Interagency Proposed Rule on Incentive Compensation Arrangements

By Styskal, Wiese & Melchione

July 6, 2016

On Thursday, April 21, 2016, the NCUA Board was the first of the federal financial regulators to propose a new rule covering Incentive Compensation Arrangements as required under Dodd Frank. The prior proposal, issued in 2011, has been dormant since the agencies collectively received over 10,000 comments. We have been anticipating a new proposed rule, and so have continued to advise clients to expect something similar to the prior proposal to come forward at any time. This new Proposed Rule has comment period that will not end until July 22, 2016, and then an effective date 18 months after a Final Rule is published—in short, while these rules will not formally be applicable until Q2 2018 at the very earliest, education and preparation at the executive and Board level will be advisable.

This new proposal expands upon the prior Proposed Rule and includes additional clarifications. While it still focuses on excessive compensation and excessive risk, for institutions over $1 billion, it goes further to provide for governance and supervision processes that are intended to control for risk. For example, the new Proposed Rule would add specific guidelines for the type of review of performance necessary to appropriately balance risk and reward, including: both financial and non-financial measures of performance; allowing non-financial measures to override financial measures; being subject to adjustment to reflect losses, inappropriate risks, compliance, or other similar aspects of performance.

Luckily for most credit unions, the record-keeping, income deferral, forfeiture, and downward adjustment requirements of the Proposed Rule apply to institutions over $50 billion in assets. However, certain new prohibitions for institutions over $50 billion will be important “red flags” for all credit unions to attend to: personal compensation hedging, maximum compensation, performance measures relative to peer institutions or industry averages, and volume-driven incentive-based compensation. Similarly, the risk management, controls, and governance functions applicable only to institutions over $50 billion are excellent risk management practices, though may prove unworkable in smaller institutions.

It is worth noting also that the “clawback” and other forfeiture provisions in the Proposed Rule apply to a narrower band of circumstances than mere poor future financial performance—executives and risk-takers should take some comfort that clawbacks and forfeitures are reserved for actions outside of the institution’s established risk parameters, non-compliance with regulatory standards, or similar results. Clawbacks can also result from fraud or misrepresentation. This framework advances the governance framework long in the works for financial institutions—more detailed and thorough lending and investment policies that set risk parameters at the Board level.

Examples of additional areas in the Proposed Rule that merit attention by credit unions of all sizes include:

• The definition of “significant risk-taker” (non-senior executives at $50 billion and above institutions who are subject to the rule) applies to persons who receive annual base salary and incentive-based compensation of which at least one-third is incentive based, and who meet one of two threshold tests (based on relative compensation or exposure). Credit union examiners may build this level of incentive compensation into their red flags, regardless of asset size, for additional review.
• Downward adjustment and forfeiture rules for $50 billion and above institutions will require that all incentive compensation be at risk of forfeiture by employees, even compensation not from the performance period when losses attributable to the employees arose. This type of forfeiture is extremely favorable to the institution, and it will remain to be seen whether regulators begin to expect this type of ability to have downward adjustments where incentive pay reaches across multiple performance periods.

What is not present in the Proposed Rule is any relief for credit unions $1 billion and above from the prohibitions and regulations already contained in the NCUA’s rules, including 12 CFR 701.21(c)(8) regarding lending-based compensation, 12 CFR 721.7 regarding incidental powers, 12 CFR 701.23(g) regarding sale of eligible obligations, or 12 CFR 712.8 regarding compensation by CUSOs.