs within certain parameters, allowing some flexibility for management. However, the Policies must contain meaningful internal controls aspects, and provide for annual review by the Board. Compensation Policies, regardless of whether the credit union is below $1 billion in assets, should also include the touchstones of the Proposed Incentive Compensation Rule—mitigation of excessive risk, and prohibitions on excessive compensation.

If your credit union would like assistance with its compensation policies, SW&M would be pleased to assist.